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In the first part of our series on ESG ratings, we considered the background, introduction, and scope of the Regulation on the transparency and integrity of ESG rating activities (the Regulation).
In this second part of our series, we will look at the organisational processes and governance requirements being introduced by the Regulation and set out some practical considerations for ESG rating providers.
Organisational processes and governance requirements
The Regulation sets out fourteen general principles for organisational, process, governance and documentation requirements that ESG rating providers must comply with.
Overall, these requirements are focused on ensuring that ESG rating providers put in place certain rules, processes, and procedures to ensure that their ESG ratings are issued, published, and distributed in a transparent manner.
Separation of business activities
In order to avoid any potential conflicts of interests, ESG rating providers must separate the provision of ESG ratings from certain other business activities. ESG rating providers will not be permitted to provide consulting services, credit ratings, benchmarks, investment activities, audit, banking, insurance or reinsurance activities.
However, ESG rating providers may provide investment, banking, or insurance activities, as long as there is a clear separation between these activities and measures are put in place to avoid potential conflicts of interest.
The Regulation also provides that ESG rating providers can make a request to ESMA to develop benchmarks. ESMA may grant such authorisation provided they are satisfied that sufficient measures have been put in place to address conflicts of interests.
Conflicts of interest
Under the Regulation, ESG rating providers are required to establish policies, procedures, and organisational arrangements to identify, disclose prevent, manage and mitigate conflicts of interest.
ESG rating providers will be required to disclose all existing or potential conflicts of interest to ESMA, with ESMA required to take action where a risk of a conflict of interest is identified. Under the Regulation, ESMA will have the power to require ESG rating providers to either cease the activities or relationships that create the conflict or cease to provide ESG ratings.
The Regulation also prohibits shareholders or members of an ESG rating provider who hold a “significant influence” from holding a significant influence in any another ESG rating provider.
Disclosure requirements
The Regulation sets out a number of transparency requirements that require ESG rating providers to make certain disclosures.
At a minimum, ESG rating providers are required to disclose on their website in a clear and transparent manner and through the European single access point the methodologies, models and key rating assumptions they use in their ESG rating activities. This information should be published in a separate section of the ESG rating provider’s website. A more granular overview of rating methodologies must be provided to users that are subject to an ESG rating.
ESG rating providers are required to review their ESG rating methodologies on an ongoing basis and are encouraged to take into account European and international developments affecting the E, S or G factors. However, ESG rating providers will still have the autonomy to determine their own methodologies.
If an ESG rating covers the E factor, then ESG rating providers will be required to provide information on whether that rating takes into account the targets and objectives of the Paris Agreement or any other relevant international agreements. Similarly, if an ESG rating of an entity covers the S or G factors the information on whether that rating takes into account any relevant international agreements will also need to be disclosed.
ESG rating providers will also be required to explicitly disclose the dimension of the double materiality principle their ratings address. Specifically, ESG rating products would be required to state whether the ESG rating assesses both material financial risk to the rated entity and the material impact of the rated entity on the environment and society, or whether the rating product takes into account only one of these.
The practicalities of ESG rating exemptions
In the first part of our series, we touched on the ESG rating exemptions available under the Regulation.
In particular, the exemption for ESG ratings issued by regulated financial undertakings in the EU that are incorporated into a product or service already regulated under EU law (including the UCITS Directive, the Benchmark Regulation and AIFMD) and are disclosed to third parties, is a welcome relief for financial undertakings already subject to burdensome regulations.
However, where the third-party disclosure forms part of the regulated financial undertaking’s marketing communications, then it will be required to include on its website the information set out in Annex III of the Regulation titled “Disclosure Requirements”. The marketing communication must also include a link to these website disclosures.
This marketing communication point also ties in with the amendment the Regulation introduces to the Sustainable Finance Disclosure Regulation (SFDR). The Regulation introduces an amendment to SFDR, in the form of Article 13(3) which requires that where a financial market participant or financial adviser discloses to third parties an ESG rating as part of its marketing communications, then they will be required to comply with the “disclosure requirements”.
Those subject to the disclosure requirements will be required to publish on their website information including:
Regulated financial undertakings and those subject to SFDR that wish to avoid complying with the disclosure requirements will need to carefully consider their use of ESG ratings in marketing communications.
From a practical perspective, if we look at the asset management industry, index providers are one of the industry’s biggest suppliers of ESG ratings with their products often regulated by the Benchmark Regulation. However, if asset managers make these ESG ratings visible to third parties as part of its marketing communications they will be under an obligation to comply with the disclosure requirements.
Small ESG providers
To balance the regulatory burden on small ESG rating providers, the Regulation introduces a lighter temporary regime for small ESG rating providers who meet the criteria of a small undertaking under the Accounting Directive.
The lighter regime is optional and small ESG rating providers who opt in will only be subject to specific organisational and transparency requirements. The regime for small ESG rating providers is temporary and those who choose to opt in will be subject to the full Regulation after three years.
A small ESG rating provider may lodge a request to ESMA for an exemption from complying with a number of the general principles.
Next steps
The Regulation is still working its way through the EU’s legislative process. It is anticipated that it will be finalised and published in the Official Journal of the European Union in the coming months. Its provisions will start applying 18 months after its publication in the Official Journal. This allows time for those impacted to take the necessary actions to comply in advance of the application of the Regulation’s obligations to them.
For further information in relation to this topic, please contact Chris Bergin, Partner, Jill Shaw, ESG & Sustainability Lead or any member of the ALG ESG & Sustainability team. With thanks to Rachel Hanley for her assistance in the preparation of this series.
