New EU Regulation on ESG Ratings: What You Need to Know

On 24 April 2024, the European Parliament have adopted the Proposal for a regulation of the European Parliament and of the Council on the transparency and integrity of Environmental, Social and Governance (ESG) rating activities (the "Regulation"). ESG ratings provide an opinion on a company’s or a financial instrument’s sustainability profile, by assessing its exposure to sustainability risks. Similarly, to the role credit ratings play in relation to credit risk, ESG ratings, when functioning, can play a pivotal role on the operation of capital markets and on investor trust in sustainable products. The current limit of ESG ratings is the lack of transparency in the applied methodologies and lack of clarity on what the rating represents. The main consequence is the incomparability of ratings provided by different providers compare.

Achieving the objective of the European Green Deal to make Europe climate neutral by 2050, requires a shift in capital flows to sustainable activities. Reliable ESG ratings, combined with the other regulatory initiatives taken at European level (for example the Corporate Sustainability Reporting Directive and the EU Taxonomy), support this capital shift by rendering sustainable investments easier as potential investor can rely on a rating to assess the ESG profile of an investment which combined with other ESG labels (as for example the European Green Bond label) and adequate comparable disclosures, reduces the burden and cost of the investor undertaking detailed due diligence.

The Regulation aims to strengthen the reliability and comparability of ESG ratings by introducing a common regulatory approach improving the transparency and integrity of the operations of ESG ratings providers and preventing potential conflicts of interests.

Who does the Regulation apply to?

The Regulation applies to ESG ratings issued by ESG rating providers operating in the European Union, regardless of whether they are established inside or outside the Union.

The Regulation includes a list of situations where it will not apply where the absence of public distribution being the common denominator,

What are the key requirements of the Regulation

Registration: ESG rating providers established in the European Union need to be authorized by the European Securities and Markets Authority ("ESMA") to provide ESG ratings.

For those ESG rating providers established outside the European Union, there are three separate regimes available:

• Equivalence: for providers established and authorized or registered in a third country, where the European Commission granted a positive decision on equivalence of the third-country regime.
• Endorsement: An authorized ESG provider within the Union can endorse any ESG ratings, which comply with the Regulation, issued by any provider within its group.
• Recognition: where a small provider that do not meet the established thresholds can benefit from the recognition regime.

Quality and reliability: to ensure the quality and reliability of ESG ratings, ESG rating providers should use rating methodologies that are rigorous, systematic, independent, continuous, and capable of justification, and these shall be reviewed on an on-going basis and at least annually.

Transparency: ESG rating providers should disclose information to the public on the methodologies, models, and key rating assumptions, including the limitations of the analysis, and should explicitly disclose which dimension of the double materiality principle the rating addresses which enable users of ESG ratings to perform their own due diligence when assessing whether to rely or not on those ESG ratings.

Financial institutions transparency: financial institutions that disclose use of ESG ratings as part of their marketing communications, must include information on the methodologies used in these ratings on their website, under a planned change to the Sustainable Finance Disclosure Regulation.

Conflicts of interest: ESG rating providers should ensure that they provide ESG ratings that are independent, impartial, systematic and of adequate quality. To avoid potential conflicts of interest, ESG rating providers should not be allowed to offer within the same entity several other services, in addition to establishing appropriate internal policies and procedures for resolving potential conflicts of interest.

Separate E, S and G ratings: separate E, S and G ratings shall be provided rather than a single ESG metric that aggregates E, S and G factors. Where an aggregate ESG rating is issued then the provider shall disclose the weighting of the three overarching ESG factors categories.

Supervision: the Regulation establishes a supervisory regime giving ESMA, as supervisor, the power to request information, conduct investigations and inspections. In case of violations, ESMA can impose administrative sanctions and other measures, such as fines, periodic penalty payments, and disclosure of such actions, for breaches of the regulation.

When will the regulation apply?

The Regulation will be applicable 18 months after its entry into force.

Conclusion

In regulating ESG ratings and ESG rating providers, the EU is enhancing ESG ratings as a tool to influence investments (in the same way as credit ratings influence investment). Looking at this tool in the context of the EU Regulatory Framework on sustainable finance, ESG ratings are one of the tools to evaluate sustainability factors in investment decisions similarly to how investors evaluate credit risk. A parallelism can be drawn between the fundamental effects of the ESG Ratings Regulation to those of the Credit Ratings Regulation.