In times of demand for rethinking regulation (see the upcoming EU simplification legislation), we ask how the Sustainable Finance Disclosure Regulation (SFDR) can really deliver on its promises. The SFDR belongs to the EU sustainable finance framework and sets out how financial market participants and financial advisors must disclose sustainability information. According to the European Commission, the SFDR contributes to one of the EU’s current political objectives, namely, to attract the private funding that enables Europe’s transition to a net-zero economy. However, we argue that in its current form, the SFDR is ill-suited to live up to this target.
Transparency vs. real change
A key outcome of the SFDR is the self-classification of financial products into Article 6, 8, and 9:
- Article 6 Funds: These have no specific sustainability focus.
- Article 8 Funds (aka. “light green” funds): These promote environmental or social characteristics but do not require sustainable investment as their primary goal.
- Article 9 Funds (aka. “dark green” funds): These funds have sustainable investment as their core objective and must invest in activities that contribute to environmental goals.
These definitions still leave a lot of room for interpretation despite further specifications on level 2 (SFDR Delegated Regulation) and level 3 (ESAs consolidated Q&As on the SFDR). In its current form, the SFDR mainly creates incentives to design products that focus their portfolios on large, publicly listed companies that meet certain sustainability KPIs. We argue that they do not encourage funds to optimize the contribution to the net-zero transition.
Where is capital the limiting factor?
A key challenge with the SFDR’s Articles 8 and 9 is that they only focus on the sustainability impact of portfolio companies, not the impact investment products have on these companies. To foster the net-zero transition, investment products would need to show how they either a) help green companies to grow faster or b) encourage companies to become greener. A key condition here is “additionality”: To have an impact, the investments must cause something that would not have happened otherwise.
Looking at the current academic knowledge, the two most promising pathways investors to have a positive impact are the following:
- Allocation of capital to green firms that are limited in their growth by the external financing conditions they face. Such conditions are mostly prevalent in young companies (e.g., start-ups), smaller companies (e.g., SMEs), early-stage infrastructure projects, and companies operating in emerging or developing economies. Access to capital is hardly a limiting factor to large established companies that are the main holdings of current Article 8 and 9 funds.
- Encouraging firms to become greener with shareholder engagement. For large and established companies, arguably the most impactful strategy to achieve impact is active engagement with companies - especially those that are not yet fully aligned with sustainability goals. This is precisely the strategy of dedicated engagement funds. Instead of only investing in green firms, they engage with "brown" firms to push them toward greener practices. However, with the strong focus on the greenness of holdings, and not on impact, the SFDR does not encourage such strategies.
Ideally, the SFDR would a) increase the capital flows to green economic activities where capital is truly a limiting factor and b) provide strong incentives for fund managers to use the rights and voice of shareholders to push companies to move faster towards a net-zero economy.
Simplifying regulation: “Do less but do it better.”
Currently, the SFDR leads to a flood of reporting requirements for investment products and provides little evidence of how increased (costly) reporting and transparency would lead to quicker progress toward a net-zero economy. We believe that the current reporting requirements could be substantially streamlined, with a focus on which metrics truly encourage greener behavior of firms or deliver orientation to end investors.
A less prescriptive and more dynamic system could also adopt a claims-based approach, ensuring that credible sustainability statements are backed with science-based justifications. A less prescriptive approach would also be more accommodating to financial innovations, a very welcome economic outcome.
From reporting framework to a true driver of real-world sustainability
In sum, while the SFDR has made important progress in improving transparency sustainability reporting, to drive real change, the regulation must:
- Encourage active shareholder engagement to improve the sustainability of “brown” firms.
- Prioritize high-impact investment in areas where capital is a limiting factor, especially for SMEs and venture capital and early-stage infrastructure.
- Simplify and refine disclosure metrics, focusing on real sustainability impact rather than bureaucratic compliance.
Nikolai Badenhoop is a legal scholar and leads the Leibniz Junior Research Group “Sustainable Finance Law in Europe” at SAFE.
Tatiana Farina is Head of the SAFE Policy Center.
Florian Heeb is Assistant Professor of Sustainable Finance at SAFE.
Loriana Pelizzon is Deputy Scientific Director and Department Director of “Financial Markets”.
Blog entries represent the authors’ personal opinion and do not necessarily reflect the views of the Leibniz Institute for Financial Research SAFE or its staff.
