The European Parliament and Council of the EU came to an agreement on how the bloc should regulate the booming ESG ratings market late on Monday.
The newly inked regime will see EU securities regulator ESMA given powers to authorise providers of ESG ratings to operate in Europe, charge supervisory fees, monitor compliance and impose daily fines in the event of breaches.
The maximum penalty for non-compliance is 3 percent of daily turnover for companies and 2 percent of daily income for persons.
Negotiations between the co-legislators began in the second week of the new year and concluded in less than a month.
This allows time for lawmakers and EU member states to give a final nod to the legal text within the current parliamentary term. Most legislative activity is expected to draw to a close around the end of February ahead of EU parliamentary elections in June.
One final approval is given, the rules will take 18 months to come into force.
The recent negotiations saw a watering down of some of the more eye-catching proposals made by the European Commission in the initial legislative text, notably a requirement for ESG ratings providers to be separate legal entities from “related” businesses lines.
The provision would have required ESG ratings providers to spin off business units that offered benchmark development, credit ratings, audit, consulting, banking, insurance and investment-related services.
RI had previously reported that both MEPs and the Council were opposed to this measure, based on leaked discussion notes.
The agreement will allow ESG ratings providers to operate in these areas as long as “appropriate internal policies and procedures” are applied to prevent conflicts of interest – although this exemption will not apply for credit ratings, audit and consulting services.
Another casualty of the negotiations was a Commission-proposed requirement for ESG ratings to be priced in line with costs. The measure attracted strong opposition from ratings providers, with MSCI calling it “a significant and extraordinary level of intrusion into the determination of fees”.
One of the few sticking points between the Parliament and Council was on the best way to lower barriers to entry for smaller providers and improve competition in a market dominated by a handful of big financial service providers.
The topic was identified as a priority for both groups of legislators based on meeting notes.
It had been flagged as a market risk as early as 2021 by ESMA, which warned that “large companies buying their way into the market” could “lead to significant consumer detriment including pricing above competitive levels, risk of collusion, entry carriers and reduced innovation and efficiency”.
There have also been concerns in Europe about US and UK dominance of the ESG ratings market.
Parliamentary negotiators had proposed that buyers of ratings would have to “consider appointing at least one ESG rating provider with no more than 15 percent market share”. The Council, however, warned that a similar requirement had not worked in the credit ratings market.
ESMA will instead operate an opt-in “lighter, temporary and optional registration regime” for three years for providers with less than €12 million in annual revenues, including exceptions on fees and certain governance requirements.
The regulator will also have the power to exempt small providers from any of the requirements upon request, as long as an applicant can prove that the rules are “not proportionate in view of the nature, scale and complexity of its business”.
Finally, parliamentary negotiators were unable to squeeze through a requirement for ratings providers to disaggregate ESG scores into their separate E, S and G components.
The measure, which was a priority for the parliament’s ECON committee, would not have banned aggregate ratings outright but required them to be equally weighted at 33 percent.
The final text will only require providers to specify and explain the weighting of E, S and G factors for aggregate scores.
Providers will also not be required to benchmark ESG ratings against relevant frameworks such as ILO standards or the Paris Agreement – another parliamentary proposal – although they will have to specify whether ratings products have been calculated on a double materiality basis.
European users will be allowed to source unauthorised ESG ratings outside the EU in certain cases, such as when no substitutes are available.
The parliament rapporteur for the ESG ratings file, MEP Aurore Lalucq, welcomed the “historic agreement” in a LinkedIn post.
“One of the most important achievements of this text is to push for the disaggregation of the environmental, social and governance criteria, which will finally provide investors with transparent and reliable sustainability information,” she said.
“Aggregating the scores for these three criteria didn’t make any sense. An excellent grade in one area may hide disastrous results in another. This is how we end up with companies in the oil sector which are very well-rated, despite the enormous environmental consequences of their activity.”
The agreed text also seeks to “protect European players from their Anglo-Saxon competitors”, Lalucq added.
The announcement was acknowledged by ESG data trade body the Future of Sustainable Data Alliance. A spokesperson said the agreement would “ensure that ESG ratings provided in the EU have adequately transparent methodologies, robust governance arrangements, and that conflicts of interests are mitigated”.