SUSTAINABLE FINANCE ROUNDUP

‘Regulating the ESG Rating Market: The European Banking Sector perspective’, Matilde Quarin, European Banking Federation

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In June 2023, the European Commission (EC) issued a proposal as one of the final components of the Sustainable Finance package, focusing on the transparency and integrity of Environmental, Social, and Governance (ESG) rating activities. This initiative represents a significant step towards regulating the ESG ratings market, with the primary objective of augmenting integrity, transparency, responsibility, good governance, and independence of ESG rating activities and, most importantly, contributing to the transparency and increased quality and comparability of ESG ratings. The proposed Regulation also seeks to establish stringent guidelines for rating agencies’ operations, aiming to mitigate conflicts of interest and biases in the rating process.

The imperative for such regulatory intervention becomes evident in the face of an expanding demand for ESG ratings, exposing inherent issues of unreliability, inaccuracy, and untimely information delivery. The inadequacies of the current ESG ratings market have not only posed challenges for investors and companies but have also eroded confidence in the credibility of these ratings. To address this, there is a pressing need for greater comparability and reliability in ESG ratings, making transparency regarding their characteristics, data sources, and methodologies primary. Furthermore, a crucial aspect to be addressed is the lack of clarity surrounding the operational practices of ESG rating agencies, particularly in relation to conflicts of interest and governance. By establishing a framework that addresses these concerns head-on, the EC aims to foster a healthier and more functional ESG ratings market, conducive to sustainable and responsible investment practices.

The Regulation will apply to ESG ratings issued by ESG ratings providers operating in the EU that are disclosed publicly or that are distributed to regulated financial undertakings in the EU or EU Member States’ public authorities. once the Regulation will have entered into force, rating providers will need to be authorised and supervised by the European Securities and Markets Authority (ESMA). It is important to remark that the Regulation does not seek to harmonize the methodologies used to build ESG ratings, but only to enhance their transparency, allowing users to understand the ratings and compare them. In fact, under this rule, ESG ratings providers would need to comply with certain organisational, record-keeping and disclosure requirements, including in respect of conflicts of interest.  Additionally, the Regulation also addresses the fees charged to clients, to make sure they are fair, reasonable, based on costs and non-discriminatory.

The European Banking Federation (EBF) strongly supports this Proposal, believing transparency to be key in ensuring the comparability and reliability of ESG ratings on the market. In particular, European banks welcome the introduction of disclosures on the websites of ESG rating providers of methodologies, information about rated companies’ fees, data sources, data “timestamps”, as well as of their level of independence. Moreover, they recommend that ESG rating providers operating in the EU are subject to the same requirements, regardless of whether they are based in the EU or not, as to ensure a level playing field among market participants. Banks as well deem important the regulation of ESG data providers whenever ESG data is modified in any manner or sourced from third parties. With data as the foundation of the sustainable finance framework, regulating ESG data providers is fundamental to ensure the overall credibility and functioning of the market. While it may not be most appropriate to address the regulation of data provides within this regulation, which was drafted with ESG Rating Providers in mind, EU banks support the introduction of a review clause for the future regulation of data providers.

While the proposal is meant to address specialized providers of ESG ratings, it may inadvertently capture products or services that may be provided by banks or asset managers, which are already regulated by rules such as the SFDR, MiFID/MIFIR, MAR, CSRD, EU Taxonomy, BMR when administrating benchmarks, and more.

For instance, some banks have developed questionnaires tailored for their clients, typically small and medium-sized enterprises (SMEs), aimed at assessing ESG elements within the context of evaluating banking services. To incentivize clients to complete these questionnaires, banks offer a complimentary ESG score, which clients can retain and optionally disclose on their websites. This practice addresses gaps in information and coverage by ESG providers, with the dual purpose of raising awareness amongst SMEs about sustainability issues and bridging data gaps crucial for risk management and portfolio steering.

In other instances, banks employ internal ESG rating methodologies to evaluate and compare the sustainability performance and associated risks of investment products in relation to ESG factors. Moreover, banks disclose ESG scores in documentation provided to clients and investors, particularly for funds categorized as Article 8 and Article 9 products under the Sustainable Finance Disclosure Regulation (SFDR). The same happens in relation to financial benchmarks (defined under Article 3(3) of the EU Benchmark Regulation) and is mandatory in regulatory public disclosures under SFDR, EU Taxonomy, Corporate Sustainability Reporting Directive (CSRD) and related European Sustainability Reporting Standards (ESRS), and Pillar 3 requirements. Further, banks also incorporate ESG ratings into investment and equity research reports, where analysts operate within a MiFID II/MAR-compliant control framework.

In all these instances and more, banks make use of forms of ESG Ratings whose disclosure and methodology are already regulated. Therefore, their scoping into the ESG Ratings regulation would unintentionally result in a double reporting burden.

Moreover, the European banking sector does not believe it was the intention of the proposal to introduce new licensing requirements for existing regulated financial undertakings. Failing to exclude financial undertakings from the scope of the Regulation would not only result in financial institutions being forced to create numerous separate entities, leading ESMA to authorize and supervise hundreds of different entities, which would likely not be manageable, but also negatively affect emerging good practices to boost sustainability in the market. The requirement to create separate entities would also result in increased costs for end-clients and/or in a reduced offer from financial undertakings.

The support to this Regulation from the European banking sector underscores the significance of these measures in fostering a more functional and responsible ESG ratings market. Despite this support, concerns about potential unintended consequences, especially related to the scope of the regulation and its impact on financial institutions, call for careful consideration by policymakers. Clarifications in the final text are imperative to prevent any hindrance to emerging sustainability practices and to avoid unnecessary reporting burdens for activities that are already regulated. Yet, ultimately, the proposed Regulation signifies a crucial step toward cultivating a transparent, credible, and sustainable ESG ratings landscape in the European Union.

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For more information:

Matilde Quarin, Financing Sustainable Growth, m.quarin@ebf.eu

Alexia Femia, Financing Sustainable Growth Adviser, a.femia@ebf.eu

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