Brussels throws the rulebook at raters in historic ESG shake-up

The first major move by regulators to apply rules to how companies’ ESG credentials are rated for investment purposes was made this week.

And given that it has set itself up as the body that will lead on such critical regulation globally, it was no surprise that it was a European Union initiative.

Member states and the European Parliament reached a deal on the bloc's first ever set of rules to regulate ESG ratings, with sustainability factors front-of-mind given the rise of so-called greenwashing and allegations of woke capitalistic practices fuelled by what detractors have seen as an arbitrary approach to ratings.

The ratings industry and the guidance it gives are responsible for trillions of pounds in investments around the world. That’s well beyond the EU’s home turf, but the ramifications of the regulation will be felt more broadly.

Bloomberg called the regulation the toughest yet in the drive to provide guardrails for ESG investing.

As Reuters put it, “Raters will have to explicitly disclose if their ratings cover how a company's operations affect the environment or social factors such as human rights, and not just the impact of ESG on a company's bottom line.”

Under the new agreement, the European Securities and Markets Authority (ESMA) will authorise and supervise all major EU-based ESG rating agencies. Others located outside the EU must be formally endorsed in order to carry out ratings activities.

What this means in practice is that in providing ratings on each company they assess, ratings firms will have to adhere to EU rules and apply standard approaches to how they draw their conclusions. One main intention is that this will avoid raters applying differing approaches to how they classify ESG-related corporate performance, which has resulted in wide variations in how the likes of tobacco, automotive and energy firms have been rated. This Euractiv piece explains more.

The penalties may not seem stiff - three per cent of daily turnover for ratings companies - but combine that with two per cent of daily earnings for individuals responsible and consider that those infringements are per firm rated, and it’s obvious that there is a significant financial deterrent.

As Responsible Investor pointed out, the regulation has been softened by the EU from its original draft, which would have seen the ratings industry forced to break up some of its business activities into separate entities to avoid potential conflicts of interest.

What happens next? Well, there are a couple of hurdles and timing is not fixed yet. The new rules will need to be formally adopted by the European Parliament and Council before becoming part of EU law - which should be a formality. If this happens before the European parliamentary elections in June they could come into force next year, but that may take a little longer.

Regardless, the first big move in reigning in ESG investment ratings, and more broadly the implicit value purported by companies and raters of sustainable actions, is off and running.