EU: Council and European Parliament reached provisional agreement on a proposal to regulate ESG ratings

On 6 February 2024, the Council and European Parliament reached a provisional agreement on a proposal for a regulation on ESG rating activities. It sets reporting, supervision, organisation, and other requirements with the goal of boosting investor confidence in sustainable products that increasingly rely on ESG ratings. This regulation is expected to enter into force on the 20th day following that of its publication in the Official Journal of the European Union. It will then apply eight months after the entry into force. 

Under the new rules, ESG rating agencies will need to be authorised and supervised by the European Securities and Markets Authority (ESMA) and comply with transparency requirements, in particular with regard to their methodology and sources of information. 

Key requirements and actions required by ESG Rating Agencies are summarised in the Appendix. 

The EU and other jurisdictions are acting to increase market confidence in ESG ratings. These new regulations mean that issuers, along with other stakeholders, can access more consistent information from the ESG rating agencies in relation to those methodologies and limitations (further details are below). Tighter rules for ESG ratings agencies’ business operation could lead to a further consolidation of ESG rating agencies.

Increased transparency should improve the comparability of data across sectors for issuers to improve their ESG ratings. It could also help firms manage their ESG ratings more effectively and streamline the process in the long run, potentially more “hassle-free” engagement. Issuers could consider dedicating resources to reviewing ESG rating agencies’ assessments and engaging with ESG rating agencies relevant to key investors. 

Tighter rules around ESG ratings could help companies on a number of fronts:

1. Benchmarking – across peers and ESG rating agencies

Issuers can use peer benchmarking to evaluate sustainability performance across the industry and can leverage industry best practices to enhance sustainability performance and ESG ratings. A benchmarking analysis could also help businesses align with current industry trends and stay informed about peers’ performances.

2. Guiding sustainability performance/policies and company reporting strategy 

ESG rating reports could also inform ESG reporting gaps, highlighting areas of weakness and strength that are material to the specific company and its underlying industry through greater understanding of the assessment criteria. 

Due to improved transparency, issuers could use ESG rating agencies’ reports to identify the latest views on material ESG issues to target, manage, measure, and report their ESG performance. 

Given increased investor use cases of ESG ratings in determining exclusions, and evaluating ESG performance and controversies, continued engagement with ESG rating agencies should be an important aspect of issuers’ funding and investor relations activities. 

Specifically, the EU's ESG ratings regulation should help Treasurers gain access to the relevant information allowing them to assess ESG rating agencies’ analysis and its underlying scores more systematically.

Supporting Treasurers’ engagement with investors and financing partners 

Enhanced transparency of ESG rating agencies could enhance investors and lenders’ confidence in ESG ratings when assessing companies’ ESG performance by leveraging data from one or several ESG rating agencies.

ESG ratings can be used as part of investor/lender engagement and communications including during marketing of debt securities and lender presentations to help support the company's sustainability profile. However, there may be a cost associated with this.

Informing Treasurers’ strategy on ESG data management 

As ESG rating agencies must be more transparent on the data disclosures informing ESG ratings, company Treasuries should be able to develop a data-sourcing and sustainability disclosures strategy that maximises ESG ratings and improves engagement with investors, ESG rating agencies and other stakeholders. 

Enhanced transparency and governance around ESG ratings methodologies should provide information on how the data points lead into the ultimate ratings. It would be beneficial for treasury teams to familiarise themselves with the evolving corporate disclosure obligations under the Corporate Sustainability Reporting Directive (CSRD) (and accompanying European Sustainability Reporting Standards - ESRS) and the Taxonomy regulation, as these data points are to some extent already being integrated into ESG rating agencies’ assessments, and this integration is expected to deepen over time.

UK: Government is also set to regulate ESG rating agencies

In March 2023, HM Treasury launched a consultation asking whether ESG rating agencies should be subject to a new regulatory regime and its potential scope. On 6 March 2024, HM Treasury confirmed it will regulate ESG ratings, and ESG rating agencies will be brought into the regulatory perimeter of the Financial Conduct Authority.  

Ahead of regulation, which take time to develop and apply, ICMA published the voluntary Code of Conduct for ESG ratings and data products providers in December 2023. In line with recommendations by the International Organization of Securities Commissions (IOSCO), the code focuses on promoting transparency, good governance, management of conflicts of interest, and strengthening systems and controls in the sector. It is intended to be internationally interoperable and could be used by jurisdictions without a local code or regulation. 

On 15 December 2022, Japan’s Financial Service Agency (FSA) published a principle-based The Code of Conduct for ESG Evaluation and Data Providers, designed as a voluntary code on a “comply and explain” basis. 

List of ESG Evaluation and Data Providers that notified the FSA of their intention to endorse the Code of Conduct for ESG Evaluation and Data Providers as of 31 December 2023.

On 28 June 2023, the Monetary Authority of Singapore (MAS) released a consultation paper on elevating standards and disclosures of ESG ratings and data products in Singapore, with the intention to initiate a phased and proportionate regulatory approach, starting with a voluntary industry Code of Conduct. The industry code is set out to cover best practices on governance, management of conflicts of interest, and transparency of methodologies and data sources, including disclosure on how forward-looking elements are taken into account in the products. Response to Feedback Received on Proposed Code of Conduct for Environmental, Social and Governance (“ESG”) Rating and Data Product Providers was published on 6 December 2023.

Consultation Paper on Regulatory Framework for ESG Rating Providers (ERPs) in Securities Market was published on 22 February 2023. The consultation paper aims to standardise ESG ratings for companies under assessment and proposes to allow credit rating agencies to provide ESG ratings-related services.

• Dr Arthur Krebbers, Head of Corporate Climate & ESG Capital Markets 
• Gustavo Brianza, Head of Debt & ESG Advisory
• Ashpreet Sethi, Head of FI & SSA ESG Ratings Advisory
• Rui Zu, ESG Advisory
• Tonia Plakhotniuk, Climate & ESG Capital Markets
• Daniel Bressler, Climate & ESG Capital Markets
   

*For any unfamiliar terms used within this article please refer to our Insights glossary

EU Regulation’s key requirements and actions required by ESG Rating Agencies.

Separation of business and activities

Actions:

To prevent any potential conflicts of interest, ESG rating providers would not be allowed to offer a number of services, including: 

• Consulting activities to investors or undertakings
• The issuance and sale of credit ratings
• The development of benchmarks
• Investment activities
• Audit activities
• Banking, insurance, reinsurance activities

Providers would need to ensure that any other services they offer do not create risks of conflicts of interest.
 

Disclosure of the methodologies, models and key rating assumptions used in ESG rating activities to the public

Actions:

ESG rating providers will have to disclose on their website the methodologies, models and key rating assumptions they use in their ESG rating activities, including:

• Overview of the rating methodologies, including whether analysis is backward-looking or forward-looking and the time horizon covered, and industry classification used
• Overview of data sources including whether data is sourced from sustainability statements or from information disclosed under EU regulations and whether sources are public or non-public and an overview of data processes, estimation of input data in case of unavailability and frequency of data updates, and the ownership structure of the ESG rating provider
• Information on whether and how the methodologies are based on scientific evidence
• Information on the ratings’ clearly defined objective and marking whether the rating is assessing risks, impacts, or both
• The rating’s scope – i.e., whether it covers an individual factor (E, S, or G) or whether it is an aggregated rating (aggregating E and S and G factor), or whether it covers specific issues (e.g., transition risks); the weighting of the three overarching ESG factors categories (e.g., 33% Environment, 33% Social, 33% Governance), and the explanation of the weighting method
• Information on whether the rating is expressed in absolute or relative values
• Information on criteria used for establishing fees to clients and general information on the business/payment model
• Any limitation in data sources and methodologies used for the construction of ESG ratings including the main risks of conflicts of interest and the steps taken to mitigate them
• The reference to the use of Artificial Intelligence (AI) in the data collection or rating/scoring process including information about current limitations or risks of using AI if applicable
   

Disclosure to subscribers of ESG ratings and rated entities

Actions:

ESG rating providers will need to disclose, as a minimum, certain information, to their subscribers and to the rated entities, including: 

• Policies for the revision of methodologies 
• Last date of the revision
• The use of estimation and industry average and explanation of the underlying methodology
• The policies for updating data and revising historical data, date of last updates of data
• The data quality controls, their frequency and the remediation process if issues arise
• Any steps taken to address limitations in data sources, where applicable
   

Independence and avoidance of conflicts of interest

Actions:

ESG rating providers will have to:

• Establish robust governance arrangements, including a clear organisational structure with well-defined, transparent, and consistent roles and responsibilities for all persons involved in the provision of an ESG rating
• Ensure that any ESG rating provided is not affected by any existing or potential conflict of interest, or by any business relationship, either from the ESG rating provider itself or from their shareholders, and other related persons
• Where there is a risk of a conflict of interest within an ESG rating provider due to the ownership structure, controlling interests or activities of that ESG rating provider, of any entity owning or controlling the ESG rating provider, of an entity that is owned or controlled by the ESG rating provider, or of any the ESG rating provider’s affiliates, ESMA may require the ESG rating provider to take measures to mitigate that risk in a balanced manner