‘Using a sledgehammer to crack a nut’: EU conflict of interest rules for ESG ratings divides opinion

Some say the EU proposals could worsen market fragmentation, while confusion remains around how rules to prevent conflicts of interest should be implemented.

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Service providers and other stakeholders are still coming to grips with proposals tabled recently by the European Commission (EC) to regulate the booming ESG ratings sector, but some have criticised the approach taken by the bloc.

Topping the list of concerns is a requirement that providers of ESG ratings must stop providing ESG consulting services, credit ratings and the development of benchmarks, to avoid potential conflicts of interest.

Having related business interests could incentivise “inaccurate ESG ratings” to maintain client relationships, or create “a perceived bias”, said the EC in its own assessment of the proposals.

The rules could prompt a restructuring among the handful of data firms that currently dominate the ESG ratings market, many of which have exposures to these business areas.

The new rules are set to be enforced by financial regulator the European Securities and Markets Authority (ESMA), and breaches could result in significant fines of up to 10 percent of annual net turnover.

But there is also confusion as to the extent of changes required for companies to be regarded as operating independently.

Responsible Investor understands that a complete legal separation between an ESG ratings provider and other related business interests is required, and that additional care should be taken to ensure no conflicts arising from corporate and ownership structures.

Moody’s, S&P, Fitch, MSCI, Sustainalytics and ISS have said that they are still assessing the proposals and are weighing up engagement options. There will not be a public consultation over the proposals, which means that industry lobbying will likely focus on EU lawmakers and member states who will sign off on the measures.

Questions over the EU’s treatment of the ESG ratings sector were raised by regulatory lawyer and Simmons & Simmons partner Nicholas Colston, who described EU law as “inconsistent” on whether a conflicting business line requires separate legal entities.

An investment bank, for example, will have parallel conflicting business lines under the same legal entity, said Colston, but this is typically managed through information barriers, separation of teams, conflicts management processes and other measures.

“Forcing ESG ratings providers into a separate legal entity seems like using a sledgehammer to crack a nut, when there are other valid ways of managing conflicts.”

Regulatory scope question marks

The EU’s proposals still have some way to go to address their key objectives of fostering convergence and transparency, according to some investor groups and non-profits.

Carbon disclosure non-profit CDP said the rules have little in common with parallel initiatives worldwide and, if adopted, could lead to even more fragmentation.

According to CDP policy head Pietro Bertazzi, the absence of ESG data providers from the scope of the proposals comes as other jurisdictions are pursuing stringent regulations in the area and could cause “a potential fragmentation in the global regulatory architecture”.

“We see a number of jurisdictions diverging in the scope of their interventions and in how they define ESG ratings and other ESG data-related products. This is concerning as it can create market confusion and pose significant complexities to comply and operate across borders.”

Measures tabled in the EU and India to regulate ESG products have specifically targeted ESG ratings, while regulators in the UK, Singapore and Japan have outlined requirements – through voluntary codes of conduct – for both ESG ratings and data providers.

Similarly, the PRI’s EU regulation head, Elise Attal, said it was “surprising” to see the EU exclude ESG data from the policy’s scope.

“The need for transparency and good governance processes also extends to ESG data products, as providers not only collect raw data, but also aggregate, process and estimate ESG data,” said Attal. “For investors it is important to understand how data is sourced, including the methodologies used for estimating data, to what extent data has been verified or assured, and if and how data is being updated.”

It is yet to be seen whether the EU’s rules, which do not make a distinction between commercial providers and non-profits, will apply to the PRI’s annual scoring of signatories and CDP ratings. “CDP is not concerned about the potential to be regulated,” said Bertazzi.

The EC has been contacted for comment.

The European Parliament and Council have less than a year to agree to the proposals before the next European election in June.