ESG Matters: A new EU regulatory framework for ESG rating providers

Update
04.06.2024
In the June edition of ESG Matters, we discuss the new EU regulatory framework for ESG rating providers. Our Spotlight section brings you up to date with the latest developments in ESG governance, disclosure, financial regulation and litigation.

Highlight:

  • A new EU regulatory framework for ESG rating providers

    The number of available ESG ratings has grown rapidly in recent years, in response to investor demand for assistance in assessing the sustainability performance of potential investments. The European legislator is first to introduce a regulatory framework for entities that develop ESG ratings, so called ESG rating providers.

    ESG ratings – a wide variety
    ESG ratings show the sustainability performance of an entity or a financial instrument using a defined ranking system, e.g. a score between 0 and 100 or from A to D. There is a wide variety of information that these ratings provide and what they mean exactly. For example, ESG risk ratings assess a company’s exposure to and management of certain ESG risks. There are also ESG ratings that focus on a company's impact on the environment and society, and ESG ratings that assess compliance with certain (international) principles and guidelines.

    Although the name may suggest otherwise, ESG ratings are fundamentally different from ‘traditional’ credit ratings. Traditional credit ratings are opinions on the creditworthiness of an entity or a fixed-income security, often including ESG factors. However, the inclusion of ESG factors does not mean that such ratings fall within the scope of the term ‘ESG ratings’ (as covered by the new regulatory framework).

    EU regulation of ESG rating activities
    The proposed Regulation on transparency and integrity of Environmental, Social and Governance (ESG) rating activities introduces the first regulatory framework for ESG rating providers. It aims to improve ESG rating practices by introducing organisational rules and transparency requirements for ESG rating providers in response to concerns about (i) the lack of transparency on the characteristics of ESG ratings, their methodologies and their data sources; and (ii) the lack of clarity on the operations of ESG rating providers. The European Parliament adopted the proposal in April 2024 and the European Council has yet to formally adopt it.

    Scope of application
    The new regulatory framework applies to ratings issued by ESG rating providers operating in the EU. The scope of application is intended to be broad, with the definition of ESG ratings covering any opinion, score or combination of both on a ‘rated item’ (public and private entities and financial instruments that are to receive an ESG rating) with respect to the exposure of risks on or the impact on environmental, social and human rights or governance factors, based on both an established methodology and a defined ranking system of rating categories.

    The EU legislator aims to include ESG rating providers established inside and outside the EU territory by stipulating that an ESG rating provider established outside the EU is considered to operate in the EU if it issues and distributes its ratings by subscription or other contractual relationship to (i) EU regulated financial undertakings; (ii) EU companies falling within the scope of Directive 2013/34/EU; (iii) undertakings falling within the scope of Directive 2004/109/EC (publicly traded companies); and (iv) (parts of and entities related to) the EU and member states.

    Investor reliance on ESG ratings
    The proposed regulation explicitly states that the use of ESG ratings by investors is not regulated and that ESG rating providers must clearly and explicitly state that ESG ratings are their own opinions. It is therefore expected that (especially professional) investors will continue to have their own responsibilities in this regard. It is prudent for investors to also make their own assessment of the sustainability performance of a rated item.

    Organisational and transparency requirements
    The proposed regulation introduces rules on the organisation of ESG rating providers and the transparency of their rating methodologies. The rules are procedural in nature and do not affect the substance of the rating methodologies used.

    In terms of organisational requirements, it stipulates that ESG rating providers must ensure the independence of rating activities, that ESG ratings should be based on thorough analysis in accordance with the rating methodologies and that employees shall be properly trained and independent. It also requires a separation of activities: ESG rating providers may not be involved in e.g. advisory activities, the issuance and distribution of credit ratings (as defined in Regulation 1060/2009) and the development of benchmarks (as defined in Regulation 2016/1011). The latter rule may be particularly relevant for traditional credit rating that have developed ESG rating activities in recent years.

    In terms of transparency, the regulation includes rules on the disclosure of methodologies, models, and key rating assumptions used in ESG rating activities to the public and, in particular, to users of ESG ratings. It also requires ESG rating providers to provide separate E, S and G ratings rather than a single ESG metric that aggregates E, S and G factors. If ESG rating providers wish to provide an aggregated ESG rating, they must provide information on the weighting of the three overarching ESG factor categories and an explanation of the weighting methodology.

    Mandatory complaints mechanism and provision of datasets to rated items
    There are currently two types of business models for ESG rating providers: (i) the issuer-pays model (i.e. an entity pays an ESG rating provider to create an ESG rating); (ii) the subscription-based or user-paid model (i.e. the users (investors) pay an ESG rating provider for the use of ESG ratings mostly by means of paid subscriptions). While in the traditional credit rating market most credit ratings agencies employ an issuer pays model, the subscription-based model is more common in the ESG rating market.

    As a result, it is more common for an entity or its financial instruments to receive an unsolicited ESG rating without being consulted by the ESG rating provider. From this perspective, it is useful that the new proposal requires ESG rating providers to establish a complaints mechanism for rated items and entities (which can also be used by users). Furthermore, the proposal requires ESG rating providers to give a rated entity two working days’ notice before issuing an ESG rating and, upon request, to disclose the dataset used to produce the ESG rating, so that the rated entity has the opportunity to inform the ESG rating provider of any factual errors.

    ESMA supervision
    The EU legislator entrusts the European Securities and Markets Authority (ESMA) with the supervision on ESG rating providers. If ESMA finds that an ESG rating provider has infringed the Regulation, ESMA is empowered to take supervisory measures such as imposing fines, issuing public notices and withdrawing authorisation. If a legal entity wishes to operate as an ESG rating provider in the EU, it must apply to ESMA for authorisation (for legal entities established in the EU) or for equivalence, endorsement or recognition (for legal entities established outside the EU). In order to increase competition and reduce barriers to entry for new ESG rating providers, small ESG rating providers (which qualify as a small undertaking or a small group according to the criteria set out in Article 3 of Directive 2013/34) will temporarily benefit from a lighter supervisory regime.

    Next steps
    Once adopted by the Council, the regulation will enter into force on the 20th day following its publication in the Official Journal of the European Union. It will apply 18 months from its entry into force. Finally, parts of the regulation will be specified by regulatory technical standards to be developed by ESMA.

    What this means for you:

    • Investors: ratings can be useful tools and the Regulation may add to their reliability but be aware that the introduction of a regulatory framework for ESG ratings does not remove an investor's own responsibility to assess the sustainability performance of rated items and that reliance on ESG ratings alone should be avoided.
    • ‘Rated items’ (public and private entities and financial instruments that are the subject of ESG ratings): be aware of the possibility of unsolicited ESG ratings and put in place mechanisms to ensure a timely response to notification of the issuance of an ESG rating by an ESG rating provider.
    • ESG rating providers: (i) apply to ESMA in a timely manner for decisions on authorisation, equivalence, endorsement or recognition; (ii) adapt the business to the organisational and transparency requirements, and in particular consider whether separation of activities may be necessary and put in place complaint handling mechanisms.

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