New rules agreed on Environmental, Social and Governance ratings

Legislators on Monday agreed on rules which will add considerable transparency and structure to how environmental, social and governance (ESG) ratings are undertaken and communicated.

The new rules will regulate the ecosystem of ESG rating activities to allow investors to make more considered investments and fight greenwashing. They were agreed between a delegation of MEPs, led by Aurore Lalucq (S&D, FR) and the Belgian Presidency of the Council, representing the member states.

More transparency – Break down the ESG rating

As a rule, separate E, S and G ratings shall be provided rather than a single ESG metric that aggregates E, S and G factors. Also, if an ESG rating covers the E factor, information will also need to be provided on whether that rating takes into account the alignment with the Paris Agreement and any other relevant international agreements. If an ESG rating covers the S and G factors, information must be given on whether that rating takes into account any relevant international agreements. This breakdown should allow investors to better target their investment into one of the three areas, and have a clearer idea of the rated entity's credentials.

More transparency – Promote the ‘double materiality’ approach

The agreed rules add provisions to ensure that the rating agency should explicitly disclose whether the delivered rating assesses how the rated entity affects and is affected by E, S and G factors, i.e. whether the delivered rating addresses both material financial risk to the rated entity and the material impact of the rated entity on the environment, social and governance factors, or whether it takes into account only one of these.

In this way, ESG raters are encouraged to address the material impact of the rated entity on the environment and society (double materiality) more than is currently the case.

Boosting competition

An ESG rating provider established in the Union categorized as a small undertaking or as a small group will only be subject to some of the provisions for the first three years of its existence. This temporary light-touch approach should help start-up rating agencies and establish a more diverse ecosystem.

Quote - Aurore Lalucq (S&D, FR), rapporteur

After the deal was struck Ms Lalucq said:

"This agreement constitutes a historic breakthrough for sustainable finance. It was high time to establish clear rules in order to improve transparency in the ESG rating process and thereby restore confidence in the sustainable finance sector. Only this can allow ESG criteria to be useful tools serving the ecological and social transition.

"I am happy and proud to have negotiated on behalf of the European Parliament to make the EU the first major player to adopt ambitious legislation in this area, far from the clichés and false debates between accusations of greenwashing on the one hand and of woke capitalism on the other. One of the most important achievements of this text is the disaggregation of the Environmental, Social and Governance criteria. Only this can allow investors to be provided with transparent and reliable sustainability information."

Background

ESG investing, that is, investing which takes ESG factors into account when making investment decisions, is becoming an important part of mainstream finance. The widespread popularity and interest in ESG goals is to be welcomed as a useful tool for redirecting investment towards more sustainable companies and projects. But it also presents the risk of mis-selling and greenwashing if ESG data lacks standardized and harmonized criteria. Therefore, ensuring accurate and reliable ESG information is key. The ESG ratings market currently suffers from a lack of such transparency.

The rules aim to introduce a common regulatory approach to enhance the integrity, transparency, responsibility, good governance, and independence of ESG rating activities, contributing to the transparency and quality of ESG ratings.

They will complement other already existing legislation such as the Sustainable Finance Disclosure Regulation, the Taxonomy Regulation, the Corporate Sustainability Reporting Directive, and the Green Bonds regulation.