The European Council approves the new ESG ratings regulation

Introduction

The EU’s regulation on the Environmental, Social, and Governance (ESG) rating activities, was passed by the European Parliament on 19. November 2024. The regulation aims to standardize ESG evaluations and enhance trust in sustainable finance. In our earlier blog published in June 2023 (read here), we analysed some key highlights of the proposed regulation, and they all have been retained in the approved regulation. 

Background

With the increasing focus on ESG performance, the use of ESG ratings has become more prevalent than ever. However, both investors and companies express only moderate confidence in their accuracy and usefulness (read here). This disconnect indicates a need for substantial reforms to uphold the credibility of the ESG rating ecosystem in the future. In our widely read article, “ESG Ratings – A Primer” (accessible here), we discussed the inconsistency among ESG ratings from various providers and emphasized how the lack of transparency in rating methodologies remains a critical challenge for users.

Acknowledging the challenges associated with ESG ratings, the EU has introduced a proposal to regulate ESG rating activities. The proposed regulation identifies two key issues with the current ESG ratings: 

1. Insufficient transparency regarding their characteristics, methodologies, and data sources.
2. A lack of clarity surrounding the operational practices of ESG rating providers. 

Consequently, ESG ratings fall short in effectively informing users, investors, and rated entities about ESG-related risks, impacts, and opportunities. The regulation that has been approved aims to address these issues. 

Highlights:

Given below are some of the key points of the proposal. 

• ESG rating agencies will need authorization or a license to operate, issued by the European Securities and Markets Authority (ESMA).  
• ESMA will maintain a publicly accessible register of all authorized ESG rating providers on its website and establish requirements for information accessibility through the European Single Access Point (ESAP).  
• To safeguard investors and promote fair market practices, regulations will be established for ESG rating providers from outside the EU seeking to operate within the Union. These regulations offer three compliance pathways: equivalence, endorsement, and recognition, all contingent on the provider’s home country having regulatory standards comparable to those in the EU.
• ESG rating providers must use robust, objective, and continuously validated rating methodologies. These methodologies should undergo regular reviews, with updates conducted at least annually.
• ESG rating providers are required to publicly disclose details of their methodologies, models, and key assumptions. Ratings for Environmental (E), Social (S), and Governance (G) dimensions should be issued separately. If a combined ESG rating is provided, rating providers must disclose the individual ratings and the weight assigned to each dimension
  – ESG rating providers should avoid conflicts of interest and implement adequate measures to manage any unavoidable conflicts. Additionally, they must promptly disclose any conflicts of interest.
  – ESG rating providers will be prohibited from offering certain other services, including consulting, credit ratings, benchmarks, investment activities, and audit, banking, insurance, or reinsurance services.
  – Measures will be introduced to assist smaller ESG rating providers in sustaining their operations and entering the market. ESMA may grant exemptions from certain organizational requirements to smaller firms based on specific criteria.
  – The provisions aim to maintain consistency with other EU policies.

Structure of the regulation

This new regulation is organized into five key titles, each addressing crucial aspects of ESG rating practices.

1. Subject Matter, Scope, and Definitions (Title I):

– Subject Matter: The regulation aims to ensure the transparency and integrity of ESG rating activities within the EU.

– Scope: It applies to ESG rating providers operating in the EU, including those established outside the EU but offering services within it.

– Definitions: Provides standardized definitions for terms such as ‘ESG rating’ and ‘ESG rating provider’ to ensure uniformity.

2. Provision of ESG Ratings in the EU (Title II):

– Authorization Requirements: ESG rating providers established in the EU must obtain authorization from the European Securities and Markets Authority (ESMA).

– Temporary Regime for Small Providers: A temporary regime is introduced for small ESG rating providers to facilitate compliance.

– Equivalence and Recognition: Procedures for recognizing ESG ratings from providers outside the EU through equivalence, endorsement, or recognition, supported by cooperation arrangements.

– Register and Accessibility: ESMA must maintain a public register of authorized ESG rating providers, ensuring transparency.

3. Integrity and Reliability of ESG Rating Activities (Title III):

– Organizational Requirements: Sets governance standards, including the separation of business activities, record-keeping, and complaints-handling mechanisms.

– Transparency Requirements: Requires public disclosure of methodologies, models, and key rating assumptions used in ESG rating activities.

– Independence and Conflict of Interest: Ensures the independence of ESG ratings and mandates the management of conflicts of interest.

– Supervision by ESMA: Grants ESMA supervisory powers, including the ability to request information, conduct investigations, and perform on-site inspections.

– Supervisory Measures and Penalties: Outlines procedures for ESMA to enforce compliance through fines and other measures.

4. Delegated and Implementing Acts (Title IV):

– Delegated Acts: Empowers the Commission to adopt delegated acts to supplement or amend elements of the regulation.

– Implementing Acts: Provides for the adoption of implementing acts to ensure uniform implementation.

5. Transitional and Final Provisions (Title V):

– Transitional Provisions: Includes measures to facilitate the transition for existing ESG rating providers to comply with the new requirements.

– Review and Amendments: Establishes provisions for periodic review and potential amendments.

– Entry into Force: Specifies the date of entry into force and application of the regulation.

Conclusion

The EU’s ESG ratings regulation establishes a comprehensive framework to improve transparency, reliability, and trust in ESG evaluations. By standardizing practices and providing oversight, it strengthens the credibility of ESG ratings, thereby supporting the growth of sustainable finance and informed market decisions.

Download the approved regulation here.