The product classification in the revised SFDR does not allow for any ‘shades of green’. That is regrettable, because precisely such labels would make investment choices clearer for investors.
On 20 November, the European Commission published its long-awaited proposals to revise the Sustainable Finance Disclosure Regulation (SFDR), commonly referred to as SFDR 2.0. Much anticipation surrounded the revision of the product classification in particular.
Under the Commission’s proposal, SFDR 2.0 would introduce three new product categories. These are financial products that contribute to a transition objective (the new Article 7 ‘transition category’), financial products that incorporate sustainability factors into the investment process (the ‘ESG basics category’, the new Article 8), and financial products with an explicit sustainability objective (the ‘sustainable category’, the new Article 9).
All of these products would have to meet specific substantive criteria. For example, across all product categories, at least 70 percent of the investment portfolio must demonstrably align with the objective of the relevant category, such as transition or sustainability. In addition, all product categories must apply the Climate Transition Benchmarks and or the Paris-Aligned Benchmarks. This implies that certain non-sustainable investments must be excluded from portfolios in line with those benchmarks.
From information classification to label
The proposed product categories reveal two important shifts. First, the European Commission appears to be moving away from the original purpose of the SFDR classification system. That system was initially designed to indicate which disclosure obligations applied to a financial institution. Product classification was not intended to function as a label or quality mark. The new system, however, seems to move in that direction by introducing substantive requirements. A product may only be described as transition or sustainable if it meets the criteria set out under SFDR 2.0.
The average retail investor is unlikely to gain a clearer understanding of the three categories than under the current regime, especially now that the central concept of ‘sustainable investment’ is being removed from SFDR 2.0.
In that sense, the system appears closely aligned with the ESMA Guidelines on fund names using ESG or sustainability-related terms, published on 21 August 2024. In those guidelines, ESMA restricts the use of certain ESG and sustainability-related terms in fund names by prescribing substantive criteria, including the application of the Climate Transition Benchmarks and Paris-Aligned Benchmarks and the requirement that at least 80 percent of a fund’s investments meet environmental or social characteristics.
This points to a second underlying objective of the Commission’s proposal. The new product categories are explicitly aimed at combating greenwashing. Financial institutions may only make certain ESG claims if they meet the criteria of one of the product categories. This was also the core rationale behind ESMA’s fund name guidelines.
No new insight for investors
At first glance, this may seem sensible. However, the first question is whether the average investor will actually understand the new product categories. Even under the current classification system, it has not always been clear to retail investors what the different product categories represent. That issue does not appear to have been resolved under the proposed new framework.
Second, while the new product categories resemble a labeling system, they do not distinguish between different degrees of sustainability within a category. The system effectively operates on a pass-or-fail basis. A product either meets the criteria for the transition, ESG basics or sustainable label, or it does not. In that sense, the label is one-dimensional. ‘Shades of green’ are missing, along with the insight investors would need to make meaningful choices between products within the same category.
Whether a financial product within a given category is 70 percent or 100 percent green does not appear to be immediately visible, at least at first glance. This will partly depend on the design of the new product templates. An additional consequence is that the system does little to encourage financial institutions to improve the sustainability profile of their products over time.
Labeling based on ‘shades of green’
The criteria for the new SFDR 2.0 product categories will likely reduce greenwashing. That approach was already initiated by ESMA through its fund name guidelines and is therefore not entirely new. However, the broader goal of improving investor understanding of sustainable investing is not achieved through the new product categories. The average retail investor is unlikely to gain a clearer understanding of the three categories than under the current regime, especially now that the central concept of ‘sustainable investment’ is being removed from SFDR 2.0. Admittedly, that concept was open to multiple interpretations, but at least it stood for something.
A genuine labeling system based on ‘shades of green’ is still lacking. If the aim is to give retail investors greater insight and clearer choices within a given product category, additional labeling will be required. This could take the form of letters, numbers or color codes, similar to the energy labels used for household appliances. These are simple, familiar indicators that consumers readily understand. Such labels would do more to support sustainable investing by retail investors than the proposed product categories alone.
Randy Pattiselanno is legal and regulatory consultant at Projective Group.