Lawmakers in the European Parliament and Council announced today that they have reached a provisional agreement on a proposal to regulate ESG ratings providers, and introducing rules to increase the reliability and comparability of ESG ratings and prevent providers’ conflicts of interest.
The new regulation would bring ESG ratings providers under the authority of European markets regulator ESMA, with providers required to be authorized and supervised by the regulator, and to comply with transparency requirements into areas including methodologies used for ratings and sources of information.
The new agreement comes as pressure builds to regulate providers of ESG ratings and data, with demand for the services surging as investors increasingly integrate ESG considerations into the investment process, while 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.
Key aspects of the new agreement between the Council and Parliament include clarifications around the ESG ratings that fall under the scope of the regulation, with those included encompassing ratings that encompass environmental, social and human rights or governance factors.
The new regulation would require ESG ratings providers established in the EU to obtain an authorization from ESMA, and those established outside the EU required to be either endorsed by an EU-authorized provider, recognized based on quantitative criteria or subject to an equivalence decision based on dialogue between the providers’ country of origin’s authorities and ESMA, in order to operate in the EU.
The agreement also introduced a 3-year optional registration scheme for small ESG ratings providers, including exemption from paying ESMA supervisory fees, and lighter compliance and transparency requirements, but with full compliance and supervisory fees after the end of the 3 years.
While the Commission’s proposal required a separation of certain business activities from ESG ratings, with ratings providers not allowed to provide these activities, the agreement allows for providers to not set up separate legal entities for some activities, as long as there is a clear separation between these activities and the ESG ratings business, as well as measures put in place to avoid potential conflicts of interest, although these exceptions would not apply to ESG ratings providers that offer consulting, audit and credit rating activities.
Additional aspects of the new rules include a possibility for providers to offer separate environmental, social and governance ratings, but a requirement to detail the weightings of ‘E,’ ‘S,’ and ‘G’ factors if a single rating is provided, and a requirement for financial advisers that disclose ESG ratings as part of their marketing communications to include information about the methodologies used for the ratings on their website.
With the achievement of the provisional agreement, the new rules will need to be formally adopted by the EU Council and Parliament before officially entering into force, and will begin applying 18 months later.