• Among the changes to the European Union’s Sustainable Finance Disclosure Regulation proposed by the European Commission in its November 2025 proposal (“SFDR 2”), a notable development is extensive new exclusion criteria for products making sustainability claims within one of the three new categories. These broadly cover asset classes which are excluded from benchmark indices under the European Union’s Paris-aligned Benchmarks.
• This Debevoise In Depth assesses these new exclusion criteria under SFDR 2 and their implications for asset managers.

The European Commission (the “Commission”) released in November 2025 its proposed amendments to the Sustainable Finance Disclosure Regulation (“SFDR 2”). SFDR 2 aims to create a labelling regime for funds that make different types of environmental or social claims, requiring funds to meet new criteria under three new sustainability categories, currently proposed as Article 7 “Transition”, Article 8 “ESG Basics” and Article 9 “Sustainable”. To qualify for those categories, funds need to comply with new minimum requirements, including sets of excluded investment categories—see the Appendix. These broadly cover asset classes which are excluded from benchmark indices under the European Union’s (“EU’s”) Paris-aligned Benchmarks. ESMA has applied a version of these exclusions to funds using ESG or sustainability-related terms in their names in its “ESMA Fund Names Guidelines”, although it is expected that these rules will be phased out when SFDR 2 applies. As a result of the mandatory exclusions, some private funds have removed environmental or social terms in their names. This Debevoise In Depth assesses the new exclusion screens under SFDR 2 and the implications for asset managers.

Origin of Exclusions

As above, the proposed exclusions in SFDR 2 derive from the EU’s standards for Paris-aligned Benchmarks, which are indices used to measure the climate-related performance of sets of companies. Under these standards, companies that derive more than a set percentage of their revenues from activities related to coal, oil, gas or electricity generation with a high greenhouse gas (“GHG”) intensity are excluded from the EU Paris-aligned Benchmarks, as well as companies involved in activities related to prohibited weapons or tobacco or companies that are found to have violated United Nations Global Compact (“UNGC”) principles or the Organisation for Economic Cooperation and Development (“OECD”) Guidelines for Multinational Enterprises. Indices under the Benchmarks Regulation DR comprise listed issuers, where benchmark administrators can obtain sufficient publicly available information to apply the exclusions.

Certain of the exclusions are linked to principal adverse impact indicators in the SFDR, namely companies involved in controversial weapons and companies and violations of UNGC Principles and OECD Guidelines for Multinational Enterprises.

Concerns Raised by Industry

Applying the set of mandatory exclusions to investments in equity or debt of privately owned companies has raised a number of significant issues. Under the Commission’s draft proposal for SFDR 2, exclusions do not apply to sovereign investments, such as government bonds. As SFDR 2 currently stands, the exclusions are “binary”: sponsors must ensure that the exclusions are not breached at the point of investment and must take steps to divest if an investee company subsequently falls within the exclusions list. As private equity and debt investments are typically illiquid, sale of an investment on the grounds that it falls within the exclusions list raises significant issues and will often not be in investors’ best interests, in particular where noncompliance arises from circumstances beyond the sponsor’s control, such as changes in the strategy of a portfolio company in which a fund holds a minority stake. The private equity industry lobby has suggested various qualifications directed at a regime where breaches of exclusion criteria which arise during the holding period and outside of the manager’s control do not automatically disqualify a product from its SFDR category unless the manager has failed to take all reasonable steps within its powers to remedy the breach. Under this regime, managers would use “best efforts” to comply with the exclusions, disclosing how they assess compliance and address breaches based on available information, materiality and their actual powers of influence and describing circumstances where divestment may not be feasible.

As an additional concern, framing the exclusion criteria by reference to a proportion of a company’s revenue raises the question as to whether the revenue needs to be generated by a company’s direct involvement in the restricted sector or whether a company that indirectly generates revenue from a sector—such as financing oil fuel projects, facilitating trading in oil fuels (for instance, through a software application) or otherwise providing a support service, such as engineering or equipment leasing, to the sector—is also in scope. Unless the Commission gives guidance on this point, it is a matter of judgement for the asset manager, with the conservative view being that a close link between the company’s business and the restricted sector—often the case where the company supplies a specialist product or service to the restricted sector—is sufficient for the exclusion to apply.

In the industry lobby following publication of the SFDR 2 proposals, there has been considerable concern about the exclusion for companies that derive 1% or more of their revenues from exploration, mining, extraction, distribution or refining of hard coal or lignite, which will apply to all funds within the new categories. For instance, investment in the energy transition may well include investment in companies, such as energy distribution infrastructure, where a small proportion of revenue is linked to coal, typically with a view to reducing that proportion over time. It is worth noting that, as proposed under SFDR 2, applying the coal and lignite exclusion to Article 7 (Transition) and Article 8 (ESG Basics) funds goes beyond the ESMA Fund Names Guidelines, which apply this exclusion to funds using environmental-, impact- or sustainability-related terms but not funds using transition-related terms.

Fund of funds investors obtaining exposure to underlying investee companies through primary or secondary transactions have long been wary of mandatory exclusions given the lack of control they can exercise over selection of underlying investee companies and lack of contractual privity with those companies. To some degree, fund of fund investors can incorporate restrictions, such as by including equivalent restrictions in side letters when they make a primary investment, although that requires negotiation on a case-by-case basis. It is not generally possible to obtain equivalent protections in a secondary investment. As a result, the industry lobby has encouraged the Commission to allow funds of funds to observe the applicable exclusions by various means, depending on their access to information about, and control of the portfolio of, the underlying funds and whether they are bound to integrate the exclusions into the documentation of the underlying fund or the investment documentation.

Conclusion

The Commission’s introduction of mandatory exclusion criteria is a development of its approach in the EU Benchmarks Regulation DR and ESMA Fund Names Guidelines. Mandatory and inflexible exclusions pose considerable problems for private fund sponsors, which may well pursue more specialist strategies, such as investment in energy transition infrastructure, where an exclusion can materially constrain the strategy. In addition, private funds may have smaller portfolios than funds that invest in liquid securities, have less—or less timely access to—relevant data and, in some strategies, such as debt or minority equity, have limited control of or opportunities for engagement with the investee company to prevent management taking decisions which may trigger a breach.

Appendix: Proposed Exclusion Categories