ECON publishes draft report on the EU Commission’s proposed ESG Ratings Regulation

The EU Parliament’s ECON committee has in recent months been negotiating its position on the European Commission’s legislative proposal on authorisation and rules for ESG ratings providers published in June 2023 (see our earlier blog post here) - it has now published its draft report on the proposed Regulation, giving an early indication of its position on a number of key aspects:

• Limited changes to scope at this stage – but the Commission to consider whether to extend this scope within 3 years
• A proposed ban on aggregating E, S and G ratings into a single metric
• More stringent provisions addressing conflicts of interest, and ensuring the independence of ratings analysts
• Support for smaller ESG ratings providers

By introducing an obligation for the Commission to review scope, and the need to set out minimum requirements regarding the content of ESG ratings and their methodologies within three years of the in-force date, the Parliament appears to be sidestepping some of the potentially more contentious issues.  This could speed up current negotiations within Parliament, meaning that agreement could be reached during the current presidency – albeit this remains to be seen.

The proposals in detail

Scope

The draft ECON report does not significantly amend the scoping provisions - with the focus remaining on ESG ratings issued by ESG rating providers operating in the EU.  Further exclusions are proposed for non-profit civil society organisations that offer free rating-like services, and ESG ratings produced for the purposes of providing services to other group companies - the report also clarifies that ESG labels and controversy ratings should not fall within the ESG rating definition. 

As we reported previously, unlike the IOSCO recommendations on the same topic, the Commission is not proposing to regulate raw data at the same time as ESG ratings – and this draft ECON report does not change that position.  However a new provision has been included requiring the Commission to report on “whether the scope of this Regulation is sufficient to ensure confidence in the market and reach its objectives, including the need to extend the scope to ESG data providers.”  No doubt the extension of scope to data and data providers has been part of the current negotiations – the question remains whether those pushing for extension will be happy to accept this proposal as a compromise. 

Transparency

A key concern highlighted by the Rapporteur  in the Explanatory Statement to the draft ECON report, is that aggregating the E, S and G scores could obscure poor performance on any of these individual metrics, and therefore be “detrimental to the reliability and comparability of the ratings” – the draft ECON report therefore proposes requiring separate E, S and G ratings.   Coupled with this the following proposals are made:

• for each of these E, S and G metrics, some high-level minimum disclosure requirements referring to relevant international norms and standards; and
• the requirement for ratings providers to clearly communicate the limitations their ratings might have. 

This is quite a significant departure from the original Commission text  and it is unclear at this stage how aligned Member States are on this point – should the proposals survive into the final report, they will also need to be considered at trilogue.

The draft ECON report also proposes requiring more detailed information on the ratings’ objective – clearly marking whether the rating is assessing impact materiality, financial materiality, or some other threshold – and where only financial materiality is assessed, a clear warning about the limitations of the methodology and the conclusions that can be drawn from that rating. 

As with questions on scope, the proposal is also for the Commission to assess no later than three years after the Regulation comes into effect whether it should be expanded to include minimum requirements regarding the content of ESG ratings and their methodologies (notwithstanding that the existing draft ECON proposals already veer into this territory).

Conflicts of interest

The draft ECON report proposes stricter requirements for ESG rating providers in the management of conflicts of interest:

• prohibiting companies in the same group as the ESG rating provider from providing consulting or audit activities to rated entities - other activities can be provided to rated entities to the extent that appropriate safeguards are in place to prevent conflicts of interest;
• preventing rating analysts, employees and other persons involved in the provision of ESG ratings not only buying or selling financial instruments issued, guaranteed or supported by a rated entity, but also any entity within the same group as the rated entity – the report also extends the prohibition on past employment in the past three years to not just the rated entity but also group companies of that rated entity (a future position within the rated company cannot be taken up within a year of the provision of a rating); and
• ensuring that the independence of persons carrying out an assessment, or participating in or otherwise influencing the determination of an ESG rating is maintained.   

Rules are also proposed to restrict shareholders or members with a 5% or more interest in an ESG ratings provider from breaching threshold conditions vis-a-vis interests in other ESG ratings providers.

Where conflicts of interests cannot be adequately managed, the Commission proposal gave the right (but not the obligation) for ESMA to require the rating provider to (i) cease the activities or relationships creating the conflict or (ii) cease providing the ESG ratings – under the draft ECON proposal ESMA is mandated to act.

Competition/support for smaller ESG rating providers

The report conveys the need to encourage competition among ESG ratings providers and foster an environment where smaller ratings providers can enter the market (flagging that “consolidation can produce higher prices, barriers to entry, lower competition, reduced innovation, less geographical diversity and poor coverage of smaller issuers”). A requirement is therefore included for entities seeking more than one rating to choose at least one provider with a market share below 5%.

Third Country ESG rating providers

The draft ECON report provides for stricter equivalence, endorsement and recognition provisions – further tightening an already draconian Commission proposal.

Next Steps

The draft ECON report remains subject to debate and therefore the Parliament’s position will no doubt change before a final report is produced in the coming months.  Once both the EU Parliament and Council have respectively reached their final position, trilogues can commence – with the hope being that negotiations can conclude ahead of the 2024 European elections.    

The regulation will enter into force on the 20th day following its publication in the Official Journal, and shall apply from six months after that date.