European Commission's proposal on the regulation of ESG ratings providers

31 Aug 2023

In this blog we look at the measures released by the European Commission 13 June, 2023 to bolster its sustainable finance framework and the implications for companies.

In July 2021, the European Commission's launched its renewed sustainable finance strategy when It was announced that the EC would develop proposals to regulate ESG ratings providers. As part of the package announced on the 13th of June 2023, the European Commission published the draft text on a regulation on the transparency and integrity of the ESG rating activities.

The sustainable finance framework is aimed at helping facilitate the flow of capital needed to finance the EU's sustainability goals, including the ambitions of the European Green Deal, for things like reducing net greenhouse gas emissions by at least 55% by 2030 and achieving climate neutrality by 2050. The Commission estimates that achieving the objectives of the Green Deal will require investments of around €700 billion per year, with the bulk coming from private funding.

The framework's key building blocks include:

• The EU Taxonomy
• Rules on disclosures
• Reporting for companies and investors
• Tools such as standards and labels enabling the development of sustainable investment solutions and avoid greenwashing.

Calls to regulate the ESG ratings sector have increased in recent years, as investors increasingly integrate ESG considerations into the investment process, yet the activities and businesses of the providers are generally not covered by markets and securities regulators, which is obviously where this has all come from.

How do the changes look now?

Under the new proposals, ESG ratings providers will be supervised by ESMA (European Securities and Markets Authority) to ensure the quality and reliability of their services, and the providers will be required to use methodologies that are "rigorous, systematic, objective and subject to validation."

The proposals also include organizational requirements to prevent potential conflicts of interest, and transparency rules regarding the methodologies, models and key rating assumptions underlying the provider's ratings activities.

The EU Taxonomy is part of the EU Action Plan on Sustainable Finance. The taxonomy took effect in 2022, beginning with the first two climate objectives. The new criteria introduced today by the Commission significantly expands the taxonomy to include the remaining objectives, which include sustainable use and protection of water and marine resources, and other areas.

Who does the ESG Rating Regulation apply to?

The draft text states that it applies to "ESG ratings issued by ESG ratings providers operating in the Union that are disclosed publicly or that are distributed to regulated financial undertakings in the Union, under Non Financial Reporting Directive (NFRD) or public authorities".

Importantly, Article 2(2) sets out what the ESG Rating Regulation does not apply to. This includes a number of organizations, just to name a few, and it doesn't apply to:

• Private ESG ratings which are not intended for public disclosure or for distribution;
• Products or services that incorporate an element of an ESG rating;
• Second party opinions on sustainability bonds;
• ESG ratings produced by Member States, public authorities or central banks (subject to certain conditions)

Are there any obligations on the users of ESG Ratings?

There is no equivalent to the EU BMR Article 28 obligations on users of benchmarks, which is good news for industry. Users and rated entities will be provided with certain information about the ESG rating provider through the disclosure requirements it must satisfy both in terms of its activities and its methodologies. However, there are no other considerations for users other than to ensure that the ESG ratings they are using are being provided by an appropriately authorised firm.

So what does any of this mean in relation to CSRD?

The link with CSRD is really back to the point that the data which is now going to be captured at a corporate level is key. The data that will get reported and verified in the CSRD reports will be key in ensuring the validity of this data. If I give a top line summary as to how the CSRD link to the wider regulation and policies it goes as follows:

At the top you have the European Green Deal, from there you have the Financing of the Green Deal.

Within financing you have the following 3 areas:

1. InvestEU
2. European Green Deal Investment Plan
3. Facilitate private investment

Within the facilitate private investment section you have:

1. Sustainable Finance Disclosure regulations
2. Non-Financial Reporting Directive which will be replaced by CSRD 1st Jan 2024
3. EU Taxonomy which is a requirement of CSRD

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