Reliability of ESG ratings? How the EU plans to regulate ESG rating providers

On 13 June 2023, the European Commission published a proposal for regulating ESG rating providers. This draft EU Regulation (the Regulation) forms part of the last sustainable finance package to be issued by the EU prior to its elections in June 2024. The proposal is intended to introduce a common regulatory approach to enhance the integrity, transparency, responsibility, good governance and independence of ESG rating activities. 

The new proposal on ESG rating providers will have been long-awaited by many companies, investors and financial institutions, including for the purpose of M&A activities to obtain better initial ESG assessments on potential targets, fund management and creditworthiness assessments.

Consistent with any other ratings, ESG ratings respond to the need to provide an accurate measure of the increasingly important ESG themes. Generally, the strengths of external assessments through rating agencies lie in their ability to ensure risk sensitivity, professionalism and neutrality. They simplify complex information into easily understandable results that are accessible to everybody regardless of their background knowledge. This reduces significantly transaction costs for market participants. At present, the established credit rating agencies (CRAs) also incorporate ESG risk factors into their credit models to the extent that they assess such factors impact the creditworthiness of borrowers. Yet, credit ratings and ESG ratings differ in a number of aspects. While relatively new ESG ratings specialize in assessing the "sustainability" of companies, the well established credit ratings assess the default risk of a company, that can be influenced by ESG aspects. However, the ESG quality measurement of a company is a much more multifaceted and complex task compared to the estimation of credit risk.

Contrary to the unprecedented pace of adoption of ESG legislation by the EU, there is currently a lack of guidance and evaluation of specific ESG performance data that could serve as comparative tools. The result is that ESG ratings are widely used in practice but are often perceived as non-comparable, incomplete, methodologically unclear and lacking in audit integrity. A study by MIT from 2021 found that there was an average divergence rate between ESG rating activities of 39% (as compared to only 1% non-correlation in credit rating activities).

The new draft Regulation focuses on transparency and avoidance of conflict of interests to ensure that ESG ratings used in the EU are comparable and reliable and thereby facilitating the progress towards the goals of the Green Deal.

Scope

The proposed Regulation should apply to ESG ratings issued by rating providers operating in the EU, i.e. providing services in the EU. Only ESG ratings that are (i) disclosed publicly or that are (ii) distributed to regulated financial undertakings in the EU, or that fall under the Accounting Directive, or to EU or Member States’ public authorities, are captured by the Regulation. Private ratings or those produced by EU or Member States’ public authorities are not within the Regulation’s scope. The provision of raw ESG data that do not contain a rating element would also not qualify as an ESG rating under the Regulation.

Pursuant to the Regulation, an ESG rating means an opinion, a score or a combination of both, regarding (inter alia) an entity, a financial instrument, a financial product, or an undertaking’s ESG profile, that is based on an established methodology and defined ranking system of rating categories, and that are provided to third parties.

The Regulation would apply to ESG rating providers regardless of whether they are EU-domiciled or non-EU. Non-EU ESG rating providers may offer ESG ratings in the EU, for instance, where a positive decision on equivalence of the third-country regime has been taken by the European Commission or ESG ratings developed outside the EU may be endorsed by an authorised ESG ratings provider in the Union.

Framework

As supported by ESMA already in 2022 in the results of its Call for Evidence on ESG ratings, the proposal stipulates that ESMA will have direct authority over and supervision of ESG rating providers. ESMA will be able to authorise or withhold authorisation based on regulatory criteria and will oversee these providers through inspections, information requests, and fines for non-compliance (up to 10% of the total annual turnover of the ESG rating provider) and periodic penalty payments to compel ESG rating providers to comply with the Regulation.

The Regulation will establish a public register of authorised providers. In order to provide the public with an easy and centralized access to the relevant information, such information should be made available on the European Single Access Point (ESAP).

Obligations

Art. 14 of the proposed Regulation lays down a comprehensive list of general principles for ESG rating providers, which are (inter alia):

• ensure independence of the rating activities
• establish compliance systems that ensure adherence to the Regulation, including adoption and implementation of written policies and procedures
• use rating methodologies for the ESG ratings they provide that are rigorous, systematic, objective and capable of validation
• monitor and evaluate the adequacy and effectiveness of the systems, resources and procedures.

A particular focus is placed on the separation of rating businesses from other activities. Specifically, ESG rating providers shall not (amongst others) provide consulting activities to investors or undertakings, audit and insurance activities and shall not issue and sell credit ratings or develop benchmarks.

With regard to significant internal risk and governance structures, the proposed Regulation would require record-keeping of used information for five years and the establishment of complaints mechanisms. This should include the publication (via their website) of procedures for receiving, investigating and retaining records concerning complaints that are received. Complaints could be submitted in relation to, for example, the sources of data used for a specific ESG rating and the way in which the rating methodology has been applied.

Summary

In summary, this proposal has the potential of turning the provision of ESG ratings into a more credible service that should significantly reduce transaction costs in relevant markets. It remains to be seen how the draft Regulation will be treated over the legislative process. It is not anticipated that this proposal will be negotiated and adopted before the end of the 5-year political mandate of the current European Commission. Nonetheless, it was one of the final missing pieces of the EC’s sustainable finance commitments outlined in its action plan, and thus closes the current set of deliverables envisaged. The appetite of the new European Commission to push for the finalisation of this text will be important to ensure that the draft Regulation is brought to a conclusion, representing another important step in building expertise and know-how on sustainability issues at ESMA.