The new regulation for ESG ratings providers has been widely welcomed by the investment industry as “a crucial step forward” and “helpful” to prevent conflicts of interest.

According to the proposed regulation, which follows a provisional agreement struck between the parliament and member states earlier this month, ESG rating providers will have to provide separate ratings for the environmental (E), social (S) and governance (G) factors or, alternatively, explain the weighting of the three overarching ESG factors in the case of an aggregated ESG rating.

The European asset management association EFAMA welcomed the “much clearer mandatory disclosures”.

Chiara Chiodo, regulatory policy advisor at EFAMA, commented: “Transparent and complete ESG information is key to fully empowering investors to make confident decisions when choosing financial products with sustainability features. Covering ESG ratings in this regulation is a necessary step forward to drive the transition towards a greener economy.”

Dutch pension funds PME and PMT also welcomed the new regulation. The two schemes told IPE they expect it to boost the quality of ESG ratings, which currently often provide “a muddy picture because of a range of possible compensation effects between E, S and G,” a spokesperson for technology industry fund PME said.

A spokesperson for metals scheme PMT added: “There can be large discrepancies in ESG ratings from different providers because of differences in approach and methodology used. Because of this, we spend a lot of time interpreting these ratings before taking investment decisions based on them.”

European financial regulator takes charge

Nikolai de koning north rose fulbright

Nikolai de Koning at North Rose Fulbright

The fact that the European Securities and Markets Authority (ESMA) will assume the responsibility for supervising credit rating agencies will also make the different ESG ratings converge, according to Nikolai de Koning, a lawyer at North Rose Fulbright.

“Supervision by ESMA will force rating agencies to better explain why they arrive at certain ESG scores. As a result, I expect not only more transparency, but also more convergence. Soon everyone will be playing the same ballgame,” he said.

Finally, the new regulation also includes a provision that ESG rating providers must separate that business from other commercial services. This measure particularly affects larger agencies such as MSCI, Fitch and Moody’s, which offer credit ratings and/or benchmarks alongside ESG ratings. it is unclear, however, what this provision will exactly mean in practice.

“This still has to crystallise,” said De Koning. “Ultimately, the provision of ESG ratings will probably have to be legally and/or operationally separated from other activities. In practice, this would for example mean that the same person may not be involved in drawing up both ESG and credit ratings.”

MSCI said in a statement that it welcomes regulation that promotes “the transparency, independence and objectivity of its ESG ratings”. It added it is still reviewing the text of the new regulation for ESG rating providers and is “assessing its potential impact on our business and client offering”.

PME and PMT support the clause in the regulation that separates ESG ratings businesses from other commercial activities as they expect it to prevent conflicts of interest.

“It is important legislators look at possible conflicts of interest as rating agencies have various relationships with the companies they evaluate,” the PMT spokesperson said.

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