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ESG Ratings Regulation Proposal Questioned Over Green Deal Alignment

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An EU proposal to regulate ESG rating agencies has been criticised for failing to align with the bloc’s broader green finance laws.

While the European Commission’s (EC) proposed regulation has been widely welcomed, critics including the Institute for Energy Economics and Financial Analysis (IEEFA) say several shortcomings would render it ineffective. An ESG ratings experts has also highlighted weaknesses in its recommendation that ratings providers be banned from offering consultancy services.

“The proposed regulation fails to show coherence with the EU sustainable finance framework,” the international energy finance research body wrote in a report this week. “These pitfalls would lessen the regulation’s effectiveness in addressing ESG rating activities’ shortcomings and suitability for fulfilling the European Green Deal objectives.”

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The proposed legislation was published earlier this year in response to a call from the International Organisation of Securities Commissions (IOSCO) to bring transparency and integrity to the publication of assessments of companies’ sustainability performance. It is intended to enable investors to make better decisions on sustainable investments by bringing the providers under the watch of the European Securities and Markets Authority (ESMA).

Ratings are the most used form of ESG data and provide financial institutions. Unlike corporate and sovereign credit ratings, which tend to be consistent across the metrics’ providers, ESG ratings are rarely so similar. This has been a cause for concern among investors, who seek accurate and comparable datasets on which to base their investment and risk-management strategies.

The opaque formulations behind the metrics have also been attacked by the anti-ESG lobby, which argues that ratings provide a smokescreen behind which companies and asset managers can greenwash financial products.

By formulating a regulation to oversee the ratings providers and their activities the EU has gone further than many jurisdictions in heeding those concerns. In contrast, for instance, the UK’s Financial Conduct Authority has proposed a voluntary code of conduct for ratings setters.

Weak Proposals

The IEEFA said the proposed regulation came with welcome pledges to clarify aspects of the EU’s green finance initiative, including bringing the inclusion of non-climate environmental objectives within the Taxonomy, which prescribes what can be considered a sustainable activity.

However, the organisation said the proposal on a ratings regulation fails on two broad points. It doesn’t align with the EU’s sustainable finance framework, including the Taxonomy and disclosure regulations. And it hasn’t been drafted under the “double materiality” principle that tests the two-way interactions of companies’ activities and environmental processes and change.

“In IEEFA’s view, the lack of a coherent sustainable finance framework would lessen the proposed regulation’s effectiveness in addressing ESG rating activities’ shortcomings and suitability for fulfilling the European Green Deal objectives,” the organisation wrote.

Consultation Shortcomings

Daniel Cash, ESG ratings and regulations lead at international law firm Ben McQuhae, added to IEEFA’s criticism of the proposal, saying that its call for a ban on ratings firms’ engaging in consultancy services would be counterproductive. The drafters of the anticipated regulation included this to prevent conflicts of interest arising when a firm offers advice to a company on which it also calculates a performance rating.

Cash, who is also an associate professor at Aston University and author of an about-to-be-published book on ESG ratings, said that the rule was based on challenges that are found in the credit-rating industry but not the ESG ranking business.

“The majority of ESG rating agencies utilise the investor-pays model of payment,” he told ESG Insight. “Removing this service removes the ability for investors to seek support with onboarding often complex or subjective ESG ratings, which will likely cause delays to the ESG ratings being fully utilised by investors.”

He recommended instead that the EU adopt measures taken by India in the creation of its own ratings regulations, which provide for the market to be instructed to “declare … when the payment model policy for the rating agency changes, at which point a prohibition could then take hold”.

Cash also took umbrage at criticism of the proposal’s absence of a double materiality requirement on ratings firms.

“Interfering in such a manner would remove the theoretical and required independence that the ESG rating agencies are bringing to the marketplace,” he said. “That independence is the key ingredient in the agencies bridging the asymmetrical information gap that exists in the marketplace. Infringing on the theoretical independence of a rating agencies, credit or ESG, is non-negotiable if the agency is to fulfil its role of facilitating the movement of capital.”

The EC has put the rating regulation proposal out for further discussion and are due to be passed into law.

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