The ESMA offices in Paris - the authority will have oversight of the new rules. ©ESMA

The European Parliament and Council announced at the beginning of February that they had reached a provisional agreement to finalise the regulation of ESG rating providers, which would bring positives and negatives to this process in terms of streamlining and the administration burden for fund operators.

This change could have wider effects as the regulations will formalise and regulate what has been, until now, a largely commercial process. These changes will likely be watched in other jurisdictions, including in the US, where many of the companies offering these products will be based, for possible launches of similar legislation.

“Increasing investor confidence through transparent and regulated ESG ratings can have a significant impact on our transition to a more socially responsible and sustainable future."

The changes included increased oversight and transparency of the methodologies underpinning the ratings. The Council said ESG ratings have an increasingly important impact on the operation of capital markets and investor trust in sustainable products.

“Increasing investor confidence through transparent and regulated ESG ratings can have a significant impact on our transition to a more socially responsible and sustainable future,” said Vincent Van Peteghem, Belgian Minister of Finance, on the changes proposed.

Rating providers have long been an issue of contention – largely around the availability of good data for fund operators to make good strategic and operational decisions, as well as cost and the geographic origination of the data.

In a 2022 paper from the Harvard Law School Forum on Corporate Governance, the authors were largely critical of the practice after studying the processes around it in the industry. “The data sources used to populate ratings models include public, quasi-public, and private data,” they said. Public data included company-reported filings with the SEC, company-produced sustainability reports, press releases, newswires, and media reports.

“Working with data sets such as these brings inherent problems. Three major challenges are completeness of data, standardisation, and consistency."

Quasi-public information includes data captured in government, regulatory, and NGO datasets. Non-public information might be provided by the company in response to solicited questionnaires.

“Working with data sets such as these brings inherent problems. Three major challenges are completeness of data, standardisation, and consistency,” they said.

The new European Council regulation would be designed to ease concerns around this issue. They would bring ESG ratings providers under the authority of European markets regulator the European Securities and Markets Authority (ESMA), said a press statement from the European Council. Under the new rules, ESG ratings providers operating in the European Union will be required to register with regulators and comply with strict conflict of interest policies, quality standards, and reporting rules.

The provisional political agreement is subject to approval by the Council and the Parliament before going through the formal adoption procedure. The regulation will start applying 18 months after it comes into force in mid-to-late 2025.

This development comes amidst rising criticism of overreliance on ESG ratings from investors in guiding sustainability-linked investment decisions, with the lack of regulatory guardrails raising concerns about potential greenwashing and risks from poor quality or unreliable ratings,” said FTI Consulting on the changes. “By authorising ESMA to supervise ratings providers directly, the regulation aims to stamp out opacity and inconsistent standards.”

It specified that smaller niche providers are likely to face heavier compliance burdens under the centralised oversight.

“However, exemptions are being considered during an initial transition period as a means of avoiding a reduction in competition,” said FTI in its analysis of the changes. “ESG ratings providers have long been the target of criticism, with the likes of Elon Musk, highlighting their inefficiencies in assessing company performance.”

The legislation specified that for small ESG ratings providers, the agreement also provides that if the conditions are met, ESMA “could decide to exempt an ESG rating provider from some of the requirements but only in duly justified cases and based on the nature, scale and complexity of the business of the ESG rating provider and the nature and range of the issuance of ESG ratings”.

It added that the agreement introduces as a principle a separation of business and activities, with a possibility for ESG ratings providers not to set up a separate legal entity for certain activities, provided that there is a clear separation between activities and that they put in place measures to avoid potential conflicts of interests.

However, this derogation would not apply to ESG rating providers that carry out consulting activities, audit activities, and credit rating activities. ESG rating providers may nevertheless develop benchmarks if ESMA considers that sufficient measures have been put in place to address conflicts of interest. 

 

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