European Parliament and Council in Agreement to Regulate ESG Rating Providers

In recent years, the corporate world has witnessed a notable paradigm shift, moving away from the traditional pursuit of growth and profit maximisation to embracing a more sustainable business model. This evolved approach acknowledges the significance of business profitability while integrating it with societal objectives related to sustainable development, including but not limited to, environmental conservation, human rights protection and good governance.

The notion of sustainable development within the corporate landscape is intimately intertwined with the relatively recent notion of Environmental, Social and Governance (ESG) criteria. These criteria demand that companies not only mitigate their negative effects but also actively strive to exert a positive impact on the environment and society as a whole. In this way, these criteria set a standard for a company’s conduct, rendering it more attractive in the eyes of investors and customers. This advantage has brought about an increasing demand for ESG motivated services and has fuelled recent pressure directed towards the EU to regulate ESG rating and data providers. ESG ratings play a crucial role in measuring a company’s ESG performance, providing investors with the opportunity to scrutinise the company’s operational efficiency and sustainability and as a result, make informed decisions related to investment strategies and risk management.

On 5th February 2024, the European Parliament and Council reached a provisional agreement on a proposal to govern ESG rating providers, with the objective of ensuring the trustworthiness and consistency of these ESG ratings and mitigating any potential conflicts of interest on the part of the providers. The cornerstone of these new rules involves incorporating ESG rating providers within the oversight of the European Securities and Markets Authority (ESMA). This means that providers are subject to the authority and supervision of this regulator, whilst also fulfilling transparency requisites in relation to the methodologies employed for ratings and the sources of data used in establishing these ratings. The agreement also expounds on when a rating provider will be considered to be established in the EU and thus, requiring authorisation from ESMA. On the other hand, ESG rating providers operating outside the EU must either be authorised by an EU-authorised provider, meet specific quantitative criteria for recognition, or be subjected to an equivalence decision resulting from discussions between ESMA and the competent authority pertaining to the provider’s country of origin to be able to conduct operations within the EU.

Moreover, the preliminary agreement specifies the ESG ratings falling within the remit of the regulations. These include ratings that envisage environmental, social and human rights or governance elements. Providers are allowed to furnish individual environmental, social and governance ratings, yet if a single rating is given, the weighting assigned to such rating must be provided. The provisional agreement also obliges financial market participants or financial advisers that divulge ESG ratings in their marketing communications to provide details about the methodologies employed for the ratings on their website. Further efforts to enhance transparency in this domain include ensuring the separation of business activities of ESG rating providers. While ESG rating providers engaged in other lines of business are not mandated to set up various legal entities to separate their business activities, a clear line of distinction between their specific ESG rating business and other business activities must be set. These exceptions are inapplicable to ESG rating providers providing consulting, audit and credit rating services.

The rules also propose a three-year optional registration scheme tailored for small ESG rating providers. Despite still being subjected to ESMA’s surveillance, this scheme envisages lower ESMA supervisory fees and entails less onerous compliance and transparency requirements. However, once the three years have elapsed, such small ESG rating providers must comply with all the rules and pay compliance and supervisory fees in full.

This provisional agreement marks a significant step towards enhancing integrity among ESG rating providers, which in turn bolsters investor confidence in sustainable products. However, prior to officially coming into effect, the new rules must be formally adopted by the EU Council and Parliament. Subsequently, they will start to apply 18 months after formal adoption.