The EU Takes a Pragmatic Approach to Regulating Credit Rating Agencies’ Connection to Sustainable Finance

The two elements of today’s post are common subjects here in Financial Regulation Matters. There are a variety of posts concerning credit rating agencies, on account of it being this author’s specialism, whilst there are also a number of posts concerning sustainable finance, and the incorporation of Environmental, Social, and Governance (ESG) concerns into the financial process. In the author’s most recent book The Role of Credit Rating Agencies in Responsible Finance, the continued and concerted entry of the leading CRAs into the growing field of sustainable finance was analysed, with one of the overarching sentiments being that regulatory oversight would be needed, and be needed soon. The EU has attempted to rise to that challenge and recently responded to orders from the EU Commission to put together a regulatory agenda in this field with their ‘Technical Advice’ on the matter. In this post we will look at these developments.

Released on the 18^th July, The European Securities and Markets Authority (ESMA) presented their response to the orders contained within the Action Plan for Sustainable Finance, officially disseminated in March 2018. The Action Plan aimed to build upon a report developed by an expert group earlier in 2018 that suggested that sustainable finance ‘is about two urgent imperatives’. First, there was a need to ‘improve the contribution of finance to sustainable and inclusive growth’, and second there was a need to strengthen financial stability by incorporating ESG factors into investment decision making. In Action 6 of the Plan, the Commission stated that it would engage with all relevant stakeholders ‘to explore the merits of amending the Credit Rating Agency Regulations to mandate credit rating agencies to explicitly integrate sustainability factors into their assessments’. They also ordered ESMA to ‘assess current practices in the credit market’ specifically in relation to the extent to which ESG factors are taken into account. There was also an aim to encourage sustainability ratings and market research.

The headlines surrounding the release of ESMA’s response read like ‘ESMA urges ESG transparency for credit ratings but no requirement’. The Head of ESMA, Steven Maijoor, stated that market regulation needed to reflect the ‘reality’ of climate change and that there is a ‘need for vigilance on the levels of investor protection’. Yet, in the eyes of ESMA, this is not to be achieved by mandating the methodologies of the rating agencies which, as we know, is an area of their business which CRAs defend above else. The reason for ESMA’s conclusion is rather predictable, as it is the same as every other investigation. The PRI’s polling of its signatory agencies (the very same agencies for the most part), suggested that CRAs do factor in ESG considerations, but that it is either a. difficult to determine when and to what standard because it varies, and b. the usefulness of incorporating any one of the three elements, or even more than just one, will depend upon the issuer or product that the agencies are rating. For the past few years since the agencies have been making purposeful moves into the sustainable finance marketplace, they have all been saying exactly the same thing: we have always incorporated ESG into our analysis. This makes absolute sense, because it would only serve to improve the usefulness and worth of their rating, not detract from it. But, the agencies are clear that, as an abstract concept, one cannot quantify how ESG is incorporated – they argue it is just ‘part of a larger process’. The arguments often put forward are that they become relevant depending on the sector. For example, ‘S’ocial and ‘G’overnance may impact a sovereign rating more than a coal-mining company’s rating, with that rating tending to focus more on the ‘E’nvironmental and the ‘G’overnance angles. It worth stating here that the call from the marketplace, in terms of altering the rating agencies’ methodologies, is that they should not be as focused on the financial elements of the rating, and should incorporate ESG more. The million-dollar question is ‘how does one mandate that?’

For ESMA, one cannot. It is for this reason that they state that it would be ‘inadvisable’ to alter the regulations. They do however suggest that it may be better to update the CRA Regulations’ disclosure provisions, which ESMA have noted as being a particularly important issue. In their Final Report: Guidelines on Disclosure Requirements Applicable to Credit Ratings, it is declared that there is an inconsistency amongst agencies in relation to how they are disclosing their methodologies (and the impact of ESG within those methodologies). As a result ESMA will be pushing ahead with the development of a single set of good practice, in order to increase the informational value and consistency of the agencies’ press releases and reports.

The resulting sentiment that one can take from this is extraordinarily similar to a host of other regulatory investigations since the Financial Crisis (and, in truth, long before). The aims of the EU Commission are wildly out of step with the reality of the marketplace, and ESMA have essentially made that point to the Commission. Attempting to affect elements such as methodologies and competition within the marketplace are dead-ends in the credit rating arena. This is because the oligopolistic structure is what determines developments, not regulation and legislation. The sooner legislators and regulators learn this the better. That is not to say, of course, that the rating agencies should be given free reign, because that is certainly not optimal given that we are now living with the consequences of what happens when they are given that freedom. No, instead the probable best course of action is that suggested by ESMA, in that it is the sustainable financial products, and how they are created, assimilated, and dispersed across the financial system, which need to be regulated. This is an incredibly prudent regulatory agenda, and one that should be solidified within the EU’s future plans. With the sustainable finance field growing and growing, there will be the temptation to link aspects such as a bank’s capital reserves to the amount of sustainably-positive financial products it is holding (as just one very crude example), and regulators must be incredibly wary of doing this. The result would be to incentivise the gamification of this new financial field, which would bring in the biggest players – as it is already doing – which often leads to the very same result. However, the development of sustainable finance is, arguably, societally positive, so it really ought to be protected. It is positive to see ESMA fight their corner and take a pragmatic approach to regulating this regulatory ever-so-difficult industry and its impact on the marketplace.

Keywords – Credit Rating Agencies, EU, Sustainable Finance, Business, @finregmatters