Introduction of an EU regulatory framework for ESG rating agencies

On 13 June 2023, the European Commission (EC) published a sustainable finance package, part of which relates to the introduction of regulatory framework for Environmental, Social and Governance (ESG) rating agencies.

ESG ratings are used to make informed investment and financing decisions. More than a tool to assess sustainability risks or performance of an investment activity, ESG ratings play an important role in the market soundness and trust of investors and consumers in sustainable finance.

The proposal for a regulation on the transparency and integrity ESG rating activities (the Proposal) underlines the importance of regulating and giving a framework to ESG ratings in the European Union (EU). Its general objective is the improvement of the quality of ESG ratings to enable investors to make better informed investment decisions with regards to sustainability objectives and to contribute to the prevention of greenwashing.

The Proposal would apply to ESG ratings issued by rating providers operating in the EU that are disclosed publicly or distributed to regulated financial undertakings in the EU (credit institutions, investment firms, AIFMs, UCITS ManCos, insurance and reinsurance undertakings, AIFs, UCITS), undertakings that fall under the scope of Directive 2013/34, or Union or Member States public authorities. It would, inter alia, exclude private ESG ratings, ESG ratings used for in-house and internal purposes, or credit ratings.

The Proposal defines “ESG ratings” as “an opinion, a score or a combination of both, regarding an entity, a financial instrument, a financial product, or an undertaking’s ESG profile or characteristics or exposure to ESG risks or the impact on people, society and the environment, that are based on an established methodology and defined ranking system of rating categories and that are provided to third parties, irrespective of whether such ESG rating is explicitly labelled as ‘rating’ or ‘ESG score”.

The present publication aims at highlighting the main features of the Proposal.

Authorization and supervision of ESG rating agencies by ESMA

Any legal person established in the EU who wishes to provide ESG ratings shall be subject to an authorization issued by the European Securities and Markets Authority (ESMA).

Third-country ESG rating providers have the possibility to provide ratings, subject to either of the following: 

• an implementing/equivalence decision for third-country ESG rating providers;
• an authorization for endorsement for third-country ESG rating providers; or
• a recognition of third-country ESG rating providers.

ESMA plays an important supervising role and can, inter alia:

• take supervisory measures, for instance, to withdraw or suspend the authorisation;
• impose fines (max amount: 10% of total annual net turnover) or periodic penalty payments;
• request for general information;
• conduct all necessary investigations; and
• conduct all necessary on-site inspections .

Addressing transparency and reliability issues of ESG ratings

The current ESG rating market has a huge impact on the operation of capital markets and on investor confidence towards sustainable products but suffers from deficiencies and is not functioning properly. Investors' and rated entities' needs for ESG ratings are not being satisfied, which undermines trust in ratings. This is mainly driven by a lack of transparency on the characteristics of ESG ratings, their methodologies, and their data sources, but also a lack of clarity of how ESG rating providers operate, leading to investors, users and rated entities being unable to take informed decisions as regards ESG-related risks, impacts and opportunities

The Proposal puts forwards several potential solutions to those issues:

• Improving transparency of ESG ratings characteristics and methodologies: ESG rating providers are subject to transparency requirements and should disclose information to the public on the methodologies, models and key rating assumptions used in their ESG rating activities, including inter alia, whether and how the methodologies are based on scientific evidence, or if the ratings clearly mention whether they assess risks, impacts or some other dimensions. ESG rating providers should also notably publish key information about ESG rating characteristics and methodologies, and disclose granular methodological information to their subscribers and to rated entities.
• Ensuring increased clarity on operations of ESG rating providers: the Proposal set out a number of organisational requirements, processes and documents concerning governance that ESG rating providers should comply with. For instance, ESG rating providers shall ensure the independence of their ratings activities, including from all political and economic influences or constraints, and ESG rating providers shall not provide consulting activities to investors or undertakings.
• Preventing risks of conflicts of interest at ESG rating providers’ level: the Proposal enables rated entities to take informed decisions about managing ESG risks and the impact of their operations. Ensuring that the ESG rating providers operate in a way that promotes trust and confidence in their work is equally important, by ensuring that ESG rating providers manage and prevent conflicts of interest, and that the market functions effectively.
• Preventing the risk of unintentional greenwashing: while relying on ratings provided by ESG rating agencies as part of their decision-making process, market players face a risk of unintentional greenwashing when ratings are not sufficiently transparent or accurate. This greenwashing risk is often combined with the risk of misalignment of investments. By including minimum transparency towards the public, the Proposal aims at improving investors’ protection, especially retail, against potential greenwashing.

What’s next

The Proposal will go through the EU ordinary legislative procedure and still needs to be reviewed by the European Parliament and the Council of the European Union. It shall enter into force on the 20^th day as from publication in the Official Journal of the European Union and shall apply 6 months after its entry into force.

If you have any questions on this topic, please do not hesitate to reach out to our ESG experts Aurélien Hollard, Julie Pelcé, Julien Robert or Nicolas Lorgé for more information.