The European Commission has this week proposed a new set of rules to force ESG ratings providers to comply to stricter requirements, in an effort to improve transparency and governance of a business that is perceived at times as opaque, impairing a proper investment decision-making process.

The new legislative proposal, a building block of series of measures on sustainable finance, applies to ratings issued by providers operating in the European Union, publicly disclosed, or that are distributed to regulated financial undertakings, including occupational pension institutions.

It assigns new powers to the European Securities and Markets Authority (ESMA), that could force ESG ratings providers to end a breach of the rules, or to comply with an investigation, and to conduct on-site inspections, according to the new rules.

ESMA can impose a fine of up to 10% of the total annual net turnover of the ratings provider. The periodic penalty, instead, is imposed for a maximum period of six months and is equal to 3% of the average daily turnover generated by the ratings agency in the year prior to the penalty or, in the case of natural persons, 2% of the average daily income in the prior year, according to draft legislation.

ESG ratings providers would be subject to a fee covering all administrative costs incurred by ESMA. Total annual costs to carry out new functions would increase for ESMA by approximately €3.7-3.8m, according to the document.

ESMA can also take back or suspend the authorisation of an ESG rating if rules are infringed or the provider has not conducted its business for a period of nine months.

The draft legislation requires ESG ratings providers to disclose potential conflicts of interest, separating business and activities.

ESMA may require the ESG ratings provider to take measures to mitigate that risk, including setting up an independent oversight body representing stakeholder and users of the ESG ratings, or asking the ratings provider to cease activities creating conflicts of interest, or stoppping provision of ESG ratings.

Providers of ESG ratings should refrain from offering consulting activities to investors or undertakings, and audit activities, banking, insurance or reinsurance activities, the sale of credit ratings, and developing  benchmarks, it added.

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The European Commission’s draft legislation requires ESG ratings providers to disclose potential conflicts of interest

Mairead McGuinness , cCommissioner for financial services, financial stability and capital markets, said: “We are bringing more transparency and integrity to the market by introducing rules on the operations of ESG ratings agencies. Enhancing the usability and coherence of the sustainable finance framework will be our key priority.”

The Commission is also considering monitoring the progress towards meeting the goal of the upcoming legislation through periodic surveys of investors, undertakings and ESG ratings providers, it said.

A dysfunctional market

The current market for ESG ratings suffers from deficiencies and is not functioning properly, the Commission said explaining the need for change.

There is a lack of transparency relating to the characteristics of ESG ratings, their methodologies and their data sources, and a lack of clarity on how ESG ratings providers operate, it said.

This has a negative impact on investors not able to make informed decisions on ESG-related risks, impacts and opportunities, on risk management and internal analysis made by investors.

According to Flora Rencz, research analyst at World Benchmarking Alliance (WBA), investors and stakeholders have long been frustrated with the unreliability and lack of transparency in ESG ratings.

She added: “The EU’s proposed regulation aims to address these concerns head-on. This development has the potential to redefine the role of ESG ratings in the financial ecosystem.”

Under the new rules, providers of ESG ratings should disclose to the public on their websites, and through the European Single Access Point (ESAP), information on ratings methodologies used, data sources, information on whether and how the methodologies are based on scientific evidence, on ratings’ scope, for example if it combines ESG factors, and on criteria used for establishing fees to clients, according to an annex to the legislative proposal.

The rules would also prevent ESG ratings providers from outsourcing “important operational functions”, if this has an impact on the quality of internal control policies and procedures, or impairs ESMA’s supervisory activities.

According to Emily Brock, principal consultant at ERM, the new framework will push costs of ESG ratings down.

She added: “[The legislation] could prove challenging for ESG raters that also offer services as consultants, credit raters, or other financial sector function. It will improve data quality about corporate sustainability, but may put more burden on corporations in the process.”

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