The European Commission has put forward a raft of new measures to build and strengthen the foundations of the EU Sustainable Finance framework.
It comes amid growing demand from investors for ESG-focused investment products and solutions, as well increasing European regulations such as the Sustainable Finance Disclosure Regulation, Corporate Sustainability Reporting Directive, EU Taxonomy Regulation and Shareholders Rights Direction, which have all reinforced the need for asset managers to incorporate ESG considerations into their investment processes.
However, the investment industry has warned that the lack of transparency in data sources, methodologies and quality has created uncertainty and confusion, making it difficult for asset managers to assess the true sustainability of their investments and is affecting the confidence they have in ratings providers.
In response, the Commission is seeking to make ESG ratings more reliable and transparent, providing companies with greater clarity on the way they are rated.
In a new paper published this week, the Commission said “new organisational principles and clear rules on the conflicts of interest” will increase the integrity of the ESG rating providers. It believes its proposals will improve reliability, comparability and transparency of ESG ratings.
According to the proposals, ESG rating providers offering services to investors and companies in the EU should be authorised and supervised by the European Securities and Markets Authority.
The proposals also require ESG ratings providers to use rating methodologies that are rigorous, systematic, objective and subject to validation. ESG ratings providers should review ESG rating methodologies on an ongoing basis and at least annually.
Furthermore, the commission says ESG ratings providers should disclose information to the public on the methodologies, models and key rating assumptions which they use in their ESG rating activities and in each of their ESG ratings products.
This should help investors to make better informed investment decisions regarding sustainable investments and enable rated entities to better manage ESG risks and the impact of their operations.
However, the proposals are not intended to harmonise the methodologies used for the creation of ESG ratings. ESG rating providers will remain in full control of the methodologies they use and will continue to be independent in their choice, the Commission said.
Commenting on the proposals, the European Fund and Asset Management Association (EFAMA) said that prompt improvements are crucial to provide legal certainty and reliable ESG data and ratings.
Chiara Chiodo, regulatory policy adviser at EFAMA, said: “EFAMA believes that a comprehensive regulatory framework covering both ESG data providers and ESG rating providers is essential to ensure reliable and transparent ESG information. By addressing the challenges in the ESG data ecosystem, asset managers and investors will have access to robust information for informed decision-making and compliance with regulatory requirements.”
Daniel Klier, CEO at ESG Book, added: “Any bubble driven by opaque ESG ratings won’t wait for regulation before it bursts. So regulators must act with urgency before broken ratings undermine the potential of what ESG can achieve.
“By opting for transparency over standardisation, the EU’s proposals are a promising blueprint, but they must go all the way. Transparency of methodology just amounts to transparency of the first layer. Unless it drills down to the bottom, revealing source data, markets will never understand what’s driving scores.
“These regulations must also transcend borders. As one of the first movers, the EU has a responsibility to make principles-based regulations with the rest of the world in mind, so global flows of capital aren’t strangled by a patchwork approach.”
