The European Commission has introduced the first-ever set of rules focused on regulating providers of environmental, social and governance (ESG) ratings. The goal of the new ESG Ratings Regulation is to improve the reliability, transparency and comparability of ESG ratings by scrutinizing ratings provider methodologies and vetting providers for potential conflicts of interest.
The initiative was launched to reign in what had increasingly become almost a Wild West scenario in the ESG ratings market, which the European Commission described as follows in its initial proposal: “The current ESG rating market suffers from deficiencies and is not functioning properly, with investors and rated entities’ needs regarding ESG ratings are not being met and confidence in ratings is being undermined.”
Under the new rules, all ESG ratings providers operating in the European Union (EU) will be supervised by the European Securities Markets Authority (ESMA) – the same agency that oversees Europe’s financial markets regulation. Those based outside the EU will need to have their ratings endorsed by a rating agency regulated in the EU. The UK quickly followed the EU by indicating it will introduce an ESG ratings regulation of its own in the coming months. Other jurisdictions, including India, Japan and Singapore have also introduced voluntary codes of conduct for ESG raters.
Consistency and Transparency are Good for Business
Here’s why those are positive developments for the businesses who are the subject of these ratings. For one, regulation should bring some consistency to a process that has been, at best, disjointed and fragmented. A 2022 analysis conducted by researchers at MIT Sloan and the University of Zurich, which looked at commonalities and differences in ESG ratings from six different ratings agencies, found almost no correlation between them. That’s because the different ratings agencies all included different factors, different weights to each factor and different methods of measurement.
Under the new EU regulation, ratings agencies will need to explicitly disclose how their ratings are calculated, whether they factor in double materiality and how they break out environmental, social and governance factors independent of one another. So, even if the ratings provided by different agencies are not the same, regulators, companies and investors will have some degree of transparency into how those ratings were derived.
Additionally, the move is likely to spur some consolidation in a space that is currently overflowing with providers. A 2021 analysis from Deloitte found that there were some 600 different ESG ratings providers operating in the market, often issuing different ratings for the same underlying entities. Under the new EU mandate, raters will need to maintain a strict code of independence, publish detailed methodologies on their websites and submit to oversight by ESMA – each of these layers of additional scrutiny are likely to winnow the list of viable ratings agencies down to a list of about 10 or 15 major players. In fact, as ESMA points out, a trend toward consolidation in the space has already started to take shape.
Why it Matters
Under new corporate sustainability reporting requirements introduced as part of the Corporate Sustainability Reporting Directive (CSRD), the Corporate Sustainability Due Diligence Directive (CSDDD) and new global sustainability standards developed by the International Sustainability Standards Board (ISSB), big businesses operating in Europe need to disclose more information than ever about the impact of their operations on the environment, social issues and governance practices. Importantly, these rules extend not only to the companies themselves, but also to the networks of suppliers they use around the world.
As a result, many of these companies are requiring suppliers to provide ESG ratings as a form of due diligence to assure they are meeting certain ESG standards. However, with dozens of different ratings providers out there to choose from, and very little standardization between them, many suppliers have found themselves in a situation where they need to contract with several different ratings providers depending on what each client requires. With companies paying anywhere from $220,000 to $480,000 to have themselves rated, those costs can quickly add up.
By building more transparency into the ratings process and driving consolidation in the number of ratings agencies in the marketplace, these new regulations should help companies and their suppliers better establish more standard means of ESG evaluation. This additional layer of transparency should also help build some consistency into the process of what and how companies disclose their sustainability risks, which will, in turn, help investors and consumers get a clearer handle on what corporate sustainability really means. Most importantly, though, this evolution will draw the focus away from overly reductive numerical or letter grades and toward the underlying methodology and objectives where the real insights into corporate sustainability live.
Questions Remain on the Future of ESG Ratings
The jury is still out on how, exactly, the ESG ratings agency space will evolve over the next several months as these regulations start to be adopted by EU member states. While we’re unlikely to see the emergence of a Nationally Recognized Statistical Ratings Organizations (NRSROs), as we did in the 1970s with the official designation of the major credit ratings agencies, there will likely be a hierarchy that develops as businesses and investors start to gravitate to different providers. We may also see some segmentation occur, where different ratings providers start to specialize in specific industries where they may have a deeper domain expertise or unique methodology.
However it all shakes out, the gradual maturation of the space will ultimately be a good thing for businesses and other stakeholders who want to be able to objectively measure corporate sustainability risk and benchmark companies’ progress on their journeys to build more sustainable operations. Ideally, it should also reduce some of the operational costs associated with sustainability compliance.
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