A step towards transparency in ESG ratings: New EU regulation

The Council of the European Union’s recent decision to regulate ESG ratings marks a meaningful milestone for companies involved with ESG benchmarks. This agreement aims to enhance investors’ and respondents' confidence in sustainable benchmarking tools by increasing transparency, objectivity, and comparability within ESG ratings. This article delves deeper into the objectives, implications, and significance of this regulation, providing a thorough understanding of its potential impact on companies.

Companies have long highlighted that managing ESG data is a challenge and contributes to another challenge of budget limitations. Often, this can be linked to companies trying to navigate which benchmarks are worth their effort.

The European Union is taking a practical approach to minimizing the existing complexity by introducing regulations enhancing integrity in ESG ratings. The initiative aims to correct deficiencies in the ESG markets while increasing overall confidence in ratings and their comparability. A call for evidence was launched in 2022 and counted 59 ESG rating providers active within the EU. Among the concerns raised from the report were the lack of transparency from agencies regarding their methodology, the source of the data and results, and the way they operate regarding potential conflicts of interest.

The European Commission’s proposal evaluated solutions to strengthen the confidence in and the transparency of ESG ratings in June 2023, serving as a basis for the Council’s decision. The legislators globally call for a more independent, objective, and qualitative rating market. The final interinstitutional negotiations start this month and will provide insights into the application of the mandate.

Why the demand for ESG ratings regulation?

ESG ratings have a significant role in the global capital market. They provide stakeholders, from investors to borrowers, with a comprehensive assessment of a company’s sustainability performance and profile. These ratings evaluate the risk exposure of a company or financial instrument and its impact on society and the environment. As the principles of sustainable finance become more prevalent, the ratings function as trusted agents and influencers to make better-informed decisions.

As Finch & Beak found in its research for the State of ESG 2024 report, companies were responding to 3.6 benchmarks on average. Ratings participation is a resource-intensive endeavour, especially as companies must contend with other reporting-related obligations, such as CSRD or TCFD.

This regulation therefore not only impacts the agencies and investors, but also companies in the rankings. These groups are using the results to understand their sustainability strengths and weaknesses, those of their partners and peers while sending a strong signal to interested stakeholders. The need for clarity on the methodology and the data used is a priority to understand the results, take concrete actions in sustainability, and have a real impact.

New landscape for ESG rating agencies

Under the new regulation, rating providers need to obtain authorisation and supervision from the European Securities and Markets Authority (ESMA) if they are to operate in the EU. ESMA will thus be able to investigate or sanction any rating agency not complying with their obligations. The road to compliance for rating agencies involves specific requirements, such as:

• Transparency: ESG rating organisations should publicly disclose their methodology, models, and key rating assumptions. This methodology should be reviewed at least annually, and be ‘rigorous, systematic and impartial’. It is a significant step in providing clarity to users, as investors and rated companies will comprehend better how the ratings are derived and what data is used.

• Conflicts of interest: Agencies need to establish robust policies to identify, disclose, prevent, manage, and mitigate potential conflicts of interest. This measure prohibits the provision of consulting or audit services to the companies they rate under the same entity. Other activities, including benchmarks or insurance, will still be authorised if they are conducted autonomously and avoid creating risks of conflicts of interest.

Empowering informed decision-making for companies undertaking ESG ratings

Companies, especially the ones relying on ESG ratings for investment decisions, stand to benefit significantly from this regulation. They can anticipate access to more qualitative data, resulting in a deeper understanding beyond the surface-level assessments. Obtaining these insights will enable them to understand their ESG performance better and tailor their reporting and sustainability strategies accordingly.

However, the challenge lies in choosing the most suitable ESG ratings. This decision holds important weight, as it impacts a company's ESG performance and reputation. To make an informed choice, companies should carefully identify relevant ratings based on industry alignment, shareholder requirements, and stakeholder demands.

A two-pronged approach assessing both the reach and richness of a rating is recommended. Reach considers the reputation and visibility of the requesting party, while richness evaluates the personalised feedback and benchmark focus. The regulation’s mandate for increased transparency will support companies doing so more effectively. Moreover, analysing common denominators among various ratings can help streamline the process, reduce the burden on internal teams, and ultimately save valuable time and resources.

It is crucial to recognise the ESG ratings’ goal: providing a comprehensive assessment of a company's sustainability profile. The decision of which ratings to engage with should be approached strategically. By carefully selecting ratings, companies can meet their stakeholders’ requirements, adhere to industry standards, and maximize their sustainability efforts. In essence, these regulatory changes represent a step towards a more robust ESG market that empowers companies to thrive in a sustainable future.

Interested in strengthening your company’s ESG performance?

Finch & Beak, part of SLR, offers a wide range of ESG rating services, including support for assessments, benchmarking, and gap analysis. Our ESG streamliner service helps companies to leverage their reporting efforts by combining insights from relevant benchmarks, to engage their stakeholders, and to improve in areas relevant for several ratings. To find out how Finch & Beak could support your company with its specific needs, please contact Johana Schlotter at Johana@finchandbeak.com or call +31 6 28 02 18 80.