EU’s new ESG ratings framework will be major overhaul

The EC’s proposal for regulating ESG ratings companies will bring about the biggest change the previously unregulated market has ever seen.

• A proposal from the European Commission is set to bring about a huge shake-up of the ESG ratings industry.
• Critics of the industry say regulation is long overdue, while some ratings providers are anxious about revealing their proprietary methodologies.
• While most agree change is needed, there are big differences in opinion as to how ESG ratings be regulated.

European regulators’ proposal to regulate ESG ratings providers presents a major shake-up of the previously unregulated industry. The new draft rules, proposed in June, are aimed at improving the transparency of these companies and could force some to restructure their entire businesses.

The EU’s draft proposal implies that providers will be prevented from providing consulting services to investors, as well as selling credit ratings and benchmarks, all in a bid to avoid conflicts of interest.

All companies providing ESG ratings will need to be authorised by central regulator the European Securities and Markets Authority (Esma), and any breach of the rules could see them fined up to 10% of their annual net turnover. The proposal stops short of harmonising methodologies, which had been a concern among ratings providers.

In 2021, the International Organization of Securities Commissions (Iosco) called for some form of oversight of ESG ratings, stressing the need for better transparency around methodologies and more conflict-of-interest management. For the most part, these companies say they welcome regulation and understand why it is necessary – and that regulation can inspire greater investor confidence in ESG ratings. But they are often firm on the point that their methodology is proprietary.

In a position paper on the proposal, Morningstar says it could introduce new conflicts of interest, create market disruption for investors looking to use ESG ratings produced outside of the EU, and inflate costs.

The data company also argues that the scope of the regulation does not fully address greenwashing risks for retail investors, because it does not include private ESG rating models that asset managers use internally, often by collating a range of inputs from the big ratings providers.

Meanwhile the Institute for Energy Economics and Financial Analysis (IEEFA), which comes from a different angle in that it does not create ESG ratings, has criticised the proposal for not adhering to the double materiality principle, which the EU has embraced elsewhere. IEEFA says these pitfalls would “lessen the regulation’s effectiveness in addressing ESG rating activities’ shortcomings and suitability for fulfilling the European Green Deal objectives”.

As with every regional financial regulation to have ever been proposed, there are also concerns that the EU’s proposal will fragment the ESG ratings market. The UK is also developing its own ESG ratings framework; Japan’s Financial Services Agency has created a code of conduct for ESG data providers; while the Securities and Exchange Board of India plans to extend its existing credit ratings regulation to ESG ratings providers.

The regulatory reasoning

Ratings providers including Morningstar-owned Sustainalytics, Fitch, S&P Global and MSCI have come under fire from multiple angles for as long as they have existed. These companies wield major influence by analysing public information and grading companies, which they then sort into indices. Trillions of investment dollars flow into sustainable funds, products and indices every year; many of these decisions are based on exactly this data.

A number of ratings events have brought the debate on the influence of ESG ratings into sharper focus. Last year, for instance, S&P Global was criticised for removing electric car manufacturer Tesla from its S&P 500 ESG Index following accusations of racial discrimination and poor working conditions, but retaining one of the world’s biggest carbon emitters, ExxonMobil. The saga revealed the inherent difficulty of lumping together such disparate themes as the environmental and social contributions of a company to the wider world.

Critics also say that the very nature of ESG ratings methodologies tends to reward companies that disclose more information, which typically means bigger companies with more resources.

The majority of respondents (84%) to a 2022 survey by the European Commission said that while they use ESG ratings often, the market is not functioning well today. The three central issues were: lack of transparency around methodologies, significant biases with methodology, and poor management of potential conflicts of interest.

As Dutch MEP Paul Tang told Capital Monitor last May, “different data may lead to different assessments of similar or the same companies, and that might be fine, but we need to understand why these differences exist”. He sees transparency about methodology as the first step.

The regulation is in draft form for now; European Parliament and Council will now need to consider it. The EU’s proposal suggests that it will apply six months after it enters into force.

Given the potentially major impact on some ESG ratings providers’ businesses, that is not a long time.