The EU regulation for ESG Rating Activities : the missing piece of Sustainable Finance

ESG ratings activities play an important role in helping companies and financial institutions integrate sustainability into their decision-making and the question of their supervision is not a new one, with the shortcomings most often being a lack of transparency in methodologies, a low level of comparability, inadequate arrangements for dealing with conflicts of interest and, of course, the question of the oversight of ratings. To tackle these flaws, EU has embarked on a vast project. In a new paper, I argue that new organisational principles and precise rules on the prevention of conflicts of interest will ensure the integrity of ESG rating providers' activities.

The proposal for a Regulation of the European Parliament and of the Council on the transparency and integrity of environmental, social and governance (ESG) rating activities of 24 April 2024 is therefore an essential component of the general European sustainable finance framework. Impartiality, transparency of methodologies, reliability, comparability, supervision by ESMA, register of approved providers and the publishing of any sanctions online are the main tools of this text, with the aim of making the European ESG rating market more attractive. This text also falls within the scope of the IOSCO's activities. The French Market Authority (AMF) had previously responded to a consultation on 2 June 2022 calling for the regulation of ESG data providers. In this sense, the present text largely responds to its request.

This future European regulation is also intended to avoid the possibility of Member States adopting different approaches and creating a system based on different rules that would not only fail to provide the necessary clarity but would also ‘create unequal market conditions for users’.

This highly technical text is based on an extensive impact study and includes annexes. The proposed regulation therefore has a great number of objectives: to strengthen the integrity, transparency, governance and independence of ESG rating providers, and to prevent green and social washing. Three key words (reliability, comparability and transparency) and a wide range of tools such as ESG rating methodologies and data, use of ESG data, transparency regarding ESG rating methodologies and helpful definitions such as ESG rating, ESG opinion, ESG score.

A fundamental clarification is required: in its general spirit, the text does not set out to regulate and harmonise rating methodologies, which is understandable insofar as ratings are changeable and multidimensional, with the three fields—E, S and G—being extremely different in nature. Separate E, S, and G ratings shall be provided rather than a single ESG metric that aggregates these factors.

Above all, ESMA, as supervisor, is a control tower with multiple missions: it could be responsible for authorisation and ongoing supervision of providers, ESMA can issue information requests, carry out general investigations and on-site inspections, it can also take supervisory action including withdrawing or suspending authorisations and recognitions, temporarily prohibiting the publication or distribution of the ESG rating, requiring a provider to end an infringement or issue a public notice. This is a fairly strict and restrictive supervision of ESG rating providers by ESMA, despite this being technically more burdensome and costly.

The proposed regulation also provides for a highly visible complaints-handling system, requiring ESG rating providers to publish their procedures for receiving and handling complaints on their websites. If a complaint is submitted, the rating provider must ensure the independence of the investigation, which must be conducted in a timely and fair manner, with the investigation being conducted independently of any personnel who have been involved in the subject of the complaint. Complaints may concern both the representativeness of an ESG score and the process used to achieve that score.

As it stands, this European option differs from other international initiatives in this field. One example is provided by India, which recently hosted the G20 and is ahead of the game on this issue. Professional associations such as the ICMA (International Capital Market Association) and the IRSG (International Regulatory Strategy Group) will also be key to the emergence of a draft code of conduct, which can be implemented quickly, unlike a more time-consuming regulation. This approach remains voluntary. The Japanese regulator FSA (Financial Services Agencies), for example, is in favour of such an approach. The UK's Financial Conduct Authority (FCA) has launched a consultation on the creation of a New Code of Conduct for Environmental, Social and Governance Data and Rating Providers.

This future regulation rightly states that ESG investments are becoming an important part of mainstream finance and points out that the ESG ratings offering forms part of an ESG investment ecosystem. Therefore this future regulation is a major step towards the overall success of sustainable finance. It is the missing piece in the large body of European regulations on sustainable finance (among SFRD, Taxonomy, EU Green Bonds) and undoubtedly a critical component, because without reliable ratings there can be no investor confidence, at a time when sustainable investments need more powerful support than ever.

Catherine Malecki is Professor of Private Law Rennes 2 University France and Senior Member of Institut universitaire de France (IUF).

The full paper is available here.