The EU sets out the basis for ESG ratings in finance

With the aim of setting out a common legislative framework for enhancing the transparency, integrity and quality of environmental, social and governance (ESG)  ratings, on November 6 the European Union adopted the  Regulation on the transparency and integrity of Environmental, Social and Governance rating activities. Facilitating sustainable finance alongside protecting consumers and investors are at the core of this new regulation, which is in alignment with the UN’s Sustainable Development Goals (SDGs) and the European Green Deal.

Improving the transparency and quality levels in ESG ratings are between the objectives pursued by this new regulation, in addition to guaranteeing  the integrity and comparability between them. Another priority is to protect consumers and investors from greenwashing and misinformation. Lastly, it also seeks to promote sustainable finance and channel capital flows towards sustainable investments.

To achieve its aim, the regulation imposes obligations on all ESG rating providers operating in the European Union. For the purposes of this regulation, this classification applies, among other entities, to providers issuing and publishing ratings on their websites or distributing them to regulated EU financial undertakings. The obligations to be taken into consideration by ESG rating providers are the following:

• Obtaining an authorization from the European Securities and Markets Authority (ESMA) to be able to operate in the European Union. Additionally, there is a temporary regime with reduced requirements that can benefit small providers before they obtain complete authorization.
• Disclosing on their websites and through the European Single Access Point (ESAP) the methodologies, models and key rating assumptions used by them.
• Providing detailed information on data sources, data processes and any use of artificial intelligence in both data collection and rating processes.
• Ensuring the independence of their rating activities and avoiding inappropriate influences.
• Implementing policies and procedures to identify, manage and mitigate conflicts of interest.
• Not offering consulting services, credit ratings, benchmarks, investment or audit services, or banking or insurance activities.
• Establishing an organizational structure with clear roles and responsibilities.
• Implementing internal control mechanisms and administrative procedures.
• Maintaining a permanent, independent and effective oversight function to ensure the issuance of the provision of their ESG ratings
• Notifying the rated item or the issuer before the first issuance of the ESG rating to give the opportunity to correct any factual errors.
• Providing access to the data used for the rating, thereby enabling the information to be verified.

ESMA will have the power to supervise the activities of ESG rating providers. In the event of infringement of the regulation’s obligations, it can impose sanctions, including fines and periodic penalty payments. It will also be able to suspend or withdraw authorizations for providers who do not abide by the stipulated requirements.

Any regulated financial undertakings that use ESG ratings in their products or services must ensure that they fulfill the regulation's requirements. Moreover, where they refer to ESG ratings in their marketing communications they must disclose the same information as rating providers.

The competent authorities will be in charge of supervising financial undertakings’ compliance with the regulation. To make this possible, financial undertakings are obliged to cooperate with the authorities and provide the necessary information for their supervision.

In short, the regulation on ESG ratings in the EU provides a strong legal framework for ensuring the quality, transparency and integrity of this type of ratings, and by doing so paves the way for sustainable finance as well as for protecting consumers and investors.