ESG ratings play an important role in helping companies and financial institutions integrate sustainability into their decisions. Yet critics argue that regulations are needed to address the ratings’ many shortcomings: a lack of transparency in the methodologies behind them, the difficulty of comparing ratings from different sources, inadequate arrangements for dealing with conflicts of interest that may arise from raters’ relationships with companies they rate, and, of course, the absence of any oversight over the ratings process. To tackle these flaws, the EU has embarked on a major effort to adopt principles and rules for preventing conflicts of interest and ensuring the integrity of ESG-rating providers’ activities.

On April 24, 2024, the EU issued the proposed Regulation of the European Parliament and of the Council on the transparency and integrity of environmental, social, and governance (ESG) rating activities – an essential component of the general European sustainable finance framework. Aimed at making the European ESG rating market more attractive, the proposal would require impartiality, transparency of methodologies, reliability, comparability, supervision by ESMA, a register of approved providers, and the publishing of any sanctions online. The proposal falls within the scope of the IOSCO’s activities and largely responds to the French Market Authority’s call for the regulation of ESG data providers.

A primary purpose of the proposed regulation is to avoid the possibility of EU 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. It is based on an extensive impact study and includes annexes and 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. It includes a wide range of tools such as ESG rating methodologies and data and helpful definitions of terms such as ESG rating, ESG opinion, and ESG score.

Yet a fundamental clarification is necessary: In its general spirit, the text does not set out to regulate and harmonize rating methodologies, which is understandable, given that ratings are changeable and multidimensional, with the three fields – E, S, and G –fundamentally differing in nature. Separate E, S, and G ratings will be provided rather than a single ESG metric that aggregates E, S, and G factors.

Above all, ESMA, as supervisor, is a control tower with multiple missions. It can be responsible for authorization and ongoing supervision of providers. It can also issue information requests, carry out general investigations and on-site inspections, and take supervisory action, including withdrawing or suspending authorizations and recognitions, temporarily prohibiting the publication or distribution of an ESG rating, or requiring a provider to end an infringement or issue a public notice. Overall, the regime of supervision for ESG rating providers is strict – as well as a technically more burdensome and costly one.

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 and be independent from 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 relatively quickly. This approach remains voluntary, and is supported by, for example, the Japanese regulator FSA (Financial Services Agencies). 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.

ESG investments are becoming more important in mainstream finance, and ESG ratings are an essential element of the ESG investment ecosystem. The proposed EU regulation is the missing piece in the large body of European regulations on sustainable finance and a critical component. Without reliable ratings there can be no investor confidence, especially at a time when sustainable investments deserve powerful support.

This post comes to us from Catherine Malecki, a professor of private law at Rennes 2 University France. It is based on her recent article, “The EU Regulation for ESG Rating Activities: The Missing Piece of Sustainable Finance,” available here.