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The European Commission has paved the way for a potential overhaul of its sustainable financial disclosure regulation in an effort to make the rules a more effective tool to combat greenwashing.

The Sustainable Finance Disclosures Regulation (SFDR) requires financial market participants and advisers to tell investors their approach to sustainability risks that might affect investment values, and the potential impact of investments on the environment and society. It applies to both firms and specific products.

Designed to funnel capital to sustainable projects, the regulation has drawn criticism since it came into force in 2021 for not clearly defining sustainability.

The Commission last week launched a consultation seeking feedback on the law’s “potential shortcomings”, including “legal certainty, the useability of the regulation and its ability to play its part in tackling greenwashing”.

“The consultation raises a multitude of questions, some of which carry the potential to trigger a seismic shift from the SFDR as we otherwise know it today,” Terry Yiangou, managing associate in Linklaters’ financial regulation practice, tells GTR.

According to the Commission, the SFDR “does not force market participants to consider green criteria when investing” but instead requires them “to justify the sustainability claims that they make in relation to their financial products”.

One of the issues under consultation is disclosure requirements for products promoted as sustainable. “The SFDR was designed as a disclosure regime, but is being used as a labelling scheme, suggesting that there might be a demand for establishing sustainability product categories,” the Commission says.

Firms claiming their products are sustainable “need to disclose information to back up those claims and combat greenwashing”, the Commission says.

It adds that since this could be seen as “placing additional burden on products that factor in sustainability considerations”, it is looking into whether to make it easier for investors to also have “proportionate information on the sustainability profile of a product which does not make sustainability claims”.

Currently, article 9 of the regulation covers products with specific sustainable goals as their objective, while article 8 concerns products promoting environmental or social characteristics.

Yiangou says “the acknowledgement by the Commission that the terms ‘article 8’ and ‘article 9’ have inadvertently become de facto labels or marketing tools” raises the question of whether “concepts such as ‘[environmental/social] characteristics’ and ‘sustainable investments’ should be scrapped in favour of a dedicated categorisation system that instead focuses on a product’s type of investment strategy”.

This would be more like the UK sustainability disclosure requirements’ product labelling proposals, he adds.

Other questions focus on the cost of complying with the SFDR, difficulties obtaining good quality data and how the rules interact with other sustainability legislation, like the corporate sustainability reporting directive.

Yiangou says that combined with the other points raised by the Commission, such as “the potential for a product’s sustainability to be contingent on the sustainability of the entity managing it”, the consultation “collectively points towards a risk that the SFDR could be sent back to the drawing board”.

Earlier this month, the International Trade and Forfaiting Association announced it will set up a cross-industry body to create a set of common audit standards for ESG reporting in a bid to reduce the confusion over ESG regulation.

In June, the UK’s Financial Conduct Authority (FCA) also signalled its intention to crack down on greenwashing, writing to banks to say it was increasing its scrutiny of loans linked to sustainability targets.

The consultation is open until December 15.