EU lawmakers mull new requirements to buy ESG ratings from data minnows

A European Parliament committee is set to propose that users of ESG ratings would be required to source ESG ratings from small firms when using more than one dataset.

Draft documents submitted to parliament show that the Committee on Economic and Monetary Affairs (ECON) is considering adding provisions to the EU’s recent regulatory package for the ESG ratings market asserting that buyers seeking “more than one ESG rating should choose at least one ESG rating provider with a market share below 5 percent”.

This would create “competition among ESG rating providers and an environment in which small ESG rating providers can enter the market”.

The proposed rules were published by the European Commission in June to address longstanding concerns over data integrity, conflicts of interest and transparency within the ESG ratings market.

However, they did not include measures that target users of these products or are intended to increase competition, despite EU regulators previously saying that rising barriers to entry could be detrimental to users.

In 2021, EU markets regulator ESMA identified the issue as a market risk, warning that oligopolies created by “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”.

“Even though ESG rating service provision is typically carried out in separate legal entities, commercial interests or regulatory requirements concerning other business activities may lead to conflicting priorities. The risk of ratings inflation from such potential conflicts of interest may contribute to a lack of comparability and trust,” ESMA added.

The intervention was made after a flurry of acquisition activity saw smaller, specialised ESG research and ratings houses like Oekom, Vigeo Eiris, Trucost, Beyond Ratings, Four Twenty Seven, Sustainalytics, Vivid Economics and Clarity AI integrated into the operations of larger service providers and asset managers.

The amendments proposed by ECON could significantly shape the final form of the EU regulation if it finds broader support among other lawmakers. Parliamentary proceedings require a committee or joint committees to develop the parliament’s position on draft regulations or directives prior to entering trilogue negotiations with the European council, which represents the interests of EU member states, and the EC.

ECON has had a hand in drafting the parliament’s position on virtually all of the initiatives under the bloc’s sustainable finance action plan and is considered influential on ESG topics.

Responsible Investor understands that ECON members will now debate the amendments, propose changes and vote on a final report by 28 November.

A final position by the parliament on the proposed regulation is expected in December.

RI understands that JURI, the parliament’s legal affairs committee, may also provide an opinion on the draft ESG ratings package. This will be considered advisory and non-binding.

It is hoped that negotiations between the parliament and European Council will commence early next year, and conclude ahead of the 2024 European elections.

Conflicts of interest and transparency

The draft amendments, which have been compiled by ECON rapporteur MEP Aurore Lalucq, are notable for going even further than the measures proposed by commission in June.

According to documents submitted by the committee, “entities that are part of a group to which an ESG rating provider belongs” would be prevented from offering consulting or audit firms to rated entities. The provision of such services would be allowed under the current EC proposals – as long as there is legal separation between the business units.

“Rating analysts, employees and other persons involved in the provision of ESG ratings” would not be allowed to have financial exposure to rated entities “other than holdings in diversified collective investment schemes”, cannot have been employed by a rated company within a three-year period, and are barred from being employed by a rated company in any position for one year after a rating has been issued.

Employees who have contributed to a rating are not allowed to take up “key management positions” within rated entities but only for a six month-period following a rating action under the EC’s current draft.

The rule changes would bring the future regulations in line with conflict of interest safeguards that are present in the EU’s rules for auditors and credit rating agencies.

With regards to transparency, ECON is considering doing away with aggregated ratings that combine ESG assessments into a single score, in favour of separate E, S and G ratings and justifications for each factor.

ECON has also proposed that providers disclose “the identity of the persons” responsible for the development of the methodologies underpinning ratings and those who approved their use.

ECON has suggested that the EU excludes non-profits “that offer free rating-like services” from the scope of regulation.

It would also require ESG ratings providers to include information on whether rated companies are aligned to international standards on tax evasion and whether “the remuneration criteria for management align with the sustainability strategy of the entity”.

The committee did not amend the EC’s decision to exclude ESG data providers from the scope of the regulation – despite complaints from investors over the potential for factual mistakes and a lack of transparency – but has added a clause requiring the EC to “consider a review of this regulation to assess whether the scope identified is sufficient”.

It also did not comment on the EC’s decision to require that fees charged to users should reflect the costs incurred by a provider. The move has already prompted outrage among major data firms such as MSCI, which slammed the proposals as “a significant and extraordinary level of intrusion into the determination of fees by the ESG rating providers”.

Vincent Vandeloise, a senior researcher at Finance Watch, said ECON’s submission addressed a significant number of weaknesses that have been identified by the non-profit in the EC’s proposals.

“The text importantly introduces a separation of ESG ratings which is vital,” he said. “There is a structural problem with the aggregation of environmental, social and governance factors which have little to do with one another.

“This can lead to confusing situations where an enterprise with a quality governance and good social policies but a disastrous environmental impact can end up having a high ESG rating and, subsequently, make its way into ESG investment portfolios.”

Vandeloise also welcomed the proposed review clause, saying that the impact of parallel regimes such as the CSRD, taxonomy and European Single Access Points on the ESG ratings market will need to be monitored to determine whether further intervention is needed.