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Following a legislative process Finance Watch contributed to, the final adoption of an ambitious European regulation for ESG ratings (the ratings designed to help investors understand the sustainability characteristics of their investments) is a milestone in the fight against greenwashing in financial products and a success for civil society.
For those who wish to invest sustainably, ESG ratings can provide a tool enabling them to back companies who try to reduce the impact their activities have on the environment and communities. In practice however, the ratings system as it stood remained murky, leading to fossil fuel companies being considered “sustainable” when this was clearly not the case, for instance.
EU Institutions launched a legislative process Finance Watch contributed to and came up with a text that better addresses some of the glaring loopholes the current practices included. Key recommendations pushed by Finance Watch are now part of the new regulation on ESG rating providers, though we will have to keep a watchful eye on areas that can still lead to misleading practices.
Last year, the European Commission released a legislative proposal to better regulate the governance and transparency of ESG rating providers. The proposal followed a consultation confirming concerns, both from financial industry stakeholders and civil society representatives, surrounding the lack of transparency of ESG rating methodologies and activities. At international level, the International Organization of Securities Commissions issued a report in November 2021 containing a set of recommendations on ESG ratings and data product providers.
The Commission took into account prior feedback and recommendations received and has put forward a legislative text focussing on two axes: transparency and governance. As coined by the European Commission, ESG ratings support the proper functioning of the sustainable finance market by providing important information for investment strategies, risk management and disclosure obligations by investors and financial institutions. New legislative developments were therefore urgent.
On the one hand, clarity about the objectives and methodology surrounding ESG ratings would help investors develop credible sustainable investing strategies, reducing skepticism around these ratings being misused as a fig leaf to improve the image of polluting companies.
On the other hand, preventing conflicts of interest, properly keeping record of ESG rating activities, improving internal control or monitoring of outsourcing of important operational functions would bring the confidence of a good governance in the activities of ESG rating providers.
On 24 April 2024, the European Parliament approved the final text that was agreed with the European Commission and the Council.
We now have the opportunity to see how much of Finance Watch’s initial recommendations were included in the final agreement:
The issue pointed out by Finance Watch was the absence of a legislative framework and the need to appoint a single authority to supervise ESG ratings distributed in the EU.
It’s in it! The EU ESG rating providers will need to be authorized and supervised by the European Securities and Markets Authority – ESMA. The final text also gives the possibility for non-EU providers to distribute ESG ratings in the EU, but includes specific provisions to ensure a level-playing field.
The issue pointed out by Finance Watch was that E, S and G ratings are usually bundled together (composite ratings) and that metrics can focus, for a given dimension, on financial materiality without clearly specifying it
It’s in it! While single ratings aggregating the E, S and G factors may still be distributed, rating providers will be required to disclose to the users of the ratings the separate results of the E, S and G assessment and to communicate whether the ratings consider the financial and/or impact materiality.
The issue pointed out by Finance Watch was that by leaving open the possibility to rating providers of developing their own assessment methodologies, the resulting lack of consistency across EU sustainable finance regulations would complicate instead of simplify the task of ESG investors.
It’s in it! ESG rating providers will need to indicate when a rating covers the environmental factor, whether and to what extent the rating is correlated with the Taxonomy. As supported by Finance Watch, the text shall not interfere with the rating methodologies but requires transparency to allow a proper interpretation of what the rating actually assesses.
The issue pointed out by Finance Watch was that ESG rating providers tend – despite improvements in recent times – not to publicly disclose how and on what basis they actually rate criteria, which is problematic on many levels (Reliability, conflict of interest, comparability, impact etc.)
It’s in it! The new Regulation includes a specific annex with detailed disclosure requirements, both for the public and the users of the ratings.
The issue pointed out by Finance Watch was the major risk of conflicts of interest in the sphere of ESG rating providers, as when a rating provider rates its own shareholder, for instance.
It’s (mostly) in it! The text foresees a separation of activities between the provision of ESG ratings and audit and consulting services, although the services may still be provided within a same group. The provisions on the prevention of conflicts of interest related to the ownership of rating providers are somewhat more flexible than in the Credit Rating Agency Regulation but should substantially reduce the risks, assuming an efficient authorization process.
Given the end of the political mandate, the legislative text had to be rapidly finalised and Finance Watch welcomes an agreement that focuses on addressing the most urgent shortcomings. This Regulation is the result of meaningful discussions based on a common sense approach to guarantee corporate practices, transparency and organisational measures that should already be applied by well-governed rating providers.
Despite the very positive outcome, Finance Watch still raises specific areas of concern in its overall assessment of the text. In particular, the limited inclusion of financial institutions in the scope of the Regulation may limit the level playing field between traditional rating providers and investment firms distributing ESG ratings in the context of their research services.
As supported by Finance Watch, the ESG Ratings Regulation focuses on ESG rating providers and does not interfere with the rating methodology, leaving the possibility to users of ESG ratings to subscribe to ratings that best fit their needs. This implies that users of ESG ratings also have a responsibility to ensure that ratings will not be used in a misleading way.
Today, many companies are disclosing their own ESG ratings without clearly specifying if they rely on a single or double materiality principle, nor whether they are based on an absolute or a relative assessment. If retail investors and consumers are likely to access claims based on ESG ratings, minimum transparency or quality standards should be specified in the appropriate legislation. Adaptations to the Corporate Sustainability Reporting Directive (CSRD) delegated acts should therefore be considered to require companies to disclose in their sustainability reporting only ESG ratings that would cover the double materiality principle.
ESG ratings may also be used to promote sustainability characteristics of financial products. The inclusion of transparency requirements for asset managers that disclose ESG ratings in product marketing communications was therefore necessary. However, should the Commission confirm the revision of the Sustainable Finance Disclosure Regulation (SFDR) to develop more comparable disclosures at product level, we should question whether the disclosure of ESG ratings at product level should still be permitted.
Currently, SFDR lacks clarity on the definition of key concepts. However, a revision of SFDR should bring more clarity on the concept of sustainable investment and the classification of products. The disclosure of separate ESG ratings based on non-regulated methodologies would only foster confusion. Metaphorically speaking, publishing an ESG rating for a financial product that already includes robust sustainability related disclosure would be like adding an unregulated rating on the performance of a fridge, even though the manufacturer is already required to disclose the standardised and mandatory energy efficiency label.
Finally, financial industry stakeholders also share their concerns on the absence of provisions for regulating ESG data providers. Although Finance Watch supports the Commission’s initial approach focusing on ESG ratings – considering timing and priorities – it acknowledges the need to consider better regulating ESG data providers and the development of proxies.
However, the inclusion of ESG data providers would require an important recast of the current text (e.g. defining the concept of ESG data, determining the relevant provisions that should apply to ESG data providers, adapting transparency requirements, appropriately considering requirements for mandatory reporting and public data, etc.) and the development of a separate legislative text may be preferable.
Much still needs to be done on the road towards sustainable finance (read our report: A Finance Watch guide to the next ‘sustainable finance agenda’) but major pieces of the puzzle have successfully been created, such as the ESG Ratings Regulation. The next ‘sustainable finance agenda’ could serve as a springboard towards creating a sustainable economy in the EU but contextual headwinds are threatening this aim. European policymakers must maintain their ambition to preserve the headstart for EU competitiveness in tomorrow’s sustainable market.
Finance Watch is a European non-profit association created to defend the public interest in the field of financial regulation. If you enjoyed this article, remember to subscribe to our newsletter and consider supporting our independent research with a tax-deductible donation.
If you work for a European NGO or as an independent expert, share our guide to the next ‘sustainable finance agenda’ with decision-makers in Brussels and consider joining Finance Watch as a member.
Vincent Vandeloise
Annex - The Finance Watch scorecard for the new ESG Ratings law
Progress-report-card ESG ratingsShare
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