The European Union (EU) has proposed new regulations targeting firms involved in selling environmental, social, and governance (ESG) ratings, which could potentially trigger significant restructuring within the industry. Key players such as S&P Global, Moody’s, MSCI, and Morningstar’s Sustainalytics, which offer ESG ratings to guide trillions of dollars in investments, are among those affected by the proposed regulations.
According to the EU’s draft legislation, ESG rating providers must discontinue offering consulting services to investors, selling credit ratings, developing benchmarks, and other activities to mitigate potential conflicts of interest. These providers will now require authorisation and supervision from the European Securities and Markets Authority (ESMA). Non-compliance with the new rules could result in fines of up to 10% of their annual net turnover.
“ESG ratings agencies that score companies on governance factors are completely unregulated so it’s very difficult to compare ratings by different agencies,” said Mairead McGuinness, European commissioner for Financial Services. “We have no clarity on how these ratings are reached and there appears to be a conflict of interests.
“We want them (ratings) to be reliable and comparable.”
Critics of ESG rating methodologies have argued they are currently overly complex, lack transparency, and tend to simply reward companies that disclose more information rather than those effectively managing ESG risks or minimising negative environmental impacts.
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Authorities are taking steps to encourage sustainable investment and address greenwashing by promoting transparency and providing investors with better information. Earlier this year, the UK also outlined plans to regulate ESG ratings providers.
Response from the industry
MSCI ESG Research said in a statement it was assessing the implications for its business and products and that it maintained a “culture of independence and transparency” in providing ratings.
S&P Global said it believed “consistent implementation” of the recommendations from IOSCO, the global securities regulatory body, would support ESG ratings products and help avoid fragmentation across jurisdictions.
The London Stock Exchange Group, which also provides ratings through its Refinitiv unit, said it welcomed the EU’s proposed rules:
“The proposal introduces greater transparency in the market, without prescribing ESG assessment methodologies, contributing to more effective allocation of capital to sustainable investment activities.”
Morningstar Sustainalytics said its analysts were reviewing the proposal to understand the broader industry implications.
The state of ratings
ESG ratings assess a company’s exposure to financially relevant ESG factors, such as pollution or human rights, and its management of such risks. However, these ratings typically do not measure a company’s impact on the environment and society, and there have been criticisms about their understanding among end investors.
In a recent study conducted by ERM, considerable costs are incurred by both public and private companies in order to acquire ratings. Despite a general dissatisfaction with the ratings’ accuracy, companies perceive them as an obligatory response to investor demand.
According to estimates by Morningstar, global sustainable assets under management reached $2.74 trillion in March. Much of this is invested in funds that track indexes composed of companies with specific ESG rankings or exclude firms with low rankings.
The European Commission announced its plan as part of new measures unveiled on Tuesday to encourage more ethical and sustainable investment. These included new criteria for its so-called EU taxonomy, a system that classifies which parts of the economy can be marketed as sustainable investments.
