ESMA Spell Out Their Regulatory Vision for ESG Rating Agencies

As we discussed in a previous post, the calls for the regulation of the ESG ratings sector, particularly in the EU, are growing louder by the day. ESMA have recently responded to the European Commission regarding this point – see here – via its response to public consultation regarding the Renewed Sustainable Finance Strategy, but it has now attempted to provide further detail. In a letter addressed to the EC at the end of January, ESMA provide more detail on its regulatory vision for the sector, and the obstacles that exist.

 

ESMA starts by noting that there will be difficulties in moving towards a more formal regulatory framework surrounding the ESG Rating Agencies. That the ratings and the ‘agencies’ themselves are complex in nature does not help. Also, as the industry attempts to innovate to meet the ever-growing need for its services, this has also been identified by ESMA as being problematic. They even note that ‘estimating the number of firms in the market for ESG ratings is challenging’, which highlights at what stage any regulatory endeavour is currently at – to digress for a moment, this is why my forthcoming book Sustainable Rating Agencies vs Credit Rating Agencies: The Battle to Serve the Mainstream Investor attempts to make sense of the market and its participants, because even that simple understanding is not agreed upon yet. Perhaps the biggest challenge that ESMA identify is that the regulation needs to be aligned to larger regulatory movements, like that which the EU are attempting to define the marketplace by (like the Union’s ‘Action Plan’ etc.)

 

In detailing the potential framework, ESMA describe an overarching framework that covers all ESG-related assessment tools, irrespective of measurement objective. We know full well, because of the work undertaken by a number of scholars, including those as part of the Aggregate Confusion project, that ESG ratings are certainly not uniform (not even close) and that this is causing particular problems for the market. Then, the plan is to have any firm that provides for ESG ratings or assessments registered with the regulator, thereby formalising the marketplace like its credit rating brethren. In order to categorise this, ESMA suggests that any firm that ranks entities based on ESG would count as a regulated entity. This would force the industry participants to be subject to rules relating to organisational and transparency requirements, as well as a raft of conflict-of-interest related rules. However, ESMA do note that whilst ESG rating firms should be registered and regulated, and that their product base should be regulated, this should not be done as prescriptively as the credit rating agencies have their ratings regulated – presumably, to allow firms to creatively respond to the market’s needs, and in recognition of the subjectivity of ESG analysis. As to what level of prescriptiveness is appropriate, ESMA do not say; they do state, however, that the regulations on the outputs of the ESG rating agencies ‘should be sufficiently stringent to ensure that ESG ratings and assessments are based on up to date, reliable and transparent data sources, and developed according to robust methodologies that are transparent and open to challenge by investors’. They conclude by confirming that whilst the biggest entities should be subjected to the full suite of regulations, this regulatory framework needs to be proportionate for those smaller players, in order not to stifle competition and essentially oligopolise the market (although I suggest here and in my other works, that the market does not function well with too many industry players). They finish by noting the overlap between the regulation of the ESG rating industry and other industries (like the credit rating industry) and, in that light, request that ESMA be positioned as the regulator of this new framework.

 

ESMA is correct in both identifying these issues, and positioning itself as the European regulator of this industry. Regulation is of crucial importance, because the market for the services of the ESG rating agencies is growing by the day. Also, it is clear that they will play an important part of the EU’s regulatory objectives moving forward (for example, the regulations regarding the disclosure of non-financial information will potentially have a massive impact on the ESG rating industry [and, I suggest, an ultimately negative one – see my latest article here for more on this]). It will be very interesting to see how this develops, and for two reasons: the first is how the EU will position this regulation within its overarching framework, but second it will be very interesting to see how the industry itself reacts. Will it lobby to water down the regulations? Will the credit rating agencies insert themselves into the regulatory conversation to form a regulatory framework that accelerates the likely trajectory that sees them take over the market? Does this potential regulatory intervention perhaps slow that trajectory in formalising the ESG rating industry, thereby legitimising it for the market? Will the regulatory formalisation kill the smaller players? There is a lot to be decided, but this movement from ESMA is potentially the starting point for those questions to be ultimately answered.

 

Keywords – ESG rating, sustainability, investment, ESMA, regulation, @finregmatters