In mid-June 2023, the EU Commission published an initial proposal for the regulation of ESG rating providers (“ESG Rating Regulation”). Agreement was reached on the final text of the Regulation in mid-April 2024 and since this now only needs to be ratified by the European Council, it can be assumed that the ESG Rating Regulation will come into force this year. We therefore want to take a closer look at why regulation of ESG rating providers is necessary, what the final Regulation should look like and how market participants should prepare.
What exactly are ESG ratings?
ESG ratings provide an assessment of the environmental, social and governance sustainability characteristics of a company. They assess, for example, how a company or financial product is exposed to sustainability features or what sustainability impact a company or financial product has on the outside world. ESG rating providers generally offer not only the ratings, but also the ESG data on which the ratings are based.
How are ESG ratings used and why should providers be regulated?
ESG ratings are used to assess sustainability risks. Investors and issuers of financial products are increasingly using ESG ratings as a basis for making informed and sustainable investment or financing decisions. For example, an investor can use an ESG rating to assess whether sustainability aspects represent a financial risk for a company in which the investor wishes to invest or, conversely, whether the company has a material impact on sustainability. Regulated institutions increasingly use ESG ratings for screening investments (e.g. the inclusion or exclusion of shares in a portfolio or fund), for post-investment analysis (e.g. assessing the sustainability of an investment product or fund) or for integrating ESG into investment strategies. ESG ratings are also used by companies to take operational risks into account. Ultimately, ESG ratings are therefore used for investment decisions and the allocation of capital.
Like credit ratings, ESG ratings therefore have considerable market power and influence on the functioning of the markets. Investors and consumers often place a high level of trust in them. It is to be expected that the market for ESG ratings will continue to grow considerably in the coming years. The aim of the planned regulation is therefore to increase the transparency of ESG rating methods and ensure the integrity of ESG rating providers, for example by avoiding conflicts of interest. This should improve the quality of ESG ratings.
What does the Regulation avoid?
The ESG Rating Regulation does not aim to harmonise rating methodologies. Providers of ESG ratings continue to have control over the data and methods they use. They must (in future) only be transparent in this respect.
Who exactly should the Regulation apply to?
ESG ratings issued and published by a European ESG rating provider or provided to regulated financial companies are to be covered by the ESG Rating Regulation. However, ESG ratings produced by regulated companies themselves for purely internal purposes (e.g. their own ESG ratings developed as part of risk management) or the provision of raw ESG data that has not been assessed and modelled should not be covered.
What should the Regulation look like?
In future, the provision of ESG ratings in the EU will be subject to authorisation by the European Securities and Markets Authority (ESMA). As part of the application for authorisation, the shareholder structure of the ESG rating provider, the suitability of its management and the methods used for the rating must be presented. Authorised ESG rating providers should be listed in an ESMA register.
In order to ensure the integrity of ESG rating activities, ESG rating providers must (i) ensure their independence and may not, for example, engage in advisory or investment activities or develop benchmarks, (ii) ensure that their employees are sufficiently qualified and free from insider conflicts, (iii) keep records of their activities, (iv) maintain complaints procedures, (v) observe outsourcing requirements, (vi) avoid conflicts of interest and (vii) fulfil transparency requirements and, in particular, publish information on their website, e.g. information on the environmental, social and governance factors and the use of AI for example, information on the rating methods used, data processes and data sources, the weighting of the three factors environment, social, governance and the use of AI.
As is always the case in supervisory law, a clear organisational structure, processes, and procedures, including written policies, must be in place and subject to regular review.
Who monitors compliance with the requirements?
As with credit rating agencies, ESG rating providers are to be supervised centrally by ESMA. To this end, the ESG Rating Regulation provides for the usual supervisory powers such as the submission of information, on-site inspections and sanctions, such as the withdrawal of authorisation or the imposition of fines. However, ESMA can rely on the national supervisory authorities to carry out supervisory measures.
Outlook and conclusion
Overall, regulation with the declared aim of increasing transparency regarding the data and methods used for ESG ratings would appear to be entirely welcome in view of their increasing market power.
Due to the advanced stage of the legislative process, we assume that the ESG Rating Regulation will come into force this year. Market participants that offer ratings with ESG characteristics should therefore prepare themselves now and check whether and to what extent they fall within the scope of the ESG Rating Regulation. Smaller market participants should pay particular attention to whether they can benefit from the simplifications of the ESG Rating Regulation and fall under a simplified supervisory regime. In this case, registration is sufficient instead of authorisation by ESMA.
Please contact us for further information or an informal discussion of the issues.
