Agencies that rate businesses and investment funds on their environmental, social and governance credentials may face fines for conflicts of interest under new EU rules aiming to regulate the fast-growing industry for the first time.
The proposal, to be announced by the European Commission next week as part of a crackdown on “greenwashing”, will require ESG rating agencies — including those from outside the bloc — to certify with the EU’s financial regulator.
The agencies will be required to divest from any conflicting activities, such as consulting or offering insurance to businesses they rate, and risk being fined if conflicts of interest persist — a rule that observers said would force some agencies to change their practices.
The fines would amount to up to 10 per cent of annual turnover.
European regulators are seeking to counter greenwashing in the rapidly growing sustainable finance industry and direct private financial flows towards genuinely environmentally friendly activities.
The EU’s draft proposal said that “the current ESG rating market suffers from deficiencies and is not functioning properly, with investors and rated entities’ needs regarding ESG ratings . . . not being met”. It added that “confidence in ratings is being undermined”.
The draft warns of “divergences, lack of transparency and absence of common rules” and says it aims to avoid member states introducing their own disparate measures.
The regulation will need to be agreed by the European parliament and member states before taking effect, in a process likely to include amendments.
Investors held $2.74tn in sustainable funds globally at the end of March compared with $929.9bn three years earlier, according to data provider Morningstar.
A handful of data giants dominate the provision of ratings, including New-York based MSCI and Sustainalytics, which was bought by Morningstar in 2020. Leading proxy adviser Institutional Shareholder Services has an ESG ratings branch, as does credit ratings group S&P Global.
The International Organization of Securities Commissions called in 2021 for regulators around the world to turn their attention to ESG data providers and their environmental and social claims.
One of the first to respond was the Securities and Exchange Board of India, which proposed a regulatory framework in February that would require ESG ratings providers to register with the regulator. Providers would have to take steps to avoid conflicts of interest and promote transparency.
The UK regulator is working on a voluntary code of conduct for data and ratings providers, while the UK Treasury is consulting on whether to give the regulator the power to crack down more formally on ESG ratings.
“We’re not waiting for a crisis [to act],” Sacha Sadan, head of environmental, social and governance issues at the UK’s Financial Conduct Authority, previously told the Financial Times. The industry has “grown up very fast . . . it’s a very big part of the investment chain now”.
The EU’s regulation would cover all ESG ratings providers in Europe and those from third countries that provide ratings within the bloc.
But in-house ratings departments, national authorities and in some cases central banks would be exempt, while small rating agencies — with a turnover of €8mn a year or less — would benefit from lighter-touch rules.
Agencies will have to show that ratings are sufficiently independent from their business interests, and will not be allowed to offer consulting, auditing or other financial services, according to the draft rules.
The EU estimates that 59 ratings providers will come within its regulatory scope.
Thierry Philipponnat, chief economist at Finance Watch, an NGO, said that the separation of business activities was “good governance”.
“Quite a number of [agencies] today provide consultation services and ratings, so they are not going to like that, but frankly it is good practice,” he said.
But Philipponnat added that the draft rules neglected to regulate the objectives of ratings providers, such as whether ESG scores should aim to assess the financial impact of climate change on a company’s activities or the converse, businesses’ own effect on the environment or society. Both types of objectives are currently included within the ESG umbrella.
“I really regret that this piece of regulation barely alludes to the substance,” he said.
Under the draft rules, Esma will have the authority to set out “technical standards” in later legislation. The commission declined to comment on the draft.