An evolving landscape of reforms in the ESG ratings sector continues to pose challenges to providers of ratings and scores.

By Paul A. DaviesNicola HiggsRob Moulton, Michael D. GreenBecky Critchley, Anne Mainwaring, and Charlotte Collins

International momentum to regulate ESG ratings continues as the European Commission released a consultation on 13 June 2023 to create a new regulatory regime for ESG ratings providers. This consultation follows a Call for Evidence that the European Securities and Markets Authority (ESMA) issued on 4 April 2022.

The Commission’s consultation marks the next step in global regulatory action with respect to ESG ratings following IOSCO’s call for oversight in November 2021 (for more information, see this Latham blog post). National regulators have since responded to IOSCO’s request for oversight:

  1. The Japan Financial Services Agency (JFSA) adopted the IOSCO standard through a “comply or explain” code in December 2022.
  2. The Securities and Exchange Board of India (SEBI) was a first mover in launching its consultation to formally regulate ESG ratings. The public consultation closed on 6 March 2023. The regime is expected to impact ESG ratings on Indian public companies by requiring Indian / emerging markets to meet specific parameters in the rating but without a formal licensing regime for ESG ratings providers (for more information, see this Latham blog post).
  3. The more recent UK HM Treasury (HMT) consultation to formally regulate ESG ratings providers represented the first national-level regime to introduce a new regulated activity for ESG ratings providers (for more information, see this Latham blog post). The EU proposal now follows suit by articulating a detailed new regulatory licensing and ongoing compliance regime for ESG ratings providers.

A comparative analysis of the above-mentioned proposals is set out below.

European Proposals

The Commission has described its proposed rules for ESG ratings as an integral part of its renewed sustainable finance strategy published on the same date, 13 June 2023. The new regulatory regime for ESG ratings providers will be introduced via regulation, which will have direct effect across all EU Member States. This aligns with other analogous regulatory regimes for benchmarks (EU Benchmark Regulation) and credit ratings (EU Credit Rating Regulation). Further, ESMA proposes to be the supervisory body for ESG ratings providers (as per the EU regulatory regime for credit rating agencies).

Scope

ESG ratings issued by ESG rating providers operating in the EU that are disclosed publicly or are distributed to financial undertakings in the EU. The definition of “ESG rating” broadly tracks the IOSCO proposal by including the following defined terms and clarifying that the difference between an ESG rating and an ESG score is an element of qualitative assessment by a ratings analyst in the case of a rating, which is not required for a score:


Exemptions From the Scope of ESG Ratings

The Commission has set out a comprehensive list of exemptions from the scope of the regulatory regime for ESG ratings:


In addition to the formal exemptions listed above, the EU appears to include a proposed definition of “ESG rating provider” as “a legal person whose occupation involves the offering and distribution of ESG ratings or scores on a professional basis”. This inclusion could be an attempt, as per the equivalent UK proposal, to exclude ESG ratings produced by charities.

The exemption (at Number 5 above) in relation to products or services that incorporate an element of an ESG rating also provides useful guidance to market participants considering whether ESG scoring within investment research, financial benchmarks, and credit ratings would also be exposed to the ESG rating regime on a standalone basis and indicates that it would not. This point will no doubt be further explored during the advocacy process.

Requirements to Provide ESG Ratings in the EU

Tracking the existing regime for regulated benchmark administrators under EU BMR, the consultation proposes that any ESG rating provider looking to provide ESG ratings in the EU must pursue one of the following routes.


Register of ESG Rating Providers

As with other regulated firms, ESMA will maintain a publicly accessible register of EU ESG ratings providers.

Ongoing Compliance Obligations

EU-regulated ESG ratings providers will be subject to ongoing compliance obligations to ensure the integrity and reliability of ESG rating activities. In summary, these obligations require:

  1. Independence of rating activities from all political and economic influences or constraints and due diligence to ensure business interests do not impair the independence or accuracy of the assessment activities. This obligation will require robust and detailed conflicts mapping for in-scope firms.
  2. Separation of business and activities that prohibits ESG rating providers from engaging in:
    • consulting activities to investors or undertakings;
    • issuing and selling credit ratings;
    • developing benchmarks;
    • investment activities;
    • audit activities; or
    • banking, insurance, or reinsurance activities.
  3. Integrity of ratings and methodologies to ensure that ESG ratings are based on a thorough analysis of all relevant information available with methodologies that are rigorous, systematic, objective, and capable of validation.
  4. Rating analysts to meet knowledge and experience requirements. Individuals involved in the provision of ESG ratings and scores are not allowed to:
    • initiate or participate in negotiations regarding fees or payments with any rated entity or any person directly or indirectly linked to the rated entity by control;
    • own, buy, or sell any financial instrument issued, guaranteed, or otherwise supported by any rated entity other than holdings in diversified collective investment schemes, including managed funds. They are also not allowed to engage in any transaction in such financial instruments; and
    • have a recent employment, business, or other relationship with the rated entity that may cause or may be generally perceived as causing a conflict of interest.
  5. Transparency so that ESG rating providers shall disclose both to users and on their website the methodologies, models, and key rating assumptions they use in their ESG rating activities.
  6. Fair, reasonable, transparent, and non-discriminatory treatment of users of ESG ratings in which ESG rating providers shall take adequate steps to ensure that fees charged to clients are fair, reasonable, transparent, non-discriminatory, and are based on costs.
  7. Fines to be imposed if ESMA finds that an ESG rating provider, or, where applicable, its legal representative, has intentionally or negligently infringed the regulation. The maximum fine shall be 10% of the total annual net turnover of the ESG rating provider, calculated on the basis of the most recent available financial statements approved by the management body of the ESG rating provider.

Considerations for ESG Ratings and Data Providers

ESG ratings and data are inherently global in nature. The producers of those ratings/data may be located in one jurisdiction and license that data into multiple global jurisdictions. The primary challenge for these providers is navigating the evolving global landscape of reforms in this space.