ESG Ratings Regulations – European Council agrees on the negotiating mandate with European Parliament

ESG Ratings Regulations – European Council agrees on the negotiating mandate with European Parliament

December 2023 ended with a flurry of activities related to the European Green Deal, including the agreement between the European Parliament and European Commission(EC) on the EU CSDDD, the new rules to Decarbonize buildings,  EU Sustainable Product Deals, and the publication of default values related to the Carbon Border Adjustment Mechanism (CBAM), among others. One similar milestone is the decision by the European Council and the European Parliament to start negotiating on the ESG Ratings Regulation (read the press release here).

Background

Unlike credit ratings which are highly standardized, corporate ESG ratings are highly divergent, thanks to the differing methodologies used by the various ratings providers. As a result, corporates and the users of the ESG ratings have a difficulty in relying on these ratings. In one of our widely read blogs, we examined the implications of this divergence in great detail(read here).

In June 2023, the European Union published a proposal for regulating ESG rating activities. The stated objective of the regulation proposed by the EU is to enhance the reliability, comparability, and transparency of ESG ratings. We had highlighted the key highlights of the proposal in our analysis here, and a few of them are reproduced below for better context. 

• To provide ESG ratings within the European Union, rating agencies need to obtain authorization from the European Securities and Markets Authority (ESMA).
• ESMA shall be required to maintain a registry on its website, listing all sanctioned ESG rating providers, and stipulates mandates regarding the availability of information on the European Single Access Point (ESAP).
• To safeguard investors and maintain fairness in the market, rules need to be set for ESG rating providers based outside the Union who intend to conduct operations within the Union.

Key Changes

The proposal was opened up for the public consultations from 15 June 2023 to 1 September 2023, and 68 feedbacks were received. Following the consultations, the European Council(EC) has published its mandate for negotiation with the European Parliament. The negotiating mandate can be downloaded here. The key aspects of the negotiating mandate are as follows. 

• ESG rating providers operating in the EU must comply with requirements: authorization from ESMA, equivalence decision, endorsement, or recognition for non-EU providers.
• The mandate outlines territorial scope and operation definitions in the EU, with specific provisions under the endorsement regime.
• It introduces a lighter, three-year, optional registration regime for existing and new small ESG rating providers.
• Small providers under the lighter regime are exempt from ESMA fees; must adhere to general organizational, governance, and transparency requirements, and are subject to ESMA oversight.
• Upon exiting the temporary regime, small providers must comply with full regulation, including governance and supervisory fee requirements.
• Council allows ESG rating providers to combine certain activities without separate legal entities, given clear distinction and conflict of interest avoidance measures, excluding consulting or audit activities for rated entities.

Way Forward

Subsequent to review of the feedback and further analysis, both the European Council and European Parliament moved to the next step, which is to negotiate among themselves on the final regulation before it can be implemented. 

During the plenary session held from 11 to 14 December 2023, the European Parliament reached a consensus on its negotiating position. The Council’s mandate, agreed upon on 20th December, sets the stage for interinstitutional discussions, expected to commence in January 2024.

Further to this, the International Capital Market Association (ICMA), which was tasked with the development of globally consistent voluntary guidelines on ESG ratings, released a Code of Conduct (CoC) for ESG ratings and data products providers(Read more about the CoC here). 

The key difference between the EU ESG Ratings Regulations and the Code of Conduct is that while the former is mandatory and applicable in the EU jurisdiction, the latter is voluntary and is applicable across the world. Together with the EU ESG Ratings Regulations, the CoC is expected to drastically improve the confidence of the market participants in the ESG ratings, both inside and outside Europe.