Regulation on ESG Rating Services
The European Union stated in its recent sustainable finance policy that it requires ESG rating services to meet the authorization and supervision of the European Securities and Markets Authority (ESMA).
The EU believes that ESG investment is becoming an essential component of the financial industry, with a global value of over $40 trillion. ESG rating services are an important basis for investors, businesses, and other stakeholders to implement decisions. Reliable and high-quality ESG ratings play a crucial role in EU’s sustainable financial market.
However, the methods and objectives of ESG rating still lack transparency, and there is still uncertainty about how to manage potential conflicts of interest. These factors affect the market’s trust in ESG ratings. The European Union has decided to incorporate ESG rating services into regulatory, with various rating agencies directly responsible by ESMA.
ESG Rating Authorization
The EU requires that ESG rating providers need to apply for authorization from ESMA, and ESMA will decide whether the application is approved within 120 working days. These applications are not only applicable to ESG rating providers registered in the EU, but also to subsidiaries of non-EU registered parent companies.
For ESG ratings provided by third countries, the EU also requires rating providers to submit documents to ESMA to continuously monitor whether ESG ratings comply with EU regulations. The rating provided by a third country needs to maintain at least the same level of rigor as the regulatory policies formulated by the EU. ESMA can hire external auditors to evaluate ESG ratings provided by third countries.
Regulation of ESG Rating Services
The EU requires ESG rating providers to maintain the independence of their rating services, establish appropriate rules and procedures to ensure that ESG ratings comply with EU regulatory policies, and implement internal due diligence to ensure that commercial interests do not compromise the accuracy of ESG ratings.
ESG rating providers need to adopt strict, systematic, objective, and verifiable rating methods, and review them at least annually. For rating agencies that provide other services at the same time, the EU requires ESG rating services to be independent of credit rating, benchmark setting, audit activities, and reinsurance activities, to reduce the risk of conflicts of interest.
For analysts engaged in ESG rating work, the EU requires them to have the knowledge and experience to perform their duties and shall not trade any financial instruments issued, guaranteed, or otherwise supported by rating entities. Analysts need to protect the rating methods owned by ESG rating providers and not share confidential information with others. When an analyst terminates their employment relationship and joins a rated entity, the ESG rating provider needs to review their work within one year.
In terms of record keeping, the EU requires ESG rating providers to maintain all information for at least five years and publish procedures for accepting, investigating, and retaining complaint records on their websites. Stakeholders can file complaints regarding the data sources, rating methods, rating agencies, and other aspects of ESG ratings.
To ensure the quality of internal control procedures, the EU requires ESG rating providers not to outsource important operational functions and disclose all outsourced activities. ESG rating providers also need to disclose the methods, models, and key assumptions used in rating activities, and other necessary information in accordance with ESMA’s subsequent policies.
Conflict of Interest Management
The EU requires ESG rating providers to take necessary measures to ensure that the ratings provided are not directly or indirectly influenced by shareholders, management, analysts, or other natural persons, and to establish clear, transparent, and consistent responsibilities for all personnel involved in the ratings. When a conflict of interest arises, ESMA has the right to demand the cessation of activities or relationships that generate a conflict of interest, or to cease providing ratings. ESG rating providers also need to review their operational status annually to identify potential conflicts of interest.
In terms of fees for rating entities, ESG rating providers should ensure that the fees charged to customers are fair, reasonable, and transparent, and based on actual costs. ESMA has the right to impose fines on rating providers after discovering problems.
Reference:
EU Sustainable Finance Package 2023
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