EU cracks down on ESG ratings for conflict of interest

Funds could be fined up to 10% of their turnover if they fail to comply with proposed regulations regarding ethical scores .Agencies that rate businesses and investment funds on their environmental, social and governance credentials may face fines for conflicts of interest under new EU rules aiming to regulate the fast-growing industry for the first time.

The European Commission will announce the proposal next week, as part of its crackdown on “greenwashing”. It will require ESG ratings agencies — even those outside the EU — to certify their work with the EU financial regulator.

The agencies must divest themselves of any conflicts, including consulting with or providing insurance to the businesses they rate. They risk fines if these conflicts persist.

Fines could be as high as 10% of the annual turnover.

The European regulators aim to combat Greenwashing and redirect private financial flows toward genuinely eco-friendly activities.

According to the EU’s draft proposal, “the current ESG market is inefficient and does not meet investors’ and rated entity’s needs with regard to ESG ratings. . . not being met”. The report added, “confidence in ratings has been undermined”.

The draft is a warning against “diversities, lack of transparency, and absence of common standards” and aims to prevent member states from introducing their own disparate policies.

Before the regulation can take effect, it will have to be approved by both the European Parliament and all member states. This process may include some amendments.

According to Morningstar, investors held $2.74tn of sustainable funds worldwide at the end March. Three years ago they had $929.9bn.

Morningstar, a company based in New York, acquired Sustainalytics by MSCI in 2020. S&P Global and Institutional Shareholder Services, a leading proxy adviser, both have an ESG rating branch.

In 2021, the International Organization of Securities Commissions (IOSC) called on regulators to pay attention to ESG data suppliers and their environmental claims.

The Securities and Exchange Board of India was one of the first to respond. In February, it proposed a regulatory structure that would require ESG rating providers to register with regulator. The providers would be required to take measures to promote transparency and avoid conflicts of interests.

The UK regulator has been working on a code of conduct that will be voluntary for data and rating providers. Meanwhile, the UK Treasury is holding a consultation on giving the regulator more formal power over ESG ratings.

The Financial Times reported that “we’re not going to wait for a crisis before we act.” Sacha Sadan is the head of environmental issues, social issues, and governance at the UK Financial Conduct Authority. The industry “has grown very quickly.” . . It’s now a major part of the investment process”.

All ESG rating providers in Europe, as well as those from other countries who provide ratings to the EU, would be covered by this regulation.

Small rating agencies, with an annual turnover of EUR8mn or less, would also be exempt.

According to the draft regulations, agencies will be required to demonstrate that their ratings are sufficiently separate from their business interests and will not have access to consulting, auditing, or any other financial services.

According to the EU, 59 rating providers will fall under its regulatory jurisdiction.

Thierry Philipponnat is the chief economist of Finance Watch, a non-profit organization. He said that separation of business operations was “good governance”.

He said: “A number of [agencies] provide ratings and consultation services today, so they will not like it, but honestly, this is good practice.”

Philipponnat said that the draft regulations failed to regulate the goals of rating providers. For example, whether ESG scores are meant to assess the financial impacts of climate change on an organization’s activities, or, conversely, the impact of businesses on society or the environment. ESG includes both types of objectives.

He said, “I regret that this regulation barely makes a reference to the content.”

Esma has the power to establish “technical Standards” in future legislation. The commission refused to comment on this draft.