On 13 June 2023, the European Commission (Commission) published a proposal for a Regulation on Environmental, Social and Governance (ESG) ratings. The legislative proposal lays out a regulatory framework for the provision of ESG ratings in the EU. The main aim of the proposal is to improve the transparency of ESG ratings characteristics and methodologies and by ensuring increased clarity on operations of ESG rating providers and the prevention of risks of conflict of interest at ESG rating providers’ level.

This blog provides a high-level overview of the proposed Regulation, as well as an update on the legislative process in the European Parliament and the Council.

ESG ratings proposal: content

Scope and definitions

The proposed Regulation would apply to ESG ratings issued by ESG rating providers operating in the EU that are disclosed publicly or that are distributed to regulated financial undertakings in the EU. Several ratings, including private ESG ratings not intended for public disclosure, are excluded from the scope of the proposed Regulation. ESG ratings from an authorised ESG rating provider that are disclosed to users by a third party are outside the scope of the proposed Regulation as well. The Commission proposal defines an ESG rating as “an opinion, a score or a combination of both, regarding an entity, a financial instrument, a financial product, or an undertaking’s ESG profile or characteristics or exposure to ESG risks or the impact on society and the environment, that are based on an established methodology and defined ranking system of rating categories and that are provided to third parties, irrespective of whether such ESG rating is explicitly labelled as ‘rating’ or ‘ESG score’”.

Main requirements for the provision of ESG ratings in the EU

The proposed Regulation will require legal persons established in the EU to be authorised by the European Securities and Markets Authority (ESMA) to be able to provide ESG ratings in the EU. The Regulation provides for an authorisation process, as well as the procedure that ESMA should follow for authorising an ESG rating provider. Third-country ESG rating providers can provide ESG ratings in the EU without authorisation, under the condition that the third country is subject to an equivalence decision by the Commission and if the ESG rating provider has notified ESMA that it wishes to provide ESG ratings in the EU. In the event that the Commission has not adopted an equivalence decision for that third country, a third-country ESG rating provider can apply for ESMA recognition. The third-country ESG rating provider applying for recognition must, among other things, show that its annual net turnover for ESG rating activities has been below EUR 12 million for three consecutive years. A third option for the provision of ESG ratings by third-country ESG rating providers is by obtaining endorsement by an EU-authorised ESG rating provider. ESMA would be provided with a mandate to establish a register that containing information on ESG rating providers.

Organisational requirements, transparency and independence

The proposed Regulation contains a list of general principles that ESG rating providers must adhere to. These principles include the independence of their rating activities, the regular review of their rating methodologies, the monitoring and evaluation of the effectiveness of the systems and resources, and the maintenance of effective accounting and control systems. ESMA can exempt providers from one or more principles following a reasoned request. ESG rating providers must separate the provision of ESG ratings from other business activities, such as consulting activities, the issuance and sale of credit ratings, the development of benchmarks and investment activities. ESG rating providers must ensure that their employees have the necessary knowledge, experience and independence. The proposal also provides for record-keeping requirements and a complaints-handling mechanism. ESG rating providers would not be allowed to outsource important operational functions if such outsourcing would materially impair the quality of the ESG rating provider’s internal control policies and procedures.

ESG rating providers would be required to disclose on their website the methodologies, models and key rating assumptions they use in their ESG rating activities. Separate disclosures are required for subscribers to the ESG rating and the rated entities.

ESMA supervision

As discussed above, ESMA will be responsible for the authorisation and supervision of ESG rating providers. The proposed Regulation provides for powers with regard to requests for information, general investigations and on-site inspections. ESMA will be able to impose administrative fines on ESG rating providers that do not comply with the proposed Regulation.

Legislative process – European Parliament

The legislative review of the proposed Regulation in the European Parliament is ongoing. On 6 October 2023, the European Parliament’s rapporteur Aurore Lalucq (S&D, FR) published her draft report on the proposal, which will be discussed by the European Parliament’s Economic and Monetary Affairs (ECON) Committee. The draft report contains proposed amendments including those to:

• Scope and definitions: Lalucq proposes to exclude from the scope of the proposed Regulation non-profit civil society organisations that put together scoreboards or rankings for non-commercial purposes and who make these rankings freely accessible, to ensure that these entities do not require authorisation. In addition, the rapporteur proposes to explicitly exclude several disclosures made under the Sustainable Finance Disclosure Regulation and the Sustainable Finance Taxonomy Regulation to avoid possible conflicts of rules or unintended consequences. The exclusion from the scope of the proposed Regulation of ESG ratings produced by regulated financial entities in the EU that are used for internal purposes has also been expanded to ensure that services to other entities from the same group are also included.
• Separation of business and activities: Under the Commission’s proposal, ESG rating providers are not allowed to provide a number of professional activities, such as consulting services. Lalucq proposes to expand this prohibition by laying down that ESG rating providers, and any other entity from the same group, cannot provide consulting activities or audit activities to rated entities. In addition, Lalucq proposes to provide ESMA with a mandate to develop draft regulatory technical standards that would detail the safeguards that ESG rating providers must adhere to in the context of separating their ESG ratings business from other activities that may generate conflict of interests.
• Legislative review: The rapporteur proposes to delete the mandate in Article 46 for the Commission to amend the Annexes to the proposed Regulation, which contain the information to be provided in the application for authorisation (Annex I), the organisational requirements for ESG rating providers (Annex II), and disclosure requirements (Annex III), through the adoption of a Delegated Regulation. The proposed amendment would ensure that amendments to the Annexes would have to go through a full legislative process with more powers for the European Parliament and the Council. To compensate for this, the rapporteur proposes to shorten the Commission’s review mandate on the entire text of the proposed Regulation, including the Annexes – the review would, under the amendment proposed by the rapporteur, take place three years following the entry into force of the proposed Regulation.

The draft report will be discussed in the ECON Committee in the coming weeks.

Legislative process – Council

In the Council, Member States have held Council Working Group meetings on the proposed Regulation. We understand that the Council is still in the first stages on its review and is focusing on selected aspects. The last Council Working Group meeting that discussed the proposed Regulation took place on 18 October 2023. In terms of content, we understand that Member States discussed the following:

• Third-country regime: Under the Commission’s proposal, third-country firms would have three ways in which ESG ratings could be provided in the EU: through equivalence, endorsement, and recognition (see overview above). The Spanish Presidency of the Council has acknowledged that currently, only a few jurisdictions have introduced regulatory frameworks for ESG rating providers, but that equivalence may be granted in the future as jurisdictions may shape their own ESG ratings framework in a way that resembles the EU framework. Regarding endorsement however, Member States have raised concerns that the proposed framework may be used to circumvent the EU ESG ratings framework. The regime is meant for larger ratings providers that have a subsidiary located in the EU and which would endorse ESG ratings provided by a third-country provider belonging to the same group.  Under the framework however, a small sister company located in the EU could endorse ESG from all of the third-country companies within the same organisation, without EU supervision of these third-country providers. We understand that the Council Presidency has proposed to remove the endorsement regime.
• Proportionality: In essence, the proposed Regulation would introduce the ESG ratings framework to all ESG rating providers, regardless of their size. In its explanatory memorandum the Commission writes that, at present, 75 percent of ESG rating providers in the EU are small- or medium-sized undertakings (SMEs). To ensure that the ESG ratings framework would not become too burdensome for smaller companies, the Commission proposed to provide ESMA with the power to exempt SME ESG rating providers from certain organisational requirements. We understand that the Council Presidency believes that ESMA’s powers are too extensive and instead proposes to lay down a list of requirements that could be subject to exemptions for SMEs in the text of the proposed Regulation.

Next steps

The legislative review of the proposed Regulation, which was published in June this year, is expected to take at least one year. We expect the Council and the European Parliament to adopt their respective negotiating positions on the file in Q1 2024. That said, the European Parliament elections taking place in June 2024 are likely to significantly delay the legislative process: the European Parliament will go into recess at the end of April 2024 and is expected to restart its work on legislative files in July 2024 at the earliest. Should the constitution of the ECON Committee change significantly because of the election, the European Parliament may decide to change its negotiating position on the file.