At first glance, the initiative of the European Securities and Markets Authority (ESMA) seems like a monstrosity: Not only do the words Environmental, Social, Governance, Impact and Sustainability serve as a category for sustainable funds, but also Transition.“ Under the new ESMA guidelines, funds with the word or related terms in their name are intended to accompany companies on a measurable path to sustainable change. As if the confusion wasn't already great enough! However, the guidelines finalised by ESMA in mid-May are a step in the right direction. The next EU Commission should do more work to formulate transition categories.

So far, the dispute has followed a familiar pattern. NGOs such as Urgewald, Facing Finance and Finanzwende criticise fund investments in controversial companies and sectors, and the similarity of ESG portfolios compared to the broad stock market. From the industry's point of view, however, „brown“, in other words not yet sustainable, companies also belong in a portfolio, so that fund management can encourage companies to change.

That might be a self serving viewpoint. But the categorisation makes sense in principle, as there are different views on what a sustainable fund should achieve. For some, it is about not generating returns via companies with controversial business models. This means screening out companies and sectors, such as weapons, tobacco, coal and the like.

Others want to achieve a positive impact through a sustainable orientation. In this case, it is right to invest in controversial but potentially transformative companies in order to exert influence as an owner. Both perspectives are coherent, but lead to opposing strategies. There must be different categories for them.

Despite the ESMA guidelines, regulation is still unclear. It is true that the EU Sustainable Finance Disclosure Regulation (SFDR) created two legal categories, via Article 8 („environmental or social characteristics’) and Article 9 („sustainable investments’). However, these are rather vague, and ESMA alone cannot close the gap. The legislator should do more. Requirements for a Transition category are necessary. Investment funds should provide evidence that they are actually committed to change. If the requirements were too loose, there would be a risk of a half-hearted implementation, and accusations of greenwashing would be inevitable.

It is debatable how the conflict of objectives between flexibility in capital investment and the resilience of the requirements should be resolved. The fund industry and finance industry critics will answer questions about the trade-off differently. However, not having clear categories is not an option as long as policymakers retain the obligation of funds to inquire about investors' sustainability preferences. If legislators push for sustainable investments in this way, they must create rules so that the term does not become arbitrary.

So far, Transition has mainly been associated with greenhouse gases. Energy giants, steelmakers, concrete makers, automotive companies and many others have to change in order to significantly reduce their emissions. In future, it will be important to subject other controversial issues to the same logic. This could include the monitoring of supply chains to prevent forced labour, the treatment of animals and the protection of biodiversity, consumer-friendly business policies, diversity in the workforce and much more.

The armaments industry will be a hot potato. Many sustainable funds avoid the industry, because the production and proliferation of weapons is controversial, even if they are used solely for deterrence and defence. But this is precisely why the visible presence of critical investors is important. A sustainable fund that also invests in armaments would require explanation. It should not be impossible to do.