In December, The Council reached an agreement on its negotiating mandate on a proposal for a regulation on environmental, social and governance (ESG) ratings, with the aim of boosting investor confidence in sustainable products. This article offers a succinct analysis of the upcoming legislation and the Council's current position, based on the latest developments.

This article was written by David Boekel ([email protected]) and Ruben Harding ([email protected]). Both David and Ruben have a strong focus on Sustainability Strategies where they enable businesses to develop and implement effective Sustainability strategies that drive sustainable growth and positive impact.

 

Decoding The ‘ESG Ratings

Background

Environmental, social, and governance (ESG) investing, integrating ESG factors into investment decisions, is increasingly prominent in finance. The surge in sustainable investment funds, in terms of number, size, and capital attracted, has given rise to an ESG investment ecosystem, featuring ESG ratings. These ratings assess a company's exposure to ESG factors and their societal impact, playing a crucial role in the EU's sustainable finance market. They inform investment strategies, risk management, and disclosure obligations, and help undertakings gauge sustainability risks and opportunities.

Despite their significance, the ESG rating market faces challenges, including a lack of transparency and clarity in rating methodologies and provider operations. This undermines confidence in the ratings and hinders informed decision-making regarding ESG-related risks and opportunities. In response, the EU's renewed sustainable finance strategy aims to enhance the reliability, comparability, and transparency of ESG ratings. The new proposal focuses on:

  • ESMA's authorization and supervision of third-party ESG rating providers.
  • Separation of business to manage conflicts of interest.
  • Organizational requirements based on proportionality and principles.
  • Transparency in rating methodologies, subscriber and rated company information.
  • Fair, reasonable, and non-discriminatory fee transparency.
  • Operating provisions for non-EU providers through equivalence, endorsement, and recognition regimes.

Council's Position

In its negotiating mandate, the Council clarified the circumstances under which ESG ratings fall under the scope of the regulation, providing further details on the applicable exemptions. Additionally, in line with the Corporate Sustainable Reporting Directive, it clarified that ESG ratings encompass all three pillars: environmental, social and human rights or governance factors. 

Based on the Council’s position, ESG rating providers aiming to operate within the EU must adhere to certain prerequisites. These include securing authorization from ESMA for EU-based providers, or, for those established outside the EU, achieving an equivalence decision, endorsement, or recognition of their ESG ratings.

The Council has further elaborated on the territorial scope of the regulation, clearly defining what constitutes operation within the EU. This includes criteria for EU-based providers, such as issuing and publishing ESG ratings on their website or other channels, or distributing these ratings to regulated financial entities in the Union through subscriptions or contractual agreements. Conversely, non-EU providers are considered to be operating within the Union if they distribute their ratings by subscription or similar contractual relationships to the same types of entities as EU-based ESG rating providers. The Council emphasizes that this regulation aims to oversee the issuance, distribution, and publication of ESG ratings, but does not intend to regulate their usage.

The Council also introduced a lighter, temporary and optional registration regime of three years for existing small ESG rating providers and new small markets entrants.

Small ESG rating providers who opt in under the lighter regime will not have to pay ESMA supervisory fees. They will have to comply with some general organisational and governance principles, as well as transparency requirements to the public and users. They will also be subject to the powers of ESMA to request information and conduct investigations and on-site inspections. Upon exiting this temporary regime, small ESG rating providers will need to comply with all the provisions outlined in the regulation, including the requirements regarding governance and supervisory fees.

Regarding the separation of business and activities, the Council introduced the possibility for ESG ratings providers to not have a separate legal entity for certain activities, provided that there is a clear distinction between activities and that they put in place measures to avoid conflicts of interests. This derogation would not be applicable to consulting or audit activities when they are provided to rated entities.

Timeline 

The position agreed in December formalises the Council's negotiating position. It provides the Council presidency with a mandate for negotiations with the European Parliament, which adopted its own position on 14 December 2023. The Council presidency has now a mandate to engage in interinstitutional negotiations with the European Parliament and the European Commission, so called “trialogue”. These discussions are crucial for alignment before the European elections in June 2024.

How RSM can assist you

In today's globalized world, acknowledging and embracing the differences in ESG approaches across regions is not only a strategic advantage but also a moral imperative. By emphasizing these distinctions, countries and organizations can better adapt their ESG strategies to align with local needs and expectations.

At RSM, we are part of an international network that thrives on collaboration and knowledge sharing. Our ESG consultants frequently collaborate across borders to assist our clients, exchange ideas, and gain insights into the diverse landscapes our clients operate in. We cater specifically to medium-sized enterprises and family businesses, recognizing the unique needs and regulatory landscapes of each client, both domestically and internationally.