The European Commission has released proposals to regulate ESG ratings providers in a move which could cause a fracturing of industry majors' operations.
The proposals form part of a new package of sustainable finance measures released yesterday (13 June), which also include an expansion of the criteria for environmental activities to qualify under the EU Taxonomy, and a focus on facilitating transition finance activities.
The Commission cited a market for ESG ratings which "suffers from a lack of transparency" as the motivation for additional oversight, discussions for which will now commence with the European Parliament and Council. Limited detail has been given regarding expected timescales.
Concerns over conflicts of interest among providers who sell consulting services, credit ratings and benchmark development will see the sector supervised by the European Securities and Markets Authority (ESMA) going forward, with breaches of any new rules set to incur fines of up to 10% of annual net turnover.
Lorraine Johnston, financial regulatory partner at law firm Ashurst, said the close ties between the areas meant the "crackdown" was "to be expected".
She added: "It follows shortly on the heels of the regulation of credit rating providers and benchmark administrators - but, in this instance, the regulation of ESG ratings is in anticipation of a scandal, rather than after any event."
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Mairead McGuinness, European commissioner for financial services, financial stability and capital markets union, said: "We have the foundations of the sustainable finance framework in place. Now is time to build on them […] We are bringing more transparency and integrity to the market by introducing rules on the operations of ESG ratings agencies."
In seeking transparency rather than standardisation of ESG ratings, the new package affirms one side of an ongoing industry debate regarding the comparability of scores.
In an interview with Sustainable Investment, Elizabeth Gillam, head of EU government relations and public policy at Invesco, noted the sector should be "careful" in criticising a market of uncorrelated ESG ratings.
She said: "I challenge those who say that ESG ratings should become as closely correlated as credit ratings - there are very legitimate reasons why different providers come up with different answers; we just need comfort as investors that we are using the right rating for the impact we are trying to deliver."
The EC's proposed regulation will be seeking greater clarity over ESG ratings providers' operations, including the methodologies and data sources used - something Daniel Klier, CEO of sustainability data provider ESG Book, believed was a "promising blueprint."
"But, they must go all the way", he continued. "Transparency of methodology just amounts to transparency of the first layer. Unless it drills down to the bottom, revealing source data, markets will never understand what is driving scores."
This is something Gillam too underscored as the key outcome for any regulation in the area: "What we want to know is that they have adequate resources internally, are using robust underlying data, and have appropriate governance and oversight so that if they make mistakes, they catch them quickly and are transparent about it."
The UK Treasury launched a consultation on ESG ratings providers, set to close this month, as part of the wider Green Day policy releases.
At the time, Baroness Penn, parliamentary secretary with responsibility for ESG within the Treasury, commented: "With projections that $33.9trn of global assets under management will consider ESG factors within three years, the importance of reliable ESG information is critical and growing. ESG ratings are a key element of this."
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Klier warned of the need for a joined-up approach by global regulation setters: "These regulations must also transcend borders. As one of the first movers, the EU has a responsibility to make principles-based regulations with the rest of the world in mind, so global flows of capital are not strangled by a patchwork approach."
EU Green Taxonomy updates
Yesterday's release also shared an extension in the criteria for economic activities to be classified as ‘sustainable' within the EU taxonomy.
The new categories encompass, for the first time, activities other than those directly relating to climate change as contributing to the EU's climate objectives.
The updates relating to wider environmental objectives, which are expected to be recognised as of January 2024, included the provision of water and marine protection, circular economy activities, pollution control measures, and biodiversity protection and restoration. An expansion to the criteria for some climate change mitigation and adaptation activities was also included, namely within the manufacturing and transport sectors.
The EC also announced the release of a taxonomy user guide, along with promises of further initiatives to come, to improve the usability of the rules and support "non-experts" in their reporting and disclosure efforts.
Valdis Dombrovskis, executive vice-president for an Economy that Works for People, said: "Today we are going even further in completing the regulatory landscape to help generate much-needed investments for sustainable growth. It is essential that the rules and instruments in place are coherent, user-friendly and work effectively on the ground."
Recommendations for facilitating transition finance were also included in the new package, "not only for companies that have strong sustainability records already, but also for those that are at different starting points, with credible plans or targets to improve their sustainability performance."
McGuinness asserted the "need to reap the full potential of transition finance to ensure that all companies irrespective of their starting points can have adequate tools and support for their transition efforts towards sustainability".
