Proposed framework aims to tackle conflict of interest concerns, but fails to address “quality of raw ESG data”.
The European Union’s (EU) recently proposed regulatory framework for ESG rating providers aims to crack down on conflicts of interest and boost transparency of methodologies, but it could create market confusion, according to experts.
As well as the EU, regulators in other jurisdictions are in the process of developing or introducing rules for ESG ratings providers, but slight deviations in definitions and scope could lead to regulatory fragmentation.
The proposed rules also do not apply to the provision of raw ESG data which does not contain an element of rating or scoring, an issue commonly flagged as a concern due to it limiting the potential quality of ESG-related data.
The EU’s proposal noted that the current ESG rating market “suffers from deficiencies and is not functioning properly”, with investors’ needs “not being met and confidence in ratings being undermined”.
It also outlined how the lack of an EU regulatory framework for ESG rating providers, is permitting the market to “follow its own rules” with a “lack of clarity” over what ratings providers do and how they do it.
Fragmentation and regulatory shortfalls
While the new rules offer increased transparency, Pietro Bertazzi, Global Director of Policy Engagement and External Affairs at environmental non-profit CDP, told ESG Investor that they risk “potential fragmentation” in the regulatory architecture of ESG ratings and data products “at the global scale”.
He said that jurisdictions, including India and Japan, are “diverging in the scope of their interventions and in how they define ESG ratings and other ESG data related products” through methods including the creation of firewalls.
According to Bertrazzi, this divergence in definitions and scope of regulatory interventions could create market confusion and “pose significant complexities” to comply with ESG ratings and operate across borders.
He added that CDP has been “advocating for a global alignment of regulatory frameworks” encouraging collaboration between regulators to “implement robust and ambitious policies in this space”.
Japan’s Financial Services Agency has finalised a code of conduct for ESG data providers operating in the country, while the Securities and Exchange Board of India has taken a different approach with a proposed extension its credit rating regulations which would introduce an “enforceable” regulatory and supervisory framework for market participants. The UK’s Financial Conduct Authority (FCA) is also consulting on a regulatory regime for ESG ratings.
Benjamin Maconick, Financial Regulation Team Managing Associate at global law firm Linklaters, told ESG Investor that the EU proposal does not aim to address frequently cited concerns about the “quality of raw ESG data”, recognised by global securities regulatory body International Organization of Securities Commissions (IOSCO).
IOSCO issued a call for oversight of ESG ratings and data product providers in November 2021 which recommended the promotion of transparency over ratings methodologies and the “appropriate” management of conflict of interest.
In its proposal, the European Commission notes that ESG ratings providers need to use “rigorous, systematic, objective, and continuous” methodologies that are reviewed on an annual basis to ensure their “quality and reliability“.
Maconick also flagged the tight deadlines for implementing the proposals as well as the lack of transitional provisions for non-EU rating providers.
“Large ESG ratings providers in the EU will have 12 months to get authorised once the rules are in force whilst those outside the EU taking the endorsement or recognition route have less time,” he said.
Trust and transparency
There is a high level of reliance on ESG ratings and data products, with a recent ERM report finding that 94% of investors use such tools at least once a month and 47% multiple times per week.
Despite the growing use of ESG rating products, investor confidence is deemed to be moderate, with only 37% of respondents agreeing that ESG ratings were a credible/quality source of information on corporate ESG performance.
Eight in ten respondents to a European Commission survey last year said the ESG ratings system was not functioning well. Critics pointed to the frequent divergence in scores for the same company and little transparency about how providers determine their ratings, with more than 80% of respondents supporting regulatory intervention.
Mark Manning, Strategic Policy Advisor on Sustainable Finance at the UK’s FCA, recently underlined the importance of trust and transparency on ESG data and ratings providers’ methodologies as “absolutely critical”.
He added that the abundance of products, standards and frameworks with a “complex terminology” has led to a “trust deficit and aggregate confusion” in ESG data and ratings.
Bertazzi said the EU’s proposal was a “step in the right direction” to increase transparency of ESG ratings’ methodologies, with it requiring providers to disclose whether they are based on scientific evidence and if they rely on artificial intelligence throughout the collection and assessment process.
“In the EU, we expect to see more transparency – and hopefully even improvements – in the methodologies of ESG ratings,” he added.
However, the European Commission has underlined that the proposed regulation does not intend to “harmonise the methodologies used for the creation of ESG ratings”, instead focusing on increasing the transparency of the ratings.
Ceasing conflict of interest
The EU proposed rules also aim to prevent conflicts of interest that arise from ESG ratings providers offering other services, often ESG performance-related, to companies who already are, or may eventually be, rated by ratings providers.
Through these “ancillary services”, conflicts of interest can arise as potential rated companies may have access to privileged information, noted Bertrazzi.
The ‘subscriber pays’ model implemented by most providers may also contribute to concerns around conflicts of interest, he said.
“In this model, the entity being rated bears the financial costs associated with the service, becoming a ‘direct client’ of the rating entity,” he said.
“In this regard, concerns around the influence such clients may have on rating entities arise.”
According to IOSCO, 80% to 100% of revenues on ESG ratings being derived from this revenue model.
Under the EU’s proposed rules, ESG rating providers shall be prohibited from offering a number of other services including consulting services, credit ratings, benchmarks, investment activities, audit, or banking, insurance and reinsurance activities. ESG ratings providers will also need to ensure that the provision of any other services does not create risks of conflicts of interest within its ESG rating activities.
Bertrazzi added that it is “fundamental” for ESG ratings to have transparent methodologies and be “free from conflicts of interest” as ESG ratings see further integration into investment decision-making processes.
Linklaters’ Maconick said that the restriction in providers offering services beyond ratings is “aimed at ensuring that potential conflicts of interest between an ESG rating business line and other business lines are properly managed”.
Under the proposed rules, if conflicts or other governance failings persist the European Securities and Markets Authority, which will be entrusted with authorisation and supervision of the market, will have the power to fine ESG ratings providers up to 10% of their total annual net turnover.
These sanctions aim to address concerns surrounding ESG ratings providers having an interest in the outcome of the ratings they provide or face the “temptation to influence the outcome of an ESG rating due to other business interests”, Maconick added.
