User:Yasszz/Regulation on the transparency and integrity of ESG rating activities in the EU

The proposed EU regulation on ESG rating transparency and integrity aims to improve clarity in the EU's ESG rating processes, focusing on transparency rather than a uniform methodology of ESG rating providers (ERP). It details a set of definitions on the ESG rating key players, necessary disclosures and requirements for third country ERP and a supervision framework under ESMA's umbrella, which is set to become the sole ESG rating supervisor in the EU.

Following the ordinary legislative procedure with the Council of the European Union and its preparatory bodies, an amended version of the proposal was published on July 14, 2023. This revised proposal was subsequently presented to the European Parliament for the first reading. Its adoption, in its current form or with minimal amendments, is anticipated to be a crucial step in sustainable finance regulations in the EU and worldwide.

Investments importance
Responsible investing through ESG has known a golden age globally driven by the COP21 or the Paris agreement, and the UN 2030 development goals sustainable.

ESG factors and ratings took a well-established place in the finance realm. Indeed, the 2021 ESG assets market value was over 18.4$ trillion worth of investments with a projected growth of 12.9% till 2026.

The EU has a leading position in the sustainable funds market, commanding 84% of global assets in this sector. Additionally, it stands as the most advanced and diversified market for ESG investments. In comparison, the US, following at a distance, accounted for 11% of these global sustainable fund assets by September 2023. Furthermore, it is to be noted that amid allegations of greenwashing and stricter regulations, there's a notable decrease in funds incorporating ESG-related terms into their names. An increasing number of funds in the United States are removing ESG-related terms from their names, a trend not observed in Europe.

ESG Rating Providers Market characteristics
ESG rating agencies are the main infomediaries of ESG investing. The number of ESG-rating companies in the ecosystem is not clear. Sustainalytics estimated it at over 600 in 2018.

However, the ESG market is going through an increasing trend of concentration. For instance, the data aggregator Morningstar took 40% of Sustainalytics stakes by 2017. Following that, the rating agency Moody’s acquired Vigeo Eiris in 2019, the former leader of European ESG rating agencies. ISS (Institutional Shareholder Services) acquired Germany’s Oekom, while S&P Global acquired the ESG rating business of RobecoSAM. The market's structure is divided between a few very large non-EU providers on one side, and numerous smaller EU providers on the other.

In this highly concentrated ecosystem, small groups of big index providers, like MSCI, play a pivotal role in setting the standards for what is generally accepted as sustainable finance. As for categorizing ESG rating agencies by purpose, it is crucial to distinguish between two private ESG rating clusters.

First, the ESG risk rating agencies (eg : MSCI, Sustainalytics, S&P, FTSE Russell), they are meant to measure how exposed a company is towards ESG risks -meaning the negative externalities impact on the company- more than concrete action on the three factors. Secondly, the ESG impact rating agencies (eg : Refinitiv, Moody s, ECPI, Sensefolio, Inrate) which measures ESG factors commitment, integration and results and therefore outward impact on society.

This classification is helpful for understanding the confusion around ESG ratings inefficiency in facing the big challenges ahead on the three factors. Indeed, a company with a higher score doesn’t necessarily mean that it has strong environmental, social and governance impact on the world, but rather a low exposure to ESG risks.

Legislative background
As for a legal point of view, the EU was soon sensitized to green legislation. For instance, the Netherlands launched a “green lending scheme” in 1995 and held that subject at heart since. The German government is also a major issuing body of ESG regulations.

As a whole, the engagement of EU in matter of a greener world blossomed through a flow of regulations, directives and proposals in line with the Green Deal package launched in 2020 and the EU sustainable finance Action plan.

In this regard, sustainable financial investment is a central piece of the strategy to bridge the climate finance gap reassured by COP 28. Between 2018 and 2022, the European commission accumulates a total of 574 in-force legislations regarding ESG, pushes forward problematic on ESG rating reliability and their safeguards.

Among this package of initiatives, the EU taxonomy regulation and its delegated acts aims to classify sectors and activities on their greenness and whether they are “Taxonomy-aligned”, “Taxonomy-eligible” or have a “transition exposure”( Allessi & Battiston, 2023). It depends thus on 2 axis: the level of transparency and disclosure of information, and the adequacy of the per se disclosed content to sustainable indicators updated through delegated acts.

In the context of corporate regulation, the EU taxonomy revolves around measures such as the Non-Financial Reporting Directive (NFRD), which was revised by the Corporate sustainability reporting directive (CSRD) in January 2023. This amendment expanded the scope of non-financial reporting to encompass nearly all companies, with a few exceptions, and introduced more detailed disclosure requirements. Despite these changes, concerns have been raised regarding the directive's impact on small and medium-sized enterprises (SMEs). The shift from voluntary to mandatory reporting, coupled with the increasing demands for data availability, accuracy, reliability, and understandability, is likely to result in higher administrative and training costs, potentially affecting the financial performance of SMEs. To mitigate these challenges, SMEs have been afforded additional preparation time, permitted to use simplified reporting models, and are anticipated to benefit from the disclosures through lower capital costs and reputation boosts.

In February 2023, the Sustainable Finance Disclosure Regulation (SFRD) pushes through this momentum and applies filters onto to all financial market participants (FMP) as well as their financial products as to categorize them as “Light Green” if they are broadly ESG-related (article 8) or “Dark Green” (article 9) if they are fully committed to sustainability matters. If the SFRD improved capital allocation towards global ESG friendly investments, a significant issue is referred to as the “ESG Capital Allocation Gap”. This gap states the dominance of the broad “Light Green” ESG indices, which do not meaningfully facilitate sustainability, as opposed to "Dark Green" indices that have better sustainability impact. This highlights the need for more effective capital allocation in ESG funds that integrate impactful initiatives to achieve real sustainability of the economy .FISMA is hamstrung by this issue knowing that a said 260 billion euros a year are the estimated need to put Europe on a good track to reach the 2030 ecological targets.

In the same line, since November 2023, the EU green bond standards regulation (EuGBS) adds up and guarantees that the profits made on green bonds sells are effectively directed towards “taxonomy-aligned activities” and ESMA's oversight.

The incoming regulation on the transparency and integrity of ESG rating activities (proposal on June, 2023; adoption by mid-2024) is now willing to enhance transparency, integrity, quality and independence of ERP in hope to shackle potential greenwashing linked to these infomediaries. For instance, ESMA outlined the correlation between the growth of ESG-related funds and greenwashing. The exponential rise of funds integrating vague ESG-related language in their names started since the Paris Agreement (2015), and is effective to deceivingly attract more investors. The 2020-2024 agenda of FISMA reflects dual objectives: increasing capital for sustainable investments and bolstering trust and investor protection in European financial markets.

Indeed, in the context of escalating concerns regarding the authenticity of corporate ecological sustainability claims, greenwashing has emerged as a significant issue and poses a real challenge on sustainable finance regulations gaps. This practice, wherein companies depict themselves as more environmentally responsible than they actually are, encompasses a range of deceptive tactics. According to the "Corruption and Integrity Risks in Climate Solutions" report, greenwashing manifests through misleading public communications and advertisements, the misrepresentation of ESG (Environmental, Social, and Governance) credentials, and the propagation of false or deceptive claims regarding carbon credits. The same report underscores that current regulations are markedly less rigorous for misleading ESG credentials compared to the other means.

Notably, in the jurisdictions surveyed, ESG rating agencies and auditors are not subject to any specific regulatory framework. This absence of oversight, coupled with the opacity of internal scoring methodologies- likely as a result of overprotectiveness of their proprietary methodologies - and a lack of uniformity in ESG assessments - that can be referred to as the ESG rating gap -, paves the way for potentially misleading claims. In extreme cases, this could escalate to bribery or fraud.

Recognizing these challenges, regulatory authorities are intensifying their scrutiny of ESG ratings. Efforts are underway to establish more stringent criteria for entities eligible to produce these ratings, with a focus on shrinking the risks of greenwashing and conflicts of interest. Consequently, the European Commission has introduced a proposal aimed at bolstering transparency and integrity within this domain.

Content
In the proposal, a special part should be regulated for the extension of the regulation to third-country providers in the EU. Secondly, it should outline conditions for ESG ratings in the EU. The new regulation should prescribe ESMA to maintain an approved ESG rating providers register. It should outline the ESMA’s supervisory powers and cooperation with national authorities. Final articles should grant the Commission authority for delegated acts as it was the case for the EU taxonomy.

The proposal of regulation on ESG integrity highlights concerning limitations in the regulatory framework on sustainable finance. Among them, the blurriness of the basic definition of what ESG ratings are, the delegation of executive power to an external EU agency, and the enforcement of new requirements and rules to take part of the EU responsible finance playfield.

Scope
The current Proposal does not distinguish between public and private companies that can provide ESG ratings.

As regard to the globality of the ESG raters, the regulation will apply for both EU and non-EU companies with a relative ease on small and medium undertakings largely represented by EU raters. It is expected that the regulation obligations will have an impact on small providers with some administrative burden and costs of organizational changes, but on the other hand notable benefit for the small providers should be better visibility and reputation gain.

Defining the basics
The term Environmental, Social, and Governance (ESG) was officially coined in 2004 by the UN Global Compact Initiative (UN, 2004). It set the ambitious goal to regroup three of the main ethical finance pillars: environmental, social and governance.

After near two decades, finding a unique definition of ESG rating is still challenging. This is even the case in what is considered a forefront of ESG investing and a leading regulator, the European Union. Recent efforts to define this concept stemmed from EU financial supervisors or official texts from institutions that failed to find yet a consensus.

About the former, ESMA (2021), in its letter to the European Commission, proposed the following broad definition when introducing their suggestion of a regulation on ESG rating activities :

"ESG rating means an opinion regarding an entity, issuer, or debt security s impact on or exposure to ESG factors, alignment with international climatic agreements or sustainability characteristics, issued using a defined ranking system of rating categories."

The current proposal for a regulation on the transparency and integrity of ESG rating activities (2023), at the core of this article, builds upon that pushing forward in its definition as following:

“An opinion, a score or a combination of both, regarding an entity, a financial instrument, a financial product, or an undertaking’s ESG profile or characteristics or exposure to ESG risks or the impact on people, society and the environment, that are based on an established methodology and defined ranking system of rating categories and that are provided to third parties, irrespective of whether such ESG rating is explicitly labelled as ‘rating’ or ‘ESG score”. (article 3, Proposal on the transparency and integrity of Environmental, Social and Governance (ESG) rating activities regulation).

Both sources corroborate that ESG ratings assess the environmental, social, and governance characteristics, exposures to ESG risks or the impact on the environment and society in general of an entity, a financial instrument or a financial product, through a set of methodologies that can nevertheless differ. Thus, the regulation acknowledges and maintains the diversity of opinions and flexibility of ESG ratings, rather than a harmonizing measurement.

This contrast on the basic definitions highlights the difficulty the challenge surrounding the regulation of ESG rating providers and is still subject to thorough discussions by the European Parliament and the Council.

Adopting clear definitions are key to regulation of the ESG ecosystem thus the need to define an ESG rating provider, the requirements needed to be met in this regard, the enforceability measures of this regulatory framework and the compliance supervision.

This challenging role is granted to ESMA.

ESMA’s supervision
According to the Commission proposal, conducting ESG ratings will require legal entities to apply for authorization to the European Securities and Markets (ESMA), the backbone of this proposal.

The addition of overseeing Environmental, Social, and Governance (ESG) rating providers to the European Securities and Markets Authority's (ESMA) responsibilities can be seen as a coherent extension of its existing mandate and expertise. ESMA would have supervisory powers over ESG rating providers in addition to the supervision of rating agencies. Since there are similarities between supervisory functions, ESMA will have much more facilitated future supervision.

ESMA’s birth is intimately intertwined with the 2008 financial crisis and the 2010 Eurozone crisis. At the light of these major turmoils, the prevailing EU financial supervision framework put on place by Lamfalussy did not stand the shock and was replaced by De Larosière regulatory framework. Therefore, what was known as the level 3 Lamfalussy agencies, the 3L3 Commitees (CESR, CEIOPS, CEBS) in this four level framework, were taken over by the current European Supervisory Authorities (ESA are composed of ESMA, EIOPA, EBA) in the European System of Financial Supervision (ESFS) launched in 2011 in answer to the debt crisis (Spendzharova, 2012).

However, this incremental change was subject to a whole new flow of criticism treating about the EU administrative landscape and, more specifically, the literature around agencification. In fact, scholars studied the rise of EU agencies with executive powers through a critical lens as it raised questions on the democratic principle of the delegation of these powers to external agents (Spendzharova, 2012 ), the threat toward the institutional balance of the EU, the impact on the European Parliament and the council of the EU co-decision process, the fragmentation it can cause within member states as capitals battle to host them (Lord, 2011).

ESMA started the first page of its history and enjoyed a succession of executive delegations from the commission starting with the Omnibus I (2010) and Omnibus II (2011), which made the ESA operational and gave ESMA the role of direct supervisor of Credit Rating Agencies and trade repositories. Similarly, ESMA's role in overseeing ESG rating providers can help ensure consistency in how these ratings are applied and interpreted across the European Union.

In 2012, its competences were enhanced through the EU regulation on short selling and credit defaults swaps. The year 2014 marked an intensive regulatory pressure on financial markets. The MiFID II and MiFIR gave ESMA the responsibility of implementing technical standards in the financial market. The incorporation of ESG aspects into its supervisory activities reflects an understanding that financial markets are not just influenced by traditional economic factors but also by sustainable finance too.

Its mandate includes investor protection and financial integrity and transparency with the Market abuse regulation (MAR), which is increasingly tied to ESG factors. Ensuring that ESG ratings are reliable and not misleading is an essential part of this role.

As of its growing power, they are heavily criticized by some member states. The most vocal of them were the former EU country: UK. As a matter of fact, the growing weight of the agency was seen as a threat to national sovereignty and the matter grew to a litigation process in front of the European Court of Justice on the particular case of the possibility of ESMA to block short-sellings in time of crisis. UK argument, based on the Meroni case (case 9-56 ), was that this delegation of power was anti-constitutional and was a breach to national sovereignty. However, the ECJ held against UK in this matter reassuring ESMA of outmost trust in dealing with financial regulations in case of emergency.

Each of these regulations and judgements have served as a springboard and settled ESMA as a key player in the financial realm regulatory framework and its association through the proposal of a regulation on ESG ratings activities integrity and transparency therefore aligns with the aim to concentrate a comprehensive EU Finance Single Rulebook on the hand of ESMA.

However, if ESMA is said to be accountable, independent and competent in EU financial supervision, a glance on its relations and network signals potential conflict of interests while dealing with ESG investing. The surveillance of the ESMA is up the European parliament that still has a double discourse regarding agencification and might use this supervisory power for the sake of advancing a set of personal preferred policies.

Under the proposed regulations, any entity wishing to offer Environmental, Social, and Governance (ESG) rating services within the European Union must obtain official authorization. Entities based in the EU are obliged to seek this authorization from the European Securities and Markets Authority. ESMA will grant authorization upon determining that the applicant meets the criteria outlined in the Proposal and the right to apply fines in case of non-compliance to the set of requirements on quality, integrity, independence and transparency.

Third countries ERP in the EU
ESG rating provider comes from a third country, it will have to fulfil the following requirements, once it has informed ESMA of its intention to conduct ESG rating activities in the EU. The conditions are as follows


 * Provide a legal representative and indicating the name of the competent authority responsible for the supervision of the Non-EU ERP. This way keeping track of the of the market and coordinating global policies are facilitated.


 * The European Commission needs to adopt an equivalence decision for the third country authority or delegate to ESMA authorization on a case by case basis. This might tackle the issue of potential free riders or fraudulent organizations.


 * A cooperation arrangement with the competent authorities of the third country is found. This might foster international cooperation and information exchange for a better future planing.


 * Other ERP can be endorsed by previously authorized members.

When authorized, the information on the identity of ESG rating providers that have received authorization, recognition or that complied to the proposed Equivalence Regulation will be available in the European Single Access Point (ESAP).

Quality, Integrity, Independence, and Transparency
Studies like Miller’s (2002) or Kuncoro’s (2011) confirms that transparency has a great impact on companies, investors, creditors, and information intermediaries in the capital market, specifically helping to reduce information asymmetry. In this regard, the proposal requires ESG rating providers to:


 * Publish on ERP websites methodologies, models and assumptions essential to guide the investors’ decisional process
 * Gather information on the European Single Access point
 * Commit to record at least 5 years of ESG activities

Under the current system, self-regulated and based voluntary disclosure, the information produced by companies and ratings firms is often incomplete and inconsistent. The SFDR and NFDR/CSRD aim to gear toward more compulsoriness. When ESG disclosure become mandatory, standards become clearer, and reporting becomes more consistent and comparable (El-Hage, 2021, p378). As of the proposal divergence, it tackles the question of quality of ESG rating through the requirement and checking of the ERP knowledge and previous expertise proofs.

The integrity of ESG, on ESMA’s surveillance, require the EU agency’s tasks are not hampered by any mean and therefore the future Eu ERP would be asked to:


 * Put on place complaint handling mechanisms
 * Not outsource as it impairs the judgement of ESMA and can threaten the report quality


 * None of the rating agency can undergo consulting, investments, Audit, Banking, reinsurance, credit rating activities nor elaborations of green benchmarks as to ensure their independence.