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Commentary

When is an Asset Manager an ESG Ratings Provider?

Lewis Saffin, Associate at Herbert Smith Freehills, highlights the key takeaways for asset managers from incoming ESG rating regulation in Europe.

Having the support of the European Council and the responsible European Parliament committee, the final compromise text in relation to a regulation on ESG rating activities (the regulation) is expected to start applying 18 months after its entry into force following formal approval and publication. Once live, the regulation will represent the first compulsory rules governing ESG rating activities in Europe.

ESG rating providers are the primary focus of the proposed regulation. However, alternative investment fund managers, UCITS management companies and portfolio managers which use ESG ratings for their products and services carried out in or marketed into the EU (collectively, asset managers) may be in scope if they procure these ratings from third parties or generate them using proprietary ESG methodology.

Asset managers should consider:

  • whether they are subject to regulatory obligations as an ‘ESG rating provider’ for the purposes of the regulation; and
  • whether they are subject to disclosure obligations as the provider or user of ESG ratings.

Can an asset manager be an ‘ESG rating provider’?

The regulation defines an ESG rating provider as “a legal person whose occupation includes the issuance and publication or distribution of ESG ratings on a professional basis”.

ESG ratings are broadly defined and could potentially include any sort of ESG scoring system.

As such, any asset manager which uses a proprietary methodology to generate ESG scores would potentially be issuing ESG ratings and fall within the definition of an ‘ESG rating provider’. However, there are certain exemptions from the substantive licensing, organisational and methodological obligations for ESG rating providers which could be availed of by asset managers.

Relevant exemptions for asset managers

The main carve-outs from the regulation which will be relevant to asset managers relate to:

  • private ESG ratings which are “not intended for public disclosure or for distribution”;
  • ESG ratings issued by regulated financial undertakings that are used exclusively for internal purposes or for providing in-house or intragroup financial services or products; and
  • disclosures mandated by certain provisions within Regulation (EU) 2019/2088 (the Sustainable Finance Disclosure Regulation; SFDR) and Regulation (EU) 2020/852 (Taxonomy Regulation).

Moreover, where an asset manager issues an ESG rating which is both (i) incorporated in a product or a service which is already regulated under EU law; and (ii) disclosed to a third party, the asset manager can also avail of an exemption. However, where this disclosure forms part of its marketing communications in relation to that product or service, the asset manager must comply with certain disclosure obligations discussed below (the Additional Disclosure Exemption).

Use of proprietary ESG ratings

Considered below are three typical use cases where an asset manager may use proprietary methodology to generate an ESG rating for its in-scope products or services and how we anticipate that it might avail of an exemption.

# Use Case Analysis
1 The asset manager makes the ESG rating visible to third parties in its prospectus, periodic reporting (including under Art. 11 SFDR) or other marketing communications. This should be a clear cut example of an ESG rating being incorporated in marketing communications relating to a product which is regulated under EU law and has been made visible to third parties. If this is specifically mandated by a provision in SFDR or Taxonomy Regulation (eg a statement of the degree of the product’s taxonomy alignment or GHG emissions reduction methodology), the asset manager could likely avail of the ‘disclosures mandated by SFDR’ exemption. If not, the Asset Manager should be able to avail of the Additional Disclosure Exemption (but note additional disclosure requirements).
2 The asset manager does not make the ESG rating of its product, or those of the product’s underlying investments, visible to third parties in its marketing communications, but its marketing communications confirm that the asset manager takes ESG ratings of the underlying investments into account when making investment decisions for the fund No individual ESG score, opinion, or combination of the two, has been made visible to a third party, which suggests that the ESG rating itself is not intended for public disclosure or distribution. It would follow that the asset manager should be able to avail of the ‘private ESG rating’ exemption.
3 The asset manager’s product adopts an investment policy which restricts investments to those with a certain ESG rating No individual ESG score, opinion, or combination of the two, has been expressly made visible to a third party. It could be argued therefore that the ESG rating is not intended for public disclosure or distribution and an asset manager could seek to avail of the ‘private ESG rating’ exemption. If an asset manager were to take the view that a third party could deduct an implicit ESG rating for each investment from the investment policy and that this constitutes making the ESG rating visible to a third party, they should then seek to avail of the Additional Disclosure Exemption.

Additional disclosure exemption obligations

If an asset manager discloses to third parties an ESG rating as part of its marketing communications for its regulated products and services carried out in or marketed into the EU, that asset manager will be obliged to include certain information relating to the rating’s methodologies, objective, scope, data sources, use of artificial intelligence, and the provider’s fee model, ownership structure and risks of conflicts of interest on its website. A link to such website should be included in any marketing communications in relation to the product or service.

The European Supervisory Authorities and the European Commission will develop draft regulatory technical standards to specify the details of the presentation and content of the information to be disclosed pursuant to this obligation. This will be helpful because some of the prescribed information (eg on the fee model and ownership structure) does not necessarily seem applicable to proprietary ESG ratings of an asset manager.

This article was co-authored by Shantanu Naravane, Partner, and Heike Schmitz, Partner and Co-head of ESG for the EMEA region, at Herbert Smith Freehills.

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