ESG (environmental, social, governance) sustainability factors
- Category: European Union Carbon Market Glossary
ESG (environmental, social, governance) factors are becoming increasingly significant in sustainable finance decision making, for example, asset managers in the EU are required to integrate ESG considerations into their fiduciary duties from January 2022.
5 February 2024
20 December 2023
22 November 2023
28 September 2023
The new rules will require that ESG rating providers offering services to investors and companies in the EU be authorised and supervised by the ESMA.
The current boom for the market for ESG investing can be illustrated by the fact that over the years 2000 - 2003 global sustainable fund assets tripled, reaching a record EUR 2.14 trillion in Europe at the end of 2022 (ESMA TRV Risk Analysis, ESG names and claims in the EU fund industry, ESMA50-524821-2931, 2 October 2023).
Following strong investor demand for ESG investment products in the EU, many fund management companies have responded by either launching new ESG investment products, or repurposing existing ones towards ESG-friendly investing.
EBA Discussion Paper of 3 November 2020 on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03) observed, however, that the policy framework lacked a common definition of ESG factors and, consequently, market practices also varied across institutions. Institutions have been relying on various international frameworks and standards defining ESG factors, although some of them use their own definitions.
Examples of ESG factors that are common across those definitions and practices for financial and non-financial firms include greenhouse gas emissions, biodiversity and water use and consumption in the area of environment; human rights, and labour and workforce considerations in the area of social; and rights and responsibilities of senior staff members and remuneration in the area of governance.
Taking the above into consideration, the EBA proposed the following definition for the ESG factors: 'environmental, social or governance characteristics that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual’ (p. 26).
Article 2(24) of SFDR provides a broad definition for the types of sustainability factors which may influence investment decision-making and impact, in this context sustainability factors refer to “environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters”.
SFDR defines also sustainability risks, they mean an “environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment” (Article 2(22)).
The aforementioned ESMA TRV Risk Analysis 2 October 2023 confirmes that, as of fall 2023, there is still no EU regulatory definition of an ESG investment product, although several industry and national fund labels exist (raising concerns about fragmentation). Data providers have also attempted to fill the gap, by creating their own labels to designate funds as 'ESG', 'low carbon', and so forth.
The application of the EU SFDR in March 2021 introduced definitions and disclosure requirements for:
- funds promoting environmental and social characteristics (Article 8 - so-called light green products) and
- funds with a sustainable investment obiective (Article 9 - so-called dark green products).
These disclosure rules aim to provide transparency on the sustainability-related investment activity of funds. In contrast to an official label, however, they do not establish standardised requirements, criteria or thresholds to designate a fund as ESG compliant.
In the absence of EU ESG labels, some asset managers have begun to refer to the SFDR Articles 8 and 9 designations as proxy ESG labels. This misuse of legislation can lead to confusion among investors as to whether a fund is ESG or not, thus further reinforcing concerns over potential greenwashing.
ESG ratings and ESG data products
ESG ratings provide an opinion on a company’s or a financial instrument’s sustainability profile, by assessing its exposure to sustainability risks and its impact on society and the environment.
As observed in the ESMA Call for evidence of 3 February 2022 on Market Characteristics for ESG Rating Providers in the EU (ESMA80-416-250) ESG ratings are used by a wide variety of investors to take into account risks and opportunities linked to ESG issues. Moreover, these products are having an increasingly important impact on the operation of capital markets and on the confidence of investors in sustainable finance products.
IOSCO Report of November 2021 (FR09/21, p. 6) observes the global market for ESG ratings and data products is concentrated around a small number of providers with a global presence, alongside a larger number of providers with a more regional focus or offering more specialized services.
The said Report refers to number of 160 ESG ratings and data products providers worldwide in 2020 (including both for-profit and non-profit companies that offer large or specialised ESG-related products) and 30 to 40 other smaller providers of ESG ratings, data and research products and services domiciled in the European Union (EU). It is estimated that global revenues generated by ESG data and services could more than double by 2025.
Although the Credit Rating Agencies Regulation (CRAR) includes a number of requirements relating to the disclosure and presentation of credit ratings, the above ESMA Call for evidence of 3 February 2022 notes a low level of comparability between ESG ratings, and potential conflicts of interest. With these inconsistencies in mind, in July 2019 ESMA issued Guidelines that seek to improve the quality and consistency of the information disclosed in credit rating press releases (ESMA Final Report - Guidelines on Disclosure Requirements Applicable to Credit Ratings, ESMA 33-9-320, 18 July 2019). Given the increased focus on ESG factors within investment decisions, an additional goal of these guidelines is to ensure greater transparency around the consideration of ESG factors, where they are material to a credit rating action.
In particular, the Guidelines indicate that, where ESG factors have been key drivers behind a change to the credit rating or rating outlook, CRAs are expected to:
– identify the relevant factors;
– elaborate on their materiality; and
– include a reference to where an explanation of how ESG factors are considered as part of the credit rating process can be found (e.g. a reference to their credit rating methodologies).
The Guidelines began to apply on 30 March 2020.
When it comes to the payments structure, on the basis that the business model for providers of ESG ratings is predominantly an investor pays model in the current state of play, clients of ESG rating providers are likely to also be the users of their ESG ratings. However, it is possible that alternative business models exist where the users of an ESG rating providers’ products do not have a contractual relationship with the provider, for example in the case of not for profit ESG rating providers.
It is useful to note that ESG ratings providers are increasingly providing their high level ESG scores on their websites for public access (International Organization of Securities Commissions’s (IOSCO) Final Report of November 2021 on Environmental, Social and Governance (ESG) Ratings and Data Products Providers, FR09/21, p. 18). On that basis, smaller investors would still have access to some ESG ratings as well as to the sustainability-related disclosures of listed companies.
Regulation on the transparency and integrity of Environmental, Social and Governance rating activities
Another important legislative step in this process became European Commission Proposal for a Regulation on the transparency and integrity of Environmental, Social and Governance rating activities (COM(2023) 314 final), which has been published on 13 June 2023. The key aim of the Commission proposal is to increase transparency on ESG ratings methodologies, objectives, characteristics and data sources. Additionally, it aims to increase clarity on the operations of ESG rating providers, in particular to prevent and mitigate potential risks associated with conflicts of interest. The new rules will require that ESG rating providers offering services to investors and companies in the EU be authorised and supervised by the ESMA.
The proposed rules concern the following:
- separation of business for the prevention and management of conflicts of interests
- proportionate and principle-based organisational requirements
- minimum transparency requirements to the public on ratings methodologies and objectives and more granular information to subscribers and rated companies
- transparency of fees and requirements for fees to be fair, reasonable and non-discriminatory
- possibility for providers established outside the EU to operate in the EU market under the equivalence, endorsement, recognition regimes
The new rules aim to strengthen the reliability and comparability of ESG ratings by improving the transparency and integrity of the operations of ESG ratings providers, making ratings more comparable and preventing potential conflicts of interests.
Under the proposed rules, ESG rating providers will need to be authorised and supervised by the ESMA and comply with transparency requirements, in particular with regard to their methodology and sources of information. Providers will be subject to specific measures to prevent and manage conflicts of interests.
The proposal does not cover ESG data providers.
Council's negotiating mandate
On 20 December 2023 the Council agreed negotiating mandate on the above Commission’s legislative proposal. In its mandate the Council clarified the circumstances under which ESG ratings fall under the scope of the regulation, providing further details on the applicable exemptions. Additionally, in line with the corporate sustainable reporting directive, it clarified that ESG ratings encompass environmental, social and human rights or governance factors.
ESG rating providers that wish to operate in the EU will need to comply with certain requirements, including obtaining an authorisation from ESMA, or in the case of ESG rating providers established outside the EU, an equivalence decision, an endorsement of their ESG ratings or a recognition. The Council also clarified the territorial scope of the regulation, outlining what constitutes operating in the EU, and provided further clarification on the applicable provisions under the endorsement regime.
The Council also introduced a lighter, temporary and optional registration regime of three years for existing small ESG rating providers and new small markets entrants.
Small ESG rating providers who opt in under the lighter regime will not have to pay ESMA supervisory fees. They will have to comply with some general organisational and governance principles, as well as transparency requirements to the public and users. They will also be subject to the powers of ESMA to request information and conduct investigations and on-site inspections. Upon exiting this temporary regime, small ESG rating providers will need to comply with all the provisions outlined in the regulation, including the requirements regarding governance and supervisory fees.
Regarding the separation of business and activities, the Council introduced the possibility for ESG ratings providers to not have a separate legal entity for certain activities, provided that there is a clear distinction between activities and that they put in place measures to avoid conflicts of interests. This derogation would not be applicable to consulting or audit activities when they are provided to rated entities.
Main elements of the provisional agreement
On 5 February 2024 the Council and European Parliament reach a provisional agreement on a proposal for a regulation on environmental, social and governance (ESG) rating activities.
As the Council's press release of the same date informs, the Council and the Parliament clarified the circumstances under which ESG ratings fall under the scopeof the regulation, providing further details on the applicable exclusions. The agreement also clarifies the territorial scope of the regulation, by setting out what constitutes operating in the EU.
The Council and Parliament agreed that if financial market participants or financial advisers disclose ESG ratings as part of their marketing communications, they will include information about the methodologies used in such ESG ratings on their website. This was done through an amendment of the Sustainable Finance Disclosure Regulation.
The agreement clarifies that ESG ratings encompass environmental, social and human rights or governance factors. The agreement foresees the possibility to provide separate E, S and G ratings. However, if a single rating is provided, the weighting of the E, S and G factors should be explicit.
ESG ratingprovidersestablished in the EU will need to obtain an authorisation from ESMA. ESG rating providers established outside the EU that wish to operate in the EU will need to obtain an endorsement of their ESG ratings by an EU authorised ESG rating provider, a recognition based on a quantitative criterion or be included in the EU registry of ESG rating providers on the basis of an equivalence decision in relation to the country of its origin and following a dialogue held between ESMA and the relevant third-country competent authority.
The Council and Parliament introduced a lighter, temporary and optional registration regime of three years forsmall undertakings and groups providing ESG ratings. Small ESG rating providers who opt in under the lighter regime will be exempted of paying ESMA supervisory fees. They will have to comply with some general organisational and governance principles, as well as transparency requirements vis-à-vis the public and users. They will also be subject to the powers of ESMA to request information and conduct investigations and on-site inspections. Upon exiting this temporary regime, small ESG rating providers will need to comply with all the provisions outlined in the regulation, including the requirements regarding governance and supervisory fees.
For small ESG ratings providers, the agreement also provides that if the conditions are met, ESMA could decide to exempt an ESG rating provider from some of the requirementsbut only in duly justified cases and based on the nature, scale and complexity of the business of the ESG rating provider and the nature and range of the issuance of ESG ratings.
The agreement introduces as a principle a separation of business and activities, with a possibility for ESG ratings providers not to set up a separate legal entity for certain activities, provided that there is a clear separation between activities and that they put in place measures to avoid potential conflicts of interests. However, this derogation would not apply to ESG rating providers that carry out consulting activities, audit activities and credit rating activities. ESG rating providers may nevertheless develop benchmarks if ESMA considers that sufficient measures have been put in place to address conflicts of interests.