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EU regulation on the transparency and integrity of ESG rating activities

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The current legislative proposal for a regulation on the transparency and integrity of ESG rating activities in the EU aims at enhancing the clarity and transparency of Environmental, Social, and Governance (ESG) rating processes within the European Union.

Crucially, the proposal does not enforce a uniform methodology across all rating providers. Instead, it acknowledges the diversity of the ESG rating market and focuses mainly on its transparency.

This approach, while subject to criticism, is underpinned by the need for detailed disclosure of rating methodologies and the implementation of a robust authorization and supervision framework under the European Securities and Markets Authority (ESMA).

To make ESMA the only agency capable of supervising ESG ratings in the EU, the proposal is focusing on finding common ground on the basic definitions of its players and the requirements needed to enter the soon-to-be-regulated EU ESG rating ecosystem.

Following the ordinary legislative procedure and initial discussions and 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 combating the spread of unsubstantiated sustainability information...[1]

If passed, this regulation is poised to be a game-changer. It will significantly reshape how sustainability initiatives are financed in the EU and transition the regulatory reins over to ESMA.[2]

The ESG rating process[edit]

Companies demand on ESG[edit]

The functioning of the ESG ecosystem is based on the companies demand on ESG rating providers to rate past activities or future projects, noting that these companies often ask multiple ESG rating companies and cherry-pick the most favorable towards them. According to ESMA’s consultancy, of the 34 respondents disclosing the number of ESG rating agencies they rely on, 77% use more than one provider for ESG ratings, while 23% use only one provider. The ESG rating providers most regularly specified were MSCI (28 mentions) then it's followed by other providers, therefore what MSCI does with its ratings concerns the whole industry.[3]

Leveraging the opacity and the diversity of ESG ratings methodologies by businesses questions potential threats of reliability of ratings [4], greenwashing , and relaying inaccurate and piecemeal information to investors through self-reporting [5][6].

If the incentives to greenwash are quite high as highly rated ESG firms enjoy lower capital and debt costs for example [7].This problem is mainly a question of the company’s maturity on Corporate and Societal Responsibility [8] and how it is situated on the CSR pyramid that distinguishes four distinct types of responsibilities: economic, legal, ethical, and philanthropic [9].

ESG rating agencies[edit]

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.[10]

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 [3].

ESG is not just an approach based on values and moral, it’s a lucrative opportunity[11].

This conflict of interests between commercial use and ESG research and ratings can give a chance for abuse of power to happen, consequently, diminishing the trustworthiness of ESG ratings[3].

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 investing. These big players significantly influence capital allocation towards sustainable investments and raises the question of potential threats of Sustainable finance cartelization as a replicate of regular finance (Marshall, 2012)[12].  

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.[13]

This classification is helpful for understanding why most ESG ratings are called out for a lack of efficiency in facing the big challenges ahead on the three factors. For example, a recent Harvard Business Review working paper surmised that ESG ratings are not a reliable indicator for evaluating the environmental impact of a company relying on a methodology created to measure the environmental intensity. A company with a higher score doesn’t mean that it has strong environmental, social and governance impact on the world, but rather a low exposure to ESG risks[14] (see Examples below).

All of this converges on the conclusion that ESG ratings are focused on financial materiality rather than impact materiality even if the latter have been linked to better performance (Khan et al., 2016).

To alleviate the leveraging of subjective and diversity of ESG rating methodologies in the interest of issuer companies, actors are calling to harmonize standards of reporting rather than measurements behind the scenes. Indeed, if some ESG Reporting Standards exist, meaning that ESG rating agencies follow various international frameworks, such as the Global Reporting Initiative (GRI)[15] or the Principles for Responsible Investment (PRI), few know what really goes into the making an ESG rating. [16]

This opacity and diversity can be referred to as the “ESG ratings gap” that highlights the ratings mechanism inconsistency and lack of regulation, both public and private. The ratings provided by ESG providers often vary significantly, leading to what is referred to as "aggregate confusion". Thus, this inconsistency and lack of trust in these ratings contribute to the "ESG ratings gap” (Berg et al., 2022)[17].

In this regard, a paper finds that ESG ratings agree only 60 % its sample, compared to 99% for credit ratings from the largest rating agencies (Berg et al. 2019; Fichtner et al., 2023[18]). The explanation of these discrepancies of methodologies according to the authors is the challenge of aggregating scores on three pillars, mainly the more complex social aspect (Capizzi et al., 2022[19]; Berg et al., 2022[20]).

The unreliability of ESG rating agencies stems also from the fact that they can give their clients a higher ESG ratings to their clients [21]. They are also morally hazardous as they depend on dubious self-reporting meaning the free will of companies to disclose information more than often unaudited and incomplete (Sipiczki, 2022) [22].

Another problem concerning methodologies is that there are no set-in stone and can evolve with time, making comparison attempts null and void.

For instance, MSCI has a rating system that is based on a scale of AAA (top of the line) to CCC (bottom of line), accompanied with a report explaining why a company went up or down in its score overtime. It was noted that of 150 companies on MSCI’s repertoire, 50% had a score going up while changing nothing. The ESG rater later explained that they upgraded those companies because they updated their methodologies thus the scores went up. This way, most companies had upgraded for what MSCI calls “corporate behavior and data protection”, while only one company was upgraded for emission reduction. It was argued that MSCI worked in the interest of big S&P 500 corporations to get a higher score of ESG rating to help them lower their cost of capital and attract more investors.[23]

This kind of ex post modifications were meticulously observed and linked to the thorny question of data manipulation to make ESG raters look more accurate [24].

The result is that the ESG rating landscape is plagued with incoherences makes it much harder for the big players to make a profound and thorough investment analysis (El-Hage, 2021, pp375). Because of voluntariness, ESG rating agencies do not fully disclose their methodologies or the material impact of selected indicators, likely as a result of overprotectiveness of their proprietary methodologies (El-Hage, 2021, pp365). Voluntariness also produces inconsistencies with the data, and therefore brings practical problems for investors and issuers (El-Hage, 2021, pp368).

Among some of the most probing examples:

  • MSCI’s upgrade of the company McDonald’s, which produce emissions comparable to an entire mid-size EU country like Portugal, by eliminating the significance of emissions from 5% to 0% and highlighting a new recycling initiative (installing bins in some locations). After closer inspection, it turned out that the regulatory pressures in France pushed fast-food companies including McDonald’s to do such recycling measures.[25]
  • Volkswagen. The company had an ESG rating higher than its peer average, even though in September 2015, the Environmental Protection Agency (EPA) sanctioned Volkswagen with over 25$ billion in fines for using a “defeat device”, causing the vehicles produced from 2009 to 2015 to pollute at higher much rate than advertised (El-Hage, 2021).
  • The 2010 Deepwater Horizon oil spill
  • The 2018 Facebook data privacy scandal[26]
  • Boohoo and forced labor in Covid crisis[27]

By using greenwashing in particular, companies can present their business as more ecologically sustainable than it is. According to a policy report, greenwashing includes risks such as: misleading advertisements and public communications, misleading ESG credentials, false or deceiving carbon credit claims (Chan et al., 2023).[28][29]

However, after a profound legal analysis, the Corruption and integrity risks in climate solutions report shows that regulations are significantly weaker for misleading ESG credentials than for climate washing and advertising standards. Despite imposed obligations, ESG rating agencies or ESG auditors are not regulated in any of the reviewed jurisdictions. Factors such as the lack of oversight by such third-party environmental service providers, the opacity of internal scoring methodologies, and the lack of alignment and consistency around ESG assessments can create opportunities for misleading or unsubstantiated claims, and in the worst cases, bribery, or fraud (Chan et al. 2023).

In this sense, regulators are keeping an eye on ESG ratings, trying to develop a demanding approach for being eligible to create those ratings and to avoid greenwashing threats and conflicts of interests[1]. Therefore, the new EC proposal regarding transparency and integrity undertakes efforts to regulate this area.

However, this period of regulatory transition built upon the market standards set by private market actors (diverse methodologies, accuracy of rating, transparency, etc.) and focus mainly on improving disclosure practices rather than fundamentally altering the framework[30].

Adding up to the set of aggregate confusion, once the companies are rated, this data will be refined by index providers to fuel the construction and marketing of ESG financial products by Asset managers or Institutional investors.

ESG rating financial products[edit]

The ecosystem is marked also with large financial groups, banks and assets managers that can pay their way in this market and manipulate the earlier ESG rating process.

For instance, Blackrock shows an ambiguous position in terms of ESG rating. Indeed, Blackrock is an investment firm that has a total of 10 trillion dollars in assets (worth 10% of the world economy) all over the world which is equal to half of America’s GDP. In 2020, Blackrock promoted ESG investing in one hand saying that companies have to serve a social purpose and to be environmentally friendly and that they would give every company an ESG score, on the other hand Blackrock itself is one of the largest investors in fossil fuels, gun manufacturers, oil, gas companies and firms that doesn’t respect human rights practices, all those companies and industries doesn’t respect ESG practices.[31]

These intermediaries are said to benefit from potential greenium - premium on green investments - as they can sell ESG finance products at a higher price than conventional investments and have a larger cut on fees doing so (Arat et al., 2021; Alessi et al., 2021[32]). More recently, the mere existence of greeniums is highly debated in academic literature as results are not cohesive.

Nonetheless, the role of investors in setting the tone in ESG-related finance is, at the end of the day, the key to understanding this complex gear.

The signaling received by Investors[edit]

End investors owning ESG-labeled financial products (ETFs, Funds, green bonds, etc.) are the ultimate players of the ESG rating chain. Despite previous challenges in the rating and manufacturing process, ESG investors are on the rise [33] and key to sanction negative ESG events attributed to a company through a fall of its market value [34]. Three major explanations are highlighted to grasp the resilience of ESG investing.

First, ESG investing is based on a rational aspect. Indeed, ESG-related investing is often linked to higher corporate financial performance [35] specially when they focus on true material sustainability [36]. But, no clear consensus exist, as industry research is finding a positive correlation between ESG scores and performance, while academic research tend to demonstrate an opposite pattern as aggregates [37].

To corroborate these discrepancies, the European Corporate Governance Institute paper found that companies invested in by institutional investors that signed the United Nation’s Principles of Responsible Investment had no improvement in terms of ESG scores, lower returns on investment and higher risk [38]. Also, researchers at Columbia University and London School found, after a comparison between companies that are involved in ESG portfolios and others that are not, that those included in ESG portfolios had a worse record for environmental, social and governance rules[39].

The relatively good performance of ESG products might also be explained by lower regulatory and reputational risks associated to ESG reporting [40] as well as a better shock absorption [41].

Secondly, the psychological aspect is a proven component of this resilience. A probing example would be the perception of ESG funds as pandemic-proof’ funds during the Covid-19 crisis. A perception that was been demonstrated as biased knowing that ESG funds intrinsically favors sectors that withstood the epidemy (eg : healthcare and technology) while generally undervaluing heavily-hit ones such as transport and energy [42]. Overall, the market sentiment in time of a crisis, reinforces green investing [43] which can be explained also with a sense of loyalty toward ESG investments [44] This psychological aspect can also be found in Tariq Fancy tribune (2022) as asset managers actively deceivingly foster this false sense of security associated to green investments. However, a true value-based approach of investing is acknowledged [45], knowing that 77% of end-investors are driven by their social and moral values to invest in ESG, even if institutional investors mainly focus on financial results ([46]. These divergences of view points under the big “tent” of ESG investing crystallizes the tensions  surrounding the real purpose ESG should reflect : impact or risk exposure (Pollman, 2022).

Lastly, the asymmetrical information aspect justifies the need for investors’ protection was already highlighted as a priority on FISMA Agenda. It seems that the overarching response to this need relies on relieving information asymmetries and alleviating barriers between companies and end investors. with the access to high-quality data, investors’ decision-making can empower them to positively and negatively sanction firms based on whether they are aligning with ESG impact or risk criteria by integrating/excluding them from their portfolio [47][48].

The lobbying efforts[edit]

In Europe, climate issues are becoming more and more on the list of topics in the political field. On the left political spectrum, regulators and activists accuse asset managers of "greenwashing" for exaggeration, while on the right political spectrum, the "woke" context of such regulations and investments is too much criticized.[49]

One consensus prevails nonetheless: the necessity to provide consistent and high-quality data to empower investors and guide stakeholders in their decisional process (eg: FISMA agenda 2020-2024; ESMA; Blackrock[50], etc.)

In this regulatory battle, lobbying efforts are coming from both sides of the debate.

On one hand, investor’s protection (eg: BEUC, ESMA in the EU) and transparency enhancing (eg:  Alliance for Corporate Transparency) are the main voice heard. They militate for further regulations on ESG labelling[51], increase and harmonize disclosures all over the EU, and mitigate conflict of interests and revolving doors[52]. 

On the other hand, some industry representatives in the most polluting industries[52] and big financial players [53], while publicly aligning with the ecological agenda.[54]

This diverging powers shape the EU regulatory framework on responsible investing and explains the rise of regulations as well as important concessions to satisfy both parties. However, an EU consensus was achieved in the need for more reliable disclosures through regulations. The proposal of regulation on ESG integrity highlights concerning limitations : the blurriness of the most basic definition of what ESG rating is, the delegation of executive power to an external agency, and the enforcement of new requirements and rules to take part of the EU responsible finance playfield.

Regulations on ESG ratings are still in the embryonic stage and do not tackle all of these challenges. In the attempt of catching up on a market that enjoyed a long period of impunity, a complex EU legislative train of responsible finance started up and  will be discussed below.

The EU legislative train on sustainable finance[edit]

Investment importance[edit]

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.

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. (See Exhibit 1[55])

Exhibit 1 : Global Sustainable Fund Statistics by region in 2023 Q3
Flows Assets Funds
Region USD Billion USD Billion % Total # % Total
Europe                 15.3 2.293 84 5.608 73
United States -2.7 299 11 661 9
Asia ex-Japan 2.0 67 2 539 7
Australia/New Zealand 0.0 31 1 268 4
Japan -0.9 23 1 236 3
Canada -0.1 31 1 336 4
Total 13.7 2.744 7.648

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 (See Exhibit 2[56])

Exhibit 2 Quaterly Global Sustainable Fund Flows (USD Billion)

Legislative importance[edit]

As for a legal point of view, the EU was soon sensitized to green legislations.  For instance, the Netherlands launched a “green lending scheme” in 1995 and held that subject at heart since[57]. The German  government is also a major issuing body of ESG regulations.[58]

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[59]. This pushes forward problematics on ESG rating and their safeguards. Between 2018 and 2022, the European commission cumulates a total of 574 in-force legislations regarding ESG.[58]

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)[60]. 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 [61];[62].

The taxonomy revolves also around a set of regulation aiming at corporations, such as the Non-Financial Reporting Directive (NFRD) now under the appellation of Corporate sustainability reporting directive (CSRD) in January 2023 amended as to enlarge the scope of non-financial reporting to all companies -with few exceptions- and specify updated disclosure requirements[63]. However, this directive is said to constitute a burden on small and medium enterprises (SMEs) that faces serious implementation challenges compared to bigger corporations. With the gradual move from voluntariness to compulsoriness and the  disclosing requirements – whether on availability, accuracy, reliability and understandability- on the rise, administrative and training costs might hamper their financial performance. To compensate these issue, SME were granted time to prepare, the authorization to use simplified models of reporting and hope to enjoy the benefits of disclosure, mainly lower cost of capital and a reputational boost [64].

In February 2023, the Sustainable Finance Disclosure Regulation (SFRD) pushes through  this momentum and applies filters onto to all financial market participants (FMPs) 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) [65]the more committed they are to sustainability matters.

If the SFRD improved capital allocation towards global ESG friendly investments [66], the literature around problematics on ESG 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 [67]. 

Moreover, Tariq Fancy, a whistle blower coming from the ESG industry, warns also on the detrimental “placebo effect” that ESG can contribute to by redirecting sustainable investments and efforts towards an opportunistic business approach vehiculing a false sense of security rather than fostering a concrete positive impact on society [68].

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.[69]

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 under the supervision of the ESMA.

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. Indeed, both scholars and experts. 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[10]. A look at the FISMA’s 2020-2024 Agenda, shows the concurrence of two main objectives. The first concerns increasing capital for sustainable investments and the second presumes a willingness to enhance trust and investors’ protection on European financial markets. [70]

On this behalf, the proposal positions itself as reconciling these two objectives by precising that, from now on, only transparent and supervised ESG rating providers can enter the EU sustainable capital market on ESMA’s watch.

A global context  : Spaghetti bowl[edit]

The EU regulatory framework evolves in a global context of shift toward sustainable finance regulations. Currently, there are 29 countries in the world that have in significant level of mandatory ESG disclosure regulation[71]. The U.S is considered as the first regulator on this matter with the S-K Regulation of the securities law, back in 1934, which stipulated that companies should disclose important information, including environmental liabilities and costs[72]. In 2016, U.S. Securities and Exchange Commission (SEC) published a concept addressing the possibility of requiring comprehensive ESG disclosure but has declined to adopt it (Jiang, 2021)[73].

As of Asia, China as a leader of developing world, initiated similar regulation in 1996 when the Securities and Exchange Commission (SEC) issued a document which for the first time associated the transparency with the quality characteristics of accounting information. Still, there is no compulsory reporting for China companies, but in 2022 new voluntary guidelines are issued[74]. China is undergoing ESG-related initiatives, some research points to significant challenges related to these activities, with an emphasis on high costs that reduce the performance of companies over the time[75]. Japan also promoted voluntary adoption of disclosure practices [76]. Malaysia introduced mandatory ESG reporting for public companies since 2016[77]. Still, Asia has many difficulties with transparency and ESG reporting according to the OECD reports[78].

ESG factors and ratings took a well-established place in the finance realm (see Exhibit 2). Indeed, the 2021 ESG assets market value was over 18.4$ trillion worth of investments with a projected growth of 12.9% till 2026 (PwC report, 2022)[79]. Investors and financiers often favor companies with strong ESG records, which in turn can influence their ability to engage in international trade.

Those who do are confronted to the multiplicity and divergence of regulatory frameworks around the world with specific market access pre-requisites, disclosure standards, compliance supervision, authorities, etc. Thus, the ESG market is often referred to as a “mess”[80], comparable to the “spaghetti bowl” effect regarding the profusion of global trade agreements (Bhagwati, 1995)[81].  As global supply chains expand, it is harder to find a common guideline on ESG factoring and face the subsequent “red tape” and costs, especially for SMEs (O’reilly et al., 2023)[82].

In its globality, the green regulatory framework hardens, complexifies and present never-ending interdependencies. The green-house gas emissions reporting requirements are a probing example of this "spaghetti bowl”. It is said to lead to inefficiencies and a lack of transparency effect that can be mitigated only through streamlining processes like the  SEIS (Barkmann, n.d)[83].

The proposal[edit]

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. A special chapter should be dedicated to transparency, which is the main goal. 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.

In prevision of potential amendments, we mainly focus on three of the most solid elements that the proposal expects : finding a common ground on definitions around ESG, delegating supervision to ESMA, the new requirements to be part of the EU ESG rating ecosystem.

Scope[edit]

The current Proposal does not distinguish between public and private companies that can give ESG ratings, but it is assumed that private companies would do it faster. Indeed, they have much more experience because they have many more years of prior experience and have developed expertise in that specific field. Also, they can certainly do it faster, better, and more efficiently than public companies because they have the necessary analytical technology. Moreover, they can give assessments much more independently, thus increasing the credibility of their analyses.

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 (El-Hage, 2021, pp368 [84]; ESMA, 2022 [3]

However, it won’t apply to non-lucrative ESG rating issuers such as the Carbon Disclosure Project (CDP) as these are highly trusted into giving more accurate data than corporate [85]

Defining the basics[edit]

The term Environmental, Social, and Governance (ESG) was officially coined in 2004 with the publication of the report “Who Cares Wins” 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.[86]

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.[87]

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 proposal of regulation on ESG rating:  

"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. "[88]

The current proposal for a regulation on the transparency and integrity of ESG rating activities (2023), at the core of this article, builds upon than pushing forward in its definition the 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).[89]

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 (See Section ESG Rating Process). The proposal stands thus in the position of maintaining diverse opinions and a certain degree of flexibility rather than a homogeneous measurement of ESG factors.

This contrast on the basic definitions highlights the difficulty the challenge surrounding the regulation of ESG rating providers. 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 role[edit]

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).[90]

However, this incremental change was subject to a whole new flow of critiscism 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[90]), the threat toward the institutional balance of the EU [91], the impact on the European Parliament and the council of the EU co-decision process [92], 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[93]), 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 comes with no surprise.

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.  As a matter of proof, even with the prior experience it has gathered, ESMA is still dependent on other big financial players – like Blackrock[94]- for expertise and consultancy on a variety of topics stressing the need of accountability of agencies : A matter that cannot be reassure but with an unbendable requirements and exercices of accountability. The surveillance of the ESMA is up the European parliament that still has a double discourse regarding agencification and which uses this supervisory power in advancing a set of personal  preferred policies (Rittberger, 2005, Lord, 2011)

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.

Third countries ERP in the EU[edit]

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 EC needs to adopt an equivalence decision for the third country authority or delegate to ESMA authorization on a case by case basis. This aims to exclude potential free riders or fraudulent organizations[95]
  • 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 planification.

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[edit]

Studies like Miller’s (2002) [96]or Kuncoro’s (2011) [97]confirms that transparency has a great impact on companies, investors, creditors, and information intermediaries in the capital market, specifically helping to reduce information asymmetry.

  • 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, pp378)[98]. 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

In addition to these, the independence of ESG rating is set to an unseen level before, and measure for hindering potential conflict of interests are setting the bar high as none of the rating agency can undergo consulting, investments, Audit, Banking, reinsurance, credit rating activities nor elaborations of green benchmarks.

References[edit]

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  3. ↑ 3.0 3.1 3.2 3.3 "ESMA Letter on ESG Ratings Call for Evidence" (PDF). 24 June 2022.
  4. ↑ Berg, Florian; Koelbel, Julian; Pavlova, Anna; Rigobon, Roberto (October 2022). ESG Confusion and Stock Returns: Tackling the Problem of Noise (Report). Cambridge, MA: National Bureau of Economic Research. doi:10.3386/w30562.
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