ESG ratings: European Council and Parliament reach consensus on new regulation

• ESG rating providers must be authorised by ESMA or have their ratings endorsed or registered based on equivalence to operate in the EU
  
  
• Providers must disclose rating methodologies on their websites, with separation between business activities and ESG ratings 
  
  
• Small ESG rating providers can use a temporary, lighter registration process for up to three years, after which they must fully comply

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Background

The proposal was first presented by the European Commission in June 2023 as part of the Commission's renewed sustainable finance strategy. The Commission, noting that ESG ratings, which have an increasingly important impact on the operation of capital markets, suffer from deficiencies, has committed to take action to improve the reliability, comparability and transparency of ESG ratings.

Main elements of agreement

The key terms of the provisional agreement include:

• a requirement for ESG rating providers established in the EU to obtain authorisation from ESMA with rating providers outside the EU requiring either an endorsement of their ratings by an EU authorised ESG rating provider based on quantitative criteria or entry onto an EU registry of ESG rating providers based on an equivalence decision made in respect of its country of origin, in order to operate in the EU;
• an optional lighter and temporary registration regime of three years for small undertakings and groups providing ESG ratings, with full compliance required after the end of the three years or the possibility for exemption from certain requirements where specific conditions are met;
  the introduction of transparency rules with financial market participants or financial advisers that disclose ESG ratings as part of their marketing communications being required to include information about the methodologies used for such ratings on their website; and
• a requirement to separate business and ESG ratings activities, with a possibility for ESG ratings providers not to set up a separate legal entity for certain activities where a clear separation between activities exists and measures are put in place to avoid potential conflicts of interests, although this derogation would not apply to ESG rating providers carrying out consulting, audit and credit rating activities. 

The provisional agreement also clarifies the ESG ratings that will fall under the scope of the regulation, namely those ratings encompassing environmental, social and human rights or governance factors as well as the territorial scope of the regulation. The agreement also includes a possibility for ESG ratings providers to offer single ratings provided the weightings of the 'E', 'S' and 'G' factors are detailed.

Interestingly, in a different approach, the UK's Financial Conduct Authority has taken the approach of proposing a voluntary code of conduct for ESG ratings providers ahead of possible regulation.

Next steps

The provisional agreement will require approval by both the European Council and the Parliament before going through a formal adoption procedure. It is expected that the regulation will then start applying 18 months after its entry into force.