ESMA issued a letter to EC, sharing its views on the main challenges in the area of environmental, social, and governance (ESG) ratings and assessment tools. In its letter, ESMA highlights the need to match the growth in demand for these products with the appropriate regulatory requirements to ensure their quality and reliability. This issue is linked with the more pervasive one of data quality in the area of sustainable finance, in relation to which ESMA strongly supports the efforts of EC to improve the quality of reported information through various initiatives. These initiatives include the review of the Non-Financial Reporting Directive (NFRD), the regulation on sustainability‐related disclosures (SFRD), and the disclosure requirements under the Taxonomy Regulation.
The letter builds on the response of ESMA to the EC consultation on renewed sustainable finance strategy, in July 2020, wherein specific issues related to the ESG ratings and assessment tools were raised. In the response, ESMA highlighted issues with the lack of a legally binding definition and comparability among providers of ESG ratings or legal requirements to ensure transparency of underlying methodologies of such ratings. In addition, ESMA highlighted concerns about protection against conflicts of interest that may arise in the business models of these providers, which give rise to the risks of capital misallocation, product mis-selling, and greenwashing. However, no appropriate legal tools exist to address these issues. In the letter, ESMA identifies the following actions that could be taken to address these issues effectively and proportionately:
- There should be a common definition of ESG ratings that covers the broad spectrum of possible ESG assessments on offer. This would ensure that all existing products that aim to provide an assessment of the ESG profile of an issuer or a security, regardless of the specific measurement objective, are subject to the same basic level of investor protection safeguards. This will also help future-proof any regulatory framework and mitigate against possible obsolescence. In setting up any definitions in this area it will be important to ensure consistency with definitions across other areas of EU capital markets and sustainable finance legislation, including the Taxonomy Regulation.
- Any legal entity whose occupation includes the issuing of the ESG ratings and assessments should be required to be registered and supervised by a public authority. This would ensure that these gatekeepers of ESG ratings and assessments are subject to a common core of organizational, conflict of interest, and transparency requirements.
- There should be specific product requirements applicable to the ESG ratings and assessments provided by that entity. These should not necessarily be of the same level of prescriptiveness as those applicable to credit ratings. However, they should be sufficiently stringent to ensure that ESG ratings and assessments are based on up to date, reliable and transparent data sources, and developed according to robust methodologies that are transparent and open to challenge by investors.
- Any regulatory framework in this area should ensure that larger more systemic entities are subject to a full suite of organizational and conflict of interest requirements that reflect their growing importance in sustainable finance. At the same time, it should be proportionate and adapted to the current market structure to ensure that smaller entities are eligible for certain exemptions from the most resource intensive elements, when this is appropriate. This will allow participation in the market both by well-resourced incumbents as well as the more dynamic start-ups that drive innovation.
To a large extent, these proposals have been inspired by the requirements of the Credit Rating Agencies (CRA) Regulation, as there are clear parallels between the processes of ESG and CRA rating providers and the objectives pursued by CRA Regulation. In addition to these elements, ESMA encourages that further consideration be given to how any regulatory framework could accommodate ESG ratings and assessments elaborated outside EU. The CRA Regulation could be an informative starting point in this regard. ESMA notes that ESG rating providers can be part of larger groups providing services such as green bond certification and credit ratings. Given this overlap, and to benefit from economies of scale in supervision, ESMA is ready to support possible future supervisory responsibilities in this area.
Keywords: Europe, EU, Banking, Securities, ESG, Sustainable Finance, CRA Regulation, Climate Change Risk, ESG Ratings, EC, ESMA
Dr. Denton provides industry leadership in the quantification of sustainability issues, climate risk, trade credit and emerging lending risks. His deep foundations in market and credit risk provide critical perspectives on how climate/sustainability risks can be measured, communicated and used to drive commercial opportunities, policy, strategy, and compliance. He supports corporate clients and financial institutions in leveraging Moody’s tools and capabilities to improve decision-making and compliance capabilities, with particular focus on the energy, agriculture and physical commodities industries.
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