Sustainable investments, whereby investors consider the various Environmental, Social and Governance (ESG) factors when making their investment decisions, are hot in the European capital market. Many companies are keen to take advantage of this trend and are regularly tempted to appear more sustainable than they really are. This phenomenon is commonly referred to as ‘greenwashing’. Statements made by companies about their own sustainability performance have henceforth been met with healthy suspicion. Against this background, the European Commission has introduced a system of ESG ratings.
ESG ratings should provide an objective assessment of the exposure of a company or financial product to ESG factors, and their impact on society. This includes, for example, information on how a company is working to reduce CO2 emissions, water use and waste, or information on the risks a company faces due to climate change. ESG ratings have an increasing impact on the functioning of capital markets, and on investor confidence in sustainable products.
Proposal for a Regulation on ESG rating agencies
But the issue is more complicated in practice. The European Commission has identified shortcomings in the market for ESG ratings. Companies seem to seek out ESG rating agencies they deem most favourable and in many cases it is unclear what an ESG rating is based on. To address these issues, the European Commission wants to introduce a series of measures. In that context, it published a proposal for a Regulation on the transparency and integrity of ESG rating activities on 13 June 2023. This should particularly enforce transparency with regards to the creation and characteristics of ESG ratings. ESG ratings should adequately enable users, investors and rated entities to take informed decisions on ESG-related risks, impacts and opportunities.
The draft Regulation includes transparency requirements for ESG rating agencies. ESG rating agencies must disclose, among other things, the purpose of the ESG rating and the rating methods used. In addition, the draft Regulation imposes more extensive transparency requirements on ESG rating agencies towards buyers of ESG ratings and companies rated by the ESG rating agency, and it contains several requirements regarding the ESG rating agencies’ operations. For example, the draft Regulation prohibits ESG rating agencies from also carrying out consulting or auditing work as to prevent potential conflicts of interest. Agencies must additionally be transparent about providing any other ancillary services. Furthermore, ESG rating agencies operating within the EU must apply for authorisation from the European Securities and Markets Authority, which will also supervise them.
Nonetheless, the draft Regulation does not harmonise the methods for calculating ESG ratings. As such, ESG ratings are not comparable and the various ESG rating providers will retain full control over the interpretation of the term ‘risk’ is defined. This is a deliberate choice by the European Commission which should ensure the availability of different approaches in the ESG rating market. As for now, the draft Regulation will be submitted to the European Parliament and the Council.
It is highly doubtful whether the potential finalisation of the draft Regulation will be beneficial for investors. After all, ESG investors are often less concerned with the risks of investing in companies that may lose their value if the climate or social relations change. Rather, they will be (more) occupied with the potential damaging effects of the activities of companies on the environment and society. It is typically the latter concern that ESG rating agencies do not focus on. Conducting one’s own proper research may help but is often difficult: the entire supply chain needs to be examined, and the information necessary for such an analysis is rarely easily accessible, let alone to be found in one place.
If you have any questions about ESG and/or, more specifically, the draft Regulation, or if you would like to know what we can do for you in this regard, feel free to contact us.