European Council agrees negotiating mandate on ESG ratings

The European Council has reached an agreement on its negotiating mandate for a proposed ESG rating regulation, to try to boost investor confidence in sustainable products.

Europe’s risk and insurance managers will be pleased to hear of progress in this area as corporations are finding the ratings are becoming increasingly important when raising finance, and are starting to creep into underwriting negotiations.

During our recent Risk Frontiers Benelux event in Antwerp, held in partnership with Belrim and Narim, leading risk managers expressed serious concerns over the validity and consistency of the ratings, which up till now has been unregulated.

One Belgian risk manager suggested that firms were effectively being held to ransom by the big accounting and audit firms that were keen to “cash in” on this potentially lucrative new market and by smaller start-ups with no real credentials, in what has become the “wild west” of ESG ratings.

ESG ratings provide an opinion on a company’s or a financial instrument’s sustainability profile by assessing its exposure to sustainability risks and its impact on society and the environment. ESG ratings have an increasingly important impact on the operation of capital markets and investor confidence, explained the European Council.

It said that the new rules aim to strengthen the reliability and comparability of ESG ratings by improving the transparency and integrity of ESG ratings providers, making ratings more comparable and preventing potential “conflicts of interests”.

Under the proposed rules, ESG rating providers 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. “Providers will be subject to specific measures to prevent and manage conflicts of interests,” said the Council.

In its negotiating mandate, the Council clarified the circumstances in which ESG ratings fall under the scope of the regulation, providing further details on the applicable exemptions.

In line with the corporate sustainable reporting directive, it also clarified that ESG ratings encompass environmental, social and human rights or governance factors.

“ESG rating providers that wish to operate in the EU will need to comply with certain requirements, including obtaining an authorisation from ESMA, or in the case of ESG rating providers established outside the EU, an equivalence decision, an endorsement of their ESG ratings or a recognition. The Council also clarified the territorial scope of the regulation, outlining what constitutes operating in the EU, and provided further clarification on the applicable provisions under the endorsement regime,” said the Council.

It also wants to introduce a lighter, temporary and optional registration regime of three years for existing small ESG rating providers and new small markets entrants.

“Small ESG rating providers who opt in under the lighter regime will not have to pay ESMA supervisory fees. They will have to comply with some general organisational and governance principles, as well as transparency requirements to the public and users. They will also be subject to the powers of ESMA to request information and conduct investigations and on-site inspections. Upon exiting this temporary regime, small ESG rating providers will need to comply with all the provisions outlined in the regulation, including the requirements regarding governance and supervisory fees,” explained the Council.

Some have suggested that leading accounting and audit firms shouldn’t also provide ESG ratings as this potentially creates a conflict of interest.

The Council has tackled this concern head on, though perhaps not vigorously enough for some, in what is likely to be a lively focus of debate as the negotiations continue.

“Regarding the separation of business and activities, the Council introduced the possibility for ESG ratings providers to not have a separate legal entity for certain activities, provided there is a clear distinction between activities and that they put in place measures to avoid conflicts of interests. This derogation would not be applicable to consulting or audit activities when they are provided to rated entities,” said the Council.

The agreement on the Council mandate now paves the way for interinstitutional negotiations, which are expected to start in January next year.