Financing the transition to a climate-neutral and sustainable economy by 2050 is at the heart of the EU Commission's strategy for sustainable finance. In June 2023, the Commission reaffirmed its objective in a communication entitled "A framework for sustainable finance that works on the ground". Among other things, the EU Commission proposed a regulation on the transparency and integrity of Environmental, Social and Governance ratings activities (ESG Ratings Regulation).
The ESG Ratings Regulation is in line with international efforts to include ESG ratings more definitively in the regulatory framework and ties in with a report by the International Organization of Securities Commissions (IOSCO) from November 2021 on ESG ratings data product providers.
Scope of application
The ESG Ratings Regulation applies to ESG ratings issued by ESG ratings providers operating in the EU and published or disseminated to certain institutional recipients, namely regulated financial firms in the EU, companies falling within the scope of the EU Accounting Directive or EU or member state authorities. Other than its name suggests, the ESG Ratings Regulation is essentially a service provider regulation and not a product regulation.
Authorisation and ongoing regulatory requirements
The addressees of the Regulation’s obligations are ESG ratings providers operating in the EU, which, if established in the EU, will be subject to an authorisation requirement. Third-country ESG ratings providers are not subject to an authorisation requirement, but cannot escape regulation. Rather, they have to gain access to the EU's ESG ratings market via one of three regimes: equivalence, endorsement or recognition. The equivalence regime is offered only to ESG ratings providers located in a third country where a positive decision on equivalence of the third-country regime has been taken by the Commission. The endorsement regime allows ESG ratings providers to endorse ESG ratings developed outside the EU, but within a group, provided that they establish an authorised ESG ratings provider in the EU. Smaller ESG ratings providers that do not belong to a group and may not have the means to have a legal entity authorised in the EU may benefit from the third regime, a lighter-touch recognition system. Authorised ESG ratings providers are subject to a comprehensive program of ongoing regulatory obligations, including business organisation, conflicts of interest and disclosure requirements, which are all aimed at strengthening the quality, integrity and transparency of ESG ratings.
ESMA as centralised supervisor
In order to ensure a level playing field in ongoing supervision and to eliminate the risk of regulatory arbitrage in all member states, the ESG Ratings Regulation proposes to vest the European Markets and Securities Authority (ESMA) with exclusive responsibility for the authorisation and supervision of ESG ratings providers. Originally conceived as a Level 2 and Level 3 standard setter and "supervisor of (national) supervisors", ESMA will thus be given further competences in the authorisation and ongoing supervision of individual market participants in addition to its competence to supervise traditional credit rating agencies and administrators of EU-critical benchmarks.
Following the publication of the EU Commission's proposal, the ball is now in the court of the European Parliament and the Council of the EU. If the ESG Ratings Regulation is to come into force in the foreseeable future, the Parliament and the Council will probably have to agree on a joint text by next spring at the latest and then adopt it before the European elections in early June 2024.