The European Council announced today that it has reached an agreement on a proposal to regulate ESG ratings providers, bringing the providers under the authorization of European markets regulator ESMA, with new rules to increase transparency into the methodologies and models used by the providers, and to address the risk of conflicts of interest.
Calls to regulate the ESG ratings sector have increased in recent years, as investors increasingly integrate ESG considerations into the investment process, yet the activities and businesses of the providers are generally not covered by markets and securities regulators.
In early 2021, ESMA issued a letter to the European Commission’s financial services coordinator Mairead McGuinness, advising that the current unregulated status of the ESG ratings sector and the resulting lack of transparency posed a potential risk to investors. In July 2021, the Commission launched a new Sustainable Finance Strategy, which included a pledge to take action to improve the reliability, comparability and transparency of ESG ratings, and subsequently asked ESMA to begin examining the market participants.
In June 2023, the EU Commission unveiled a proposal for ESG ratings providers to be supervised by ESMA, to ensure quality and reliability, with requirements including the use of rigorous and objective methodologies, conflict of interest prevention, and improved transparency into methodologies, models and key rating assumptions.
The agreement will form the basis for the Council’s negotiating position with the EU Parliament on the European Commission proposal.
Under the Council’s proposed position, ESG ratings providers operating in the EU would be required to obtain an authorization from ESMA, while those established outside the EU would require an equivalence decision, an endorsement of their ESG ratings or a recognition.
While the Commission’s proposal required a separation of business activities such as consulting or credit ratings from ESG ratings, with ratings providers not allowed to provide these activities, Council’s position would not require separate legal entities for these activities, as long as the providers establish a clear distinction between the activities, and put in place measures to avoid conflicts of interest.
The Council’s position also includes a temporary optional three-year regime for smaller ESG ratings providers, with no supervisory fees paid to the regulator and lighter compliance requirements. After the three year period, the smaller providers would be required to comply with all of the regulations’ provisions, including the supervisory fees.
Negotiations on the new regulation between the EU Parliament and Council are expected to begin in early 2024.