On December 20, 2023, the Council of the EU established its negotiation stance on a proposed regulation for Environmental, Social, and Governance (ESG) ratings. This proposal is a response to growing concerns about the reliability, comparability, and transparency of ESG ratings and the data underpinning them. These concerns have been raised by various stakeholders, leading to an increased demand for regulatory oversight in this area.
In early 2021, the European Securities and Markets Authority (ESMA) highlighted these concerns. In a letter to Mairead McGuinness, the European Commission’s financial services coordinator, ESMA pointed out the risks posed by the unregulated status of the ESG ratings sector, particularly regarding transparency issues and the potential risks to investors.
Responding to these concerns, in July 2021, the European Commission launched a new Sustainable Finance Strategy. This strategy included a commitment to address the issues surrounding ESG ratings, aiming to enhance their reliability, comparability, and transparency. The Commission subsequently tasked ESMA with examining the market participants involved in ESG ratings.
In June 2023, the EU Commission took a significant step by proposing that ESG ratings providers be supervised by ESMA. This supervision is intended to ensure the quality and reliability of ESG ratings. Key requirements outlined in the proposal include the use of rigorous and objective methodologies, the prevention of conflicts of interest, and enhanced transparency regarding methodologies, models, and key assumptions used in ratings.
Understanding ESG Ratings
ESG ratings are objective evaluations of the environmental, social, and governance performance and exposures of entities, financial instruments, or products. These ratings serve to inform market participants about the ESG-related aspects of what they’re investing in or engaging with. With the growing emphasis on sustainability and ethical considerations in investment and business practices, ESG ratings have become crucial for investors and other stakeholders in making informed decisions.
Various agencies today provide ESG ratings, notable ones including MSCI and Sustainalytics. However, these agencies currently operate without a regulatory framework specific to ESG ratings, leading to a lack of standardization. This situation has resulted in ratings that are difficult to compare due to divergent methodologies and frameworks, as well as reliability issues due to the unregulated nature of disclosures by these agencies. As a consequence, ESG ratings attributed by these agencies have faced increased scrutiny.
The Proposed EU Regulation on ESG Ratings
In response to these issues, the EU’s Proposed Regulation aims to create a standardized and regulated environment for ESG ratings. By establishing a regulatory framework, the EU intends to enhance the reliability, comparability, and transparency of ESG ratings. This regulation would mandate specific standards and practices for rating agencies to follow, likely impacting how they develop and apply ESG ratings.
The move to regulate ESG ratings is expected to have significant implications. For rating agencies, it will mean adapting to new regulatory requirements and possibly altering their methodologies. For investors and other market participants, it should lead to more reliable and comparable information, facilitating better-informed decisions. Overall, the regulation aims to foster a more transparent and trustworthy ESG rating ecosystem, aligning with broader goals of promoting sustainable and ethical practices in finance and business.
Changes agreed upon by the EU Council
The Council’s negotiating mandate has provided further clarity and detail on the circumstances under which ESG ratings fall under the scope of the new EU regulation, including specific exemptions and additional details related to the corporate sustainable reporting directive. This clarification is pivotal in understanding how the regulation will be applied and who it will affect.
Requirements for ESG Rating Providers
ESG rating providers wishing to operate within the EU will need to meet certain conditions:
- Authorisation and Recognition: They must obtain authorization from the European Securities and Markets Authority (ESMA), or, if they are established outside the EU, they must obtain an equivalence decision, endorsement of their ESG ratings, or recognition.
- Territorial Scope: The Council clarified what constitutes operating within the EU, ensuring that the regulation is applied appropriately and fairly across different jurisdictions.
- Endorsement Regime: Additional clarification was provided on the applicable provisions under the endorsement regime, outlining how ESG ratings from outside the EU can be used within the Union.
Temporary Registration Regime for Small Providers
Recognizing the impact of stringent regulations on small market players, the Council introduced a lighter, temporary, and optional registration regime lasting three years for existing small ESG rating providers and new small market entrants. This regime offers:
- Exemption from ESMA supervisory fees.
- A requirement to adhere to general organizational and governance principles, along with transparency requirements.
- Subjection to ESMA’s powers for information requests, investigations, and on-site inspections.
Separation of Business Activities
To address potential conflicts of interest, the Council introduced provisions regarding the separation of business activities. It allowed for ESG ratings providers to not have a separate legal entity for certain activities, provided there is a clear distinction and measures in place to avoid conflicts of interest. However, this derogation does not apply to consulting or audit activities provided to rated entities, maintaining stringent separation where it’s most critical.
Next Steps for the Proposed EU Regulation on ESG Ratings
The journey of the Proposed EU Regulation on ESG ratings is currently in a crucial phase. The European Parliament, the Council of the EU, and the European Commission are working towards a consensus on the final text of the regulation. This tripartite agreement is a standard legislative procedure in the EU for creating new regulations and directives.
In parallel to these discussions, the European Securities and Markets Authority (ESMA) is developing regulatory technical standards. These standards are crucial as they will provide detailed instructions and criteria for becoming an authorized ESG ratings provider. This development indicates that the EU is not just focusing on establishing a regulatory framework but also ensuring that the framework is comprehensive, with clear guidelines for implementation.
Once the text of the Proposed EU Regulation is finalized and agreed upon, it will be published in the Official Journal of the EU. The regulation will enter into force 20 days after this publication. However, there will be a six-month period before the regulation takes effect, allowing for a transitional phase for entities to adapt to the new requirements.
Regarding the UK’s stance, while the government has not officially published its response to the UK Consultation on similar matters, indications suggest that this response will be provided soon, likely early 2024. The UK’s approach will be particularly noteworthy given its significant financial market and the implications of such regulations on cross-border investments and companies operating both within the UK and the EU.