EU lawmakers are poised to formally regulate environmental, social and governance (ESG) ratings agencies, following a provisional deal between the European Council and Parliament struck this month on measures proposed last year.

Under new laws, any EU-based ESG ratings agency that wants to work in the region must seek clearance from the European Securities and Markets Authority (ESMA). As part of that process, agencies must show that they are complying with transparency rules around their data sources and how they decide their ratings.

However, it also requires agencies to be distinct in their approach to the three components of ESG. While the agreement sees potential for agencies to set separate E, S and G ratings, it says that in any case where a single rating is provided, that score must explicitly state its weighting between the E, S and G factors.

The Council and Parliament believe that will provide investors with greater clarity and detail for their decision-making than ratings that merely lump those factors together.

Forbidden activities

Non-EU agencies that wish to work in the region face tougher rules around their freedom to operate. One path available to an overseas agency would be to secure a formal endorsement of its ESG ratings from an EU-authorised provider. Another would be to seek inclusion in the EU’s registry of authorised providers, on the basis of an ‘equivalence decision’ linked to its country of origin. But that path would only be open following successful talks between ESMA and the relevant watchdog in the agency’s home country.

In addition, the agreement sets rules around agencies’ corporate structures and work streams. Unless agencies set up systems specifically designed to prevent conflicts of interest with their core ESG ratings business, they are forbidden to engage in activities such as consulting work for investors or companies, investment services, auditing of financial statements, insurance, reinsurance, issuing credit ratings or setting benchmarks.

Alongside the main rules, which are aimed at large agencies, the agreement also provides a “lighter, temporary and optional” regime for smaller providers. Those that opt in will be required to comply with some general governance and transparency principles. They will also be subject to ESMA’s powers to request information and carry out on-site inspections. However, they will benefit from proportionally lower ESMA fees.

In an update to clients, law firm Linklaters described the deal as an “important milestone” in the supervision and regulation of ESG ratings providers. The firm noted that while voluntary codes for agencies are underway in Japan, Singapore and the UK, the EU measures “go much further than any of those other regimes”.

Primary mission

Welcoming the agreement in a statement from the Council, Belgian Minister of Finance Vincent Van Peteghem said: “Increasing investor confidence through transparent and regulated ESG ratings can have a significant impact on our transition to a more socially responsible and sustainable future.”

Aurore Lalucq MEP, who led negotiations from the Parliament’s side, said in a LinkedIn post: “The primary mission of ESG ratings is to provide investors with useful, transparent information regarding the extra-financial performance of a company.” She said ESG ratings are currently opaque and hard to compare, leading to confusion and lack of trust in the ESG ratings system.

In the absence of clear regulation, end users of ESG ratings have often doubted the reliability and quality of the data – and “sometimes for good reasons”. Lalucq referred to a recent scandal around French nursing homes group Orpea, which she said had received an excellent ESG rating, even amid allegations that it had mistreated elderly people.

Lalucq says separating out the E, S and G criteria would provide investors with transparent and reliable sustainability information. Aggregating the scores for those criteria “didn’t make any sense. An excellent grade in one area may hide disastrous results in another,” she said.

Also taking to LinkedIn, Mairead McGuinness, EU Commissioner for Financial Services, Financial Stability and Capital Markets Union, wrote: “This landmark agreement will make ESG ratings clearer and more trustworthy.” Credible and comparable ESG ratings, she added, “will help private investment in sustainability and support a burgeoning market”.

The deal now requires formal approval by the Council and Parliament before the measures enter the EU’s adoption process. The rules will begin to apply in law 18 months after they take effect.