In his second regular column for IPE, Frédéric Ducoulombier of EDHEC Climate Institute argues that a credible categorisation-based SFDR system should require product manufacturers to substantiate how products deserve the category they claim
Regulators have approached the disciplining of sustainability claims in three ways: leaving them to general investor-protection rules, establishing terminology and mandatory disclosures, or creating product categories. These choices are consequential: once regulators define the language and framework through which sustainability considerations are communicated, they give that structure meaning and must assume responsibility for the claims it enables and the expectations it creates.
The EU Sustainable Finance Disclosure Regulation (SFDR) introduced a common vocabulary and extensive sustainability-related disclosures. It aimed to provide investors with comparable and decision-useful information, protect them against misleading claims, and help direct capital towards the transition of the economy.
Five years of experience suggest that detailed sustainability-related information plays only a limited role in investor choice, while the repurposing of SFDR disclosure categories as product labels reveals a demand for simple signposting.
Higher stakes
The European Commission’s response is to simplify disclosures and replace these unintended and potentially misleading labels with product categories backed by minimum qualification criteria. While this corrects a misuse and may improve investor orientation, it shifts the focus of the framework from disclosure towards categorisation and raises the stakes for the regulator.
Categories perform much of the communicative work before any product-specific claim is made. Official categories create legitimate expectations among distributors and investors and invite reliance on categorisation as a substitute for scrutiny. Evocative category names increase the likelihood of category errors, in which the classification is confused with the underlying reality: an investor may assume that a ‘Sustainable’ product finances sustainable activities, or that investment in a ‘Transition’ product supports the transition. This becomes consequential where categories are not faithful representations of what qualifying products do and can reasonably achieve.
The classification system must therefore support the meanings and expectations it creates. Otherwise, instead of mitigating greenwashing, it risks institutionalising it.
“A coherence test would help protect the integrity of product categories in the SFDR framework”
The proposed SFDR revision addresses this challenge primarily through category-specific qualification criteria. Criteria are indispensable. They provide legal certainty, comparability and supervisory efficiency by establishing observable conditions for category membership.
Their calibration reflects a welcome pragmatism. By allowing multiple investment approaches to count towards a minimum investment threshold, the framework recognises that different approaches may contribute to category objectives through different channels, accommodates products developed under the current regime and remains open to innovation through a route for “other” investments.
Different products may comply with the same criteria while relying on mechanisms whose contribution to the category objective, channels of action and likely effectiveness remain unspecified and, in some cases, far from obvious. The proposal addresses the risks inherent in this plasticity only marginally, requiring justification of how a product credibly contributes to category objectives only for exceptional qualification routes.
Beyond criteria
While criteria can test compliance with the letter of the framework, process-based justification, if properly substantiated, can be used to test coherence with its purpose. A credible categorisation regime requires both.
Products should therefore explain how the objectives they pursue reflect those represented by the category they claim; how their investment strategies and their implementation pursue those objectives; why their performance indicators are relevant; and, where real-economy effects are invoked, why those effects are plausible.
Such a coherence test would provide the process-based substantiation missing from the SFDR framework as a general requirement and, together with criteria-based qualification, help protect the integrity of the categories. It would also preserve their usefulness as first-level signposts while allowing investors to access product information supporting more informed allocation decisions within each category.
Learning mechanisms
This enhanced substantiation is not intended to trigger a one-off clean-up of sustainability-themed products. Political, commercial and practical considerations may justify the continued marketing of approaches whose present contribution remains limited or uncertain. But neither mere existence nor previous regulatory endorsement should entitle them to permanent protection. Transparent substantiation, ongoing monitoring and market discipline should allow products to evolve over time, supporting a genuine transition towards approaches that can demonstrate their fitness for purpose.
Transparency is not only necessary for investor decision-making, but also functions as a learning mechanism. When grounded in process-based substantiation, it improves categorised products by promoting greater coherence between objectives, strategies, mechanisms and indicators, and by forcing clarity about effectiveness and limitations.
But it can also prompt the reassessment of investment approaches and categorisation rules and, beyond that, inform the strengthening of the sustainable-finance framework by highlighting constraints and limitations in the informational foundations on which financial products and institutions build or stemming from the prudential and fiduciary rules that shape the mandatory integration of sustainability considerations. In this way, transparency may help the financial system adjust its design to the objectives set by legislators.
The same mechanisms can inform learning beyond finance. The transition towards a more sustainable and resilient economy is driven by changes in public policies, technology and societal norms. Finance can support or hinder it but cannot manufacture it. Honest disclosure of its contribution, limits and constraints protects against its use for systemic greenwashing, whereby financial representations sustain an appearance of progress while real-economy reforms and transformations are delayed. By clarifying where obstacles and responsibilities lie, transparency can pinpoint which real-economy changes need to materialise for the transition to proceed with the support of finance.
The introduction of product categories can be an opportunity for sustainable finance to come of age: to refuse to play a part in a performance of transition that substitutes for real delivery, to explain honestly what finance can and cannot do, and to identify clearly when responsibilities and reforms lie elsewhere.
Frédéric Ducoulombier is programme director, climate regulation and policies, at EDHEC Climate Institute
