On June 13, the European Commission published a package of new measures regarding the EU sustainable finance framework, including the proposal for a regulation of ESG (Environmental, Social and Governance) rating providers.
ESG factors have gained a prominent role in mainstream investing and in this context, the importance of ESG scores and their supply has increased. The scores are a method for evaluating the ESG initiatives undertaken by a particular organisation assigning a quantitative measurement, such as a numerical score or letter rating. To compute an ESG score, different vendors may use different techniques, each with its own set of criteria and proprietary algorithms. There is, however, a common method that most companies adopt. Data is gathered from a variety of sources, including ESG reports, media, academic studies, and direct interactions with the organisation being rated. The data is then examined to assign weights or values to various ESG factors. MSCI, for example, distributes grades based on timeliness and likely impact, with larger weights assigned to concerns with greater potential impact within a two-year time-frame. Companies are rated after assigning percentage weights to ESG risks and comparing them to others in the same industry. For example, MSCI’s ESG Ratings classify businesses as leaders (with scores ranging from 5.714 to 5.714).
The European Commission highlighted two problems in the current status quo in establishing ESG ratings as a tool to make informed decisions. The first problem concerns the lack of transparency on the characteristics of ESG ratings, their methodologies and their data sources, while the second is linked to the lack of clarity on how ESG rating providers operate. Therefore, the Commission is aiming at improving the transparency of the methodologies used and the rating characteristics, along with more clarity on the activities of ESG rating providers and the prevention of the risks of conflict of interest at ESG rating provider level.
The Commission’s proposal is timely and fills a gap in the EU legislation. Where the regulations are concerned, the Commission is not aiming to harmonise the different methodologies used by the providers of ESG ratings. Instead, the only objective is to increase transparency, so this creates obligations for the providers, such as disclosing their methodology, models and key-rating assumptions as stated in Article 21 of the Regulation.
Another important point is that concerning the role of ESMA. Under this framework, all entities should apply to ESMA to obtain authorisation, and it will maintain a supervisory role. In particular, ESMA may conduct all the necessary investigations also requesting telephone or data traffic after a request to the judicial authorities according to national rules. It can also conduct on-site inspections, revoke or temporarily halt the use of ESG ratings, levy fines and penalties, and issue public notices. In cases of intentional or negligent violations of the regulation, fines of up to 10% of the ESG rating provider’s total annual net turnover can be imposed.
Furthermore, according to the regulation, providers should comply with some organisational, record-keeping and disclosure requirements. The last point regards conflicts of interest and independence. As stated in Article 23 “ESG rating providers shall take all necessary steps to ensure that any ESG rating provided is not affected by any existing or potential conflict of interest”. In situations where this risk cannot be managed, the provider may be forced by ESMA to discontinue activities or associations that give rise to a conflict of interest, or they may be required to stop offering ratings altogether.
Several ESG providers have welcomed the Commission’s proposal, especially by preferring transparency over standardisation. However, it could be argued that this is one of the first steps towards harmonising how ratings are devised and an effort to undermine green-washing. MEPs from S&D have also expressed their support of this kind of regulation in order to redirect investments to more sustainable companies. However, they expressed some concerns about the aggregation of E, S and G dimensions, along with the “best in class” approach which involves considering the relative performance instead of the absolute one.
The proposal will be now discussed with the two co-legislators, for a regulation with a not only an EU impact, but a worldwide one.