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Dec 20, 2023

What the European Union agreeing to negotiate new rules on ESG ratings means for IROs

European Council says it hopes proposed regulations will ‘boost investor confidence’ in sustainable products

The path has been laid for a new set of regulations governing ESG ratings on companies listed and investment products sold in the EU, after the European Council agreed its negotiating mandate for a proposed set of guidelines.

The Council previously announced in June that it would begin the process of regulating ESG ratings to help boost investor confidence in their sustainable holdings.

The newly introduced regulations are designed to enhance the dependability and comparability of ESG ratings. Lawmakers hope this will be achieved by bolstering the transparency of operations carried out by ESG ratings providers, which ultimately will help ensure a higher level of comparability and mitigate the risk of conflicts of interest.

Now, EU lawmakers will hold negotiations in January 2024 to discuss the proposed regulations.

In the original proposal document, The European Council said: ‘The current ESG rating market suffers from deficiencies and is not functioning properly, with investors and rated entities’ needs regarding ESG ratings are not being met and confidence in ratings is being undermined.

‘This problem has a number of different facets, mainly the lack of transparency on the characteristics of ESG ratings, their methodologies and their data sources and the lack of clarity on how ESG rating providers operate.’

The document added that ESG ratings do not ‘sufficiently’ enable users, investors and rated entities to take informed decisions as regards ‘ESG-related risks, impacts and opportunities’.

Under the proposed rules, ESG rating providers will need to be authorized and supervised by the European Securities and Markets Authority and comply with transparency requirements, particularly with respect to how they source information.

The current ESG ratings market is held on a global scale. Some large ESG providers have their headquarters in the EU, whereas many others are headquartered outside the EU but have subsidiaries within the EU, those which operate inside the EU will be subject to regulation.

It is hoped that the new rules will give investors in ESG products more clarity about the securities they hold.

It is likely to impact publicly listed companies by making ratings easier to understand, and should lead to more standardization between different ratings providers.

The news comes as many listed companies are concerned about the reliability of some ESG ratings providers and the evidence they provide to back up their estimations.

This sentiment was shared by Punam Mehta, assistant general counsel at Mercer who was a speaker at the recent IR Magazine ESG Integration Forum – Autumn.

She said there was a lot of divergence within the industry in terms of reliability of companies’ ratings.

‘ESG rating providers are definitely in the spotlight,’ she said. ‘For example, regulators globally are starting to look at ESG rating providers and sending document requests to see what their methodologies consist of.’

Mehta also noted transparency and conflicts of interest as two other issues. On the latter, she said a conflict could be an ESG rating provider rating an organization and then offering competing services to help that same firm get better ratings next time.