Quick Take: The European Commission’s Proposal on ESG Ratings and Potential Regulation
Managing conflicts of interest and increasing transparency are in full focus
On June 13, 2023, the European Commission (EC) released its proposed framework for the regulation on the transparency and integrity of Environmental, Social and Governance (ESG) rating activities. The proposed framework aims to address the lack of clarity surrounding ESG rating methodologies, data sources, and regulate the operations of ESG rating providers. With a clear focus on transparency and conflict management, this regulatory framework sets forth guidelines that ESG rating providers must adhere to. This article provides an overview of the key points from the EC’s proposal and the potential implications for the industry.
Clarity AI is reviewing the proposal in detail and will respond fully in due course. It looks forward to seeing the conclusion of the trialogue discussions and further details on the regulatory standards being developed by the European Supervisory and Markets Authority (ESMA).
In the meantime, here are a few highlights from the document published on June 13, 2023.
A New Supervisory Regime
Though not a surprise to many in the market, the Commission confirmed its intention that ESMA will directly authorize and supervise ESG rating providers. This will enable ESMA to withhold authorization from market participants who do not meet the criteria outlined in the regulation. Once authorized, ESMA will supervise ESG data and rating providers, including having the authority to request any necessary information and conduct on-site inspections. It can also impose penalties for non-compliance. To ensure the quality and objectivity of ESG ratings, providers must develop internal policies, including dedicated compliance functions.
The regulation excludes in-house ratings and raw ESG data without ratings or scores.
Transparency and Conflict Management
Transparency is a primary concern highlighted in EC’s proposal. It emphasizes the need for ESG rating providers to disclose granular information not only to the users of their models but also to the entities being rated. EC also envisages disclosure of certain information to the public, via the European Single Access Point (ESAP). The EC acknowledges the potential challenge in balancing the dissemination of sensitive information while maintaining confidentiality. Clarity AI is well placed in this respect as transparency is a core value of its business.
Conflict management is fairly far-reaching for especially legacy players in the market as the EC suggests that ESG rating providers should not offer consulting, credit ratings, benchmarks, investment activities, audit or banking, insurance and reinsurance.
ESG Rating Methodologies
ESG rating methodologies must meet specific criteria outlined in the ruling. They should be rigorous, systematic, objective, continuous, and subject to validation. Additionally, these methodologies must be reviewed at least annually to maintain accuracy and relevance. Clarity AI is supportive of these measures as they formalize its way of doing business.
Governance
Analysts involved in ESG ratings will need to manage conflicts of interest carefully, avoiding ownership of any instruments supported by ESG scores. Complaints handling procedures must be established, and governance requirements can be subject to exemptions for small and medium-sized enterprises (SMEs), which are defined as having fewer than 250 employees, less than €50M in annual revenues, and less than €43M on the company’s balance sheet.
Equivalence and European Single Access Point (ESAP)
The proposed rule provides a provision for equivalence, allowing ESG rating providers registered in other jurisdictions to endorse ratings provided outside the EU. The endorsement process requires adherence to the International Organization of Securities Commissions (IOSCO) recommendations for ESG Ratings and Data Products Providers.
ESAP will serve as a centralized platform for making information on ESG ratings and providers available to the public. It will list authorized ESG rating providers, including those qualifying through third countries. ESG rating providers will be required to disclose public information on ESG ratings to ESAP in machine-readable format starting from January 2028.
Implications and Potential Challenges
The proposal sets a tight timeline for approval, with the framework expected to go into force by mid-2024. However, its final approval by the Parliament and Council may face delays, potentially impacting the implementation timeline. Compliance costs and the potential burden on smaller and innovative entities raise concerns that need to be addressed in a proportionate manner.
Penalties for non-compliance for impacted companies can be as large as 10% of a company’s global annual revenue.
Conclusion
The proposed rule on ESG ratings aims to enhance transparency, mitigate conflicts of interest, and promote the quality and objectivity of ESG ratings in the EU. ESG rating providers must be prepared to disclose comprehensive information, adhere to rigorous methodologies, and comply with the supervision and enforcement powers of ESMA. As the regulatory framework progresses towards implementation, ESG rating providers will need to navigate these requirements while ensuring compliance with the evolving landscape of sustainable finance. Clarity AI’s governing principles around being transparent, fact-based and flexible are aligned with the proposal’s principles and will help Clarity AI to continue to deliver on its mission to bring societal impact to markets. Additionally, Clarity AI will maintain its ongoing dialogue with regulators and other stakeholders to ensure that rules remain proportionate and do not discourage innovative business models that can bring creative solutions to the challenges in sustainable finance and that it remains ahead of the curve as regulation develops.
