EU’s sustainable finance disclosure regulation: does the hybrid reporting regime undermine the goal to reorient capital to climate action?

Disclosure and reporting are cornerstones of the European Union’s sustainable finance agenda with the goals of reorienting capital flows towards climate and other sustainable investments and minimizing greenwashing. A key component of the regulatory framework is the Sustainable Finance Disclosure Regulation (SFDR), which requires fund managers to calculate and disclose a ‘sustainable investment’ (SI) percentage, aggregating exposure to activities contributing to climate mitigation and adaptation and the other environmental and social sustainability objectives of the European Union. In turn, financial advisors must use SI percentages when advising customers under the Markets in Financial Instruments Directive II. Defining ‘sustainable investments’ in a robust and consistent way is crucial to the effectiveness of SFDR. Based on a review of the regulatory texts and financial sector participant observations this policy analysis article explores the overlapping guidelines framing how market participants are allowed to define sustainable investments, and the implications for achieving the goals of the sustainable finance agenda. The analysis suggests that the ‘unintentionally hybrid’ SFDR regime may perversely incentivize fund managers to forgo the use of the highly detailed EU Taxonomy rules-based approach that precisely defines climate-related ‘substantial contributions’ and apply the vague principles-based approach found in SFDR Article 2.17. This would allow each financial actor to define and determine independently what constitutes a sustainable investment, circumventing the robust, if imperfect, climate-related rules of the EU Taxonomy. The SFDR regime therefore risks undermining the European Commission’s stated goals of increasing capital allocation to sustainable activities and eliminating greenwashing.Key policy insights: A sustainability disclosure regime allowing the choice between robust rules and vague principles risks creating opportunities for greenwashing and reduced comparability.Fund managers are likely to select definitions that are least difficult to apply and maximize Sustainable Investment percentages.The current EU regime risks tacitly sanctioning the use of weak metrics, in turn slowing the reorientation of capital towards climate-related and other sustainable investments.The EU must at a minimum provide binding guidance on interpreting Article 2.17, require equal prominence for both SI percentages and EU Taxonomy-alignment scores, as well as address the usability issues of the existing Taxonomy.