Disaggregation of E, S and G factors behind scores will “help investors”, though consideration urged to avoid “unduly burdening” firms.
A European Parliament vote this week to increase the transparency of ESG ratings by disaggregating consideration of E, S and G factors is a “positive outcome” for investors, experts have told ESG Investor.
The ECON committee made significant changes to draft rules proposed by the EU Commission to regulate ESG ratings, noting that the aggregation of E, S and G scores into a single rating can “obscure poor performance” on any individual metrics.
The proposed revisions request that ratings providers disclose whether E, S, or G factors are taken into account, or an aggregation thereof, the rating given to each relevant factor, and the weighting each factor is given in the aggregation.
Vincent Vandeloise, Senior Research and Advocacy Officer at NGO Finance Watch, described the disaggregation between the E, S and G as an “important point” given that providers can currently disclose ratings through a single value despite the three underlying factors being “very distinctive [and] covering different issues and concerns”.“
“It’s very important to clearly understand what is actually behind those ratings,” he told ESG Investor.
The NGO had previously argued regulation of ESG ratings should prioritise maximum transparency by ensuring scores are split into environmental, social and governance, rather than being amalgamated into one “synthetic rating”.
“The proposal of the commission was already positive,” Vandeloise said. “What the ECON committee has done is just going one step further and bringing a stronger transparency and a consistent leverage from other regulation.
“I think it’s going to help investors and it’s quite interesting that in the end the ECON committee text was approved at large majority,” he added. “It proves having that regulation is a request from many stakeholders including NGOs but also investors.”
Emily Julier, Senior Knowledge Lawyer, Sustainable Finance and Investment at Hogan Lovells, agreed that separating out the E, S and G elements in ratings can “only be a positive outcome” for investors who can then use the weightings in a way that “follows their own strategy and purpose”.
The committee underscored the importance of ensuring the availability of “accurate and reliable” ESG information and noted that the ratings market “currently suffers from a lack of such transparency”.
The proposal requests ESG ratings firms provide information on whether the rating considers alignment with the objectives set in the Paris agreement for the ‘E’ factor, compliance with International Labour Organisation core conventions on Right to Organise and Collective Bargaining for the ‘S’ factor, and alignment with international standard on tax evasion and avoidance for the ‘G’ factor.
The ECON proposal also adds provisions to ensure rating products “explicitly disclose” the materiality of the rated entity. This means divulging whether the delivered rating addresses both material financial risk to the rated entity and the material impact of the rated entity on the environment and society, or only takes into account one of these.
EU-based investors have increasingly adopted a double materiality lens ahead of new regulations meaning they wanted to see an overall picture of financial and impact elements reflected in company ratings.
Julier said the promotion of the double materiality approach for ESG ratings in the EU “shouldn’t be a surprise”. “It is the backbone of the EU sustainability reporting regime and something that these same users may be reporting on and considering as part of their strategies,” she added.
This regulation has been designed complement other existing legislation including the Sustainable Finance Disclosure Regulation, Taxonomy Regulation, Corporate Sustainability Reporting Directive, and Green Bonds regulation.
Peter Sellar, Regulatory Partner at Fieldfisher, described the proposal as a “welcome step”, but he warned that the breakdown of ESG criteria requires “careful consideration” to strike the right balance in ensuring regulatory measures “support and enhance” the reliability of ESG information without “unduly burdening” companies and businesses.
“Efforts should be focused on streamlining processes to encourage green finance, ensuring that regulatory frameworks work synergistically rather than duplicating efforts,” he added.