Regulation of the European Parliament and of the Council on the transparency and integrity of Environmental, Social and Governance (ESG) rating activities
Made by
European Parliament & Council of the EU
Made under
Art.114
History
Date made
2023-06-13
Entry into force
—
Proposed
Regulation of ESG rating in the European Union are proposed European Union regulations of environmental, social, and corporate governance (ESG) rating activities' transparency and integrity to improve clarity in the EU's ESG rating processes. The regulations were first designed after 2020 and an amended draft was published in 2023.
The focus for the proposed regulations are on transparency rather than a uniform methodology of ESG rating providers (ERP).[1] 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.[2][3][4][5]
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 its 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.
History
The European Union's planned a comprehensive approach, comprising regulations, directives, and proposals aligned with the 2020 Green Deal package and the EU Sustainable Finance Action Plan.[6][7]
Between 2018 and 2022, the European commission accumulates a total of 574 in-force legislations regarding ESG.[8] This proposal of regulation 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).[9] 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.[10][11]
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.[14]
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.[15]
Under the current system, self-regulated and based on 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.[16]
The incoming regulation on the transparency and integrity of ESG rating activities (proposal in June 2023; adoption by mid-2024) is now willing to enhance transparency, integrity, quality and independence of ESG Rating providers (ERP) and supervise their activities.[17]
It aims to shackle potential greenwashing linked to these infomediaries.
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.[18]
Scope
The current Proposal does not distinguish between public and private companies that can provide ESG ratings.
Regarding the global aspect of the ESG rating activities, 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.[19][20]
EU central banks are exempted and the ECB favorably welcomed this exclusion as to create its own ESG ratings awaiting for private ERP to be more reliable.[21]
It won't neither 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 lucrative issuers.[22]
Defining the basics
Finding a clear definition of ESG rating is challenging.[23] Recent efforts to define the concept stemmed from EU financial supervisors or official texts from institutions that failed to find a consensus yet. 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."[24]
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).[25]
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 surrounding the regulation of ESG rating providers and is still subject to thorough discussions by the European Parliament and the Council[26]
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 handed 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).[27][28]
Apart from granting authorisation to provide ESG ratings in the EU, the proposal confers supervisory powers to ESMA.[29] In order to carry out its supervisory competence, ESMA may require relevant persons to provide all information necessary to carry out its supervisory duties. The proposal defines the scope of the relevant persons rather broadly, including:[30]
ESG rating providers.
Persons involved in ESG rating activities.
Rated entities, third parties to whom the ESG rating providers have outsourced operational functions or activities.
Persons otherwise closely and substantially related or connected to ESG rating providers or ESG rating activities.
The relevant persons are obliged to provide the requested information.[31]
ESMA may also conduct necessary investigations of relevant persons. The right to carry out general investigations includes:[32]
Examination of records, data, procedures, and any other material relevant to the execution of its tasks.
Obtaining certified copies of or extracts from such records, data, procedures, and other material.
Requesting relevant persons or their representatives or staff to provide explanations on facts or documents related to the subject matter and purpose of the inspection, including interviews (with consent of such person).
Requesting records of phone and data traffic.
In order to carry out its duties, ESMA may conduct on-site inspections at the business premises of the relevant legal persons, possibly also without prior announcement.[33]
Administrative sanctions and other administrative measures
According to the proposal, ESMA has the competence to take supervisory measures where it finds that an ESG rating provider has not complied with its obligations. These include:[34]
Withdrawal of the authorisation of the ESG rating provider.
Temporary prohibition of the ESG rating provider from providing ESG ratings, until the infringement has ceased.
Suspension of the use of the ESG ratings provided by the ESG rating provider, until the infringement has ceased.
Requesting the ESG rating provider to end the infringement.
When taking the supervisory measures, ESMA shall consider the nature and seriousness of the infringement. The measures must be in any case effective, proportionate, and dissuasive.[36]
The proposal introduces periodic penalty payments as an instrument to compel ESG ratings providers or the relevant persons to comply with previously issued decisions, requests for information, or investigation and inspections.[37]
The proposal also grants a right to review by the Court of Justice where ESMA has imposed a fine or a periodic penalty payment. The Court shall have competence to review such decision and may annul, reduce, or increase the fine or periodic penalty payment.[38]
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:[39][40]
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 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.
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)[41] or Kuncoro's (2011)[42] 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:[43]
Provide proof of knowledge and past expertise in ESG rating.
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.
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.
Related Research Articles
EUR-Lex is the official online database of European Union law and other public documents of the European Union (EU), published in 24 official languages of the EU. The Official Journal (OJ) of the European Union is also published on EUR-Lex. Users can access EUR-Lex free of charge and also register for a free account, which offers extra features.
Comitology in the European Union refers to a process by which EU law is implemented or adjusted by the European Commission working in conjunction with committees of national representatives from the EU member states, colloquially called "comitology committees". These are chaired by the European Commission. The official term for the process is committee procedure. Comitology committees are part of the EU's broader system of committees that assist in the making, adoption, and implementation of EU laws.
Sustainability reporting refers to the disclosure, whether voluntary, solicited, or required, of non-financial performance information to outsiders of the organization. Sustainability reporting deals with qualitative and quantitative information concerning environmental, social, economic and governance issues. These are the criteria often gathered under the acronym ESG.
The European Institute of Innovation and Technology (EIT) is an independent body of the European Union with juridical personality, established in 2008 intended to strengthen Europe's ability to innovate. The EIT’s three “core pillars” of activities are: entrepreneurial education programmes and courses across Europe that transform students into entrepreneurs; business creation and acceleration services that scale ideas and budding businesses; and innovation-driven research projects that turn ideas into products by connecting partners, investors, and expertise.
The Roaming Regulation 2022 bans roaming charges (Eurotariff) within the European Economic Area (EEA), which consists of the member states of the European Union, Iceland, Liechtenstein and Norway. This regulates both the charges mobile network operator can impose on its subscribers for using telephone and data services outside of the network's member state, and the wholesale rates networks can charge each other to allow their subscribers access to each other's networks. The 2012 Regulation was recast in 2022.
ENTSO-E, the European Network of Transmission System Operators, represents 40 electricity transmission system operators (TSOs) from 36 countries across Europe, thus extending beyond EU borders. ENTSO-E was established and given legal mandates by the EU's Third Package for the Internal energy market in 2009, which aims at further liberalising the gas and electricity markets in the EU. Ukrainian Ukrenergo became the 40th member of the association on 1 January 2024.
The Civil Mediation Council (CMC) is the recognised authority in England and Wales for all matters related to civil, commercial, workplace and other non-family mediation. It is the first point of contact for the Government, the judiciary, the legal profession and industry on mediation issues.
Environmental, social, and governance (ESG) is shorthand for an investing principle that prioritizes environmental issues, social issues, and corporate governance. Investing with ESG considerations is sometimes referred to as responsible investing or, in more proactive cases, impact investing.
The European Securities and Markets Authority (ESMA) is an agency of the European Union located in Paris.
Council Implementing Regulation (EU) No. 282/2011 was adopted by the Council of the European Union on 15 March 2011. This was mainly because the terms and wording of Directive 2006/112/EC have been inconclusive in some cases. The Regulation provided new implementing measures for the VAT Directive. Especially due to the amendment of the VAT Directive itself and the consistent case-law of the European Court of Justice, the former Implementing Regulation (EC) No. 1777/2005 had to be recast and clarified in certain aspects. This Implementing Regulation became effective on 1 July 2011 and does not have to be transported into national legislation of the individual member states of the European Union and thus is directly applicable.
Directive on intra-EU-transfers of defence-related products is a European Union Directive with relevance for the European Economic Area. "Transfer" in this context means "any transmission or movement of a defence-related product from a supplier to a recipient in another Member State".
Enterprise 2020 was an initiative launched in October 2010 to address the European and global challenges that question patterns of living, working, learning, communicating, consuming and sharing resources. The initiative aimed to promote responsible and sustainable business practice and prepare businesses for emerging societal challenges across the globe, including climate change, demographic change, resource scarcity and increased urbanisation. In the context of the European Union's Europe 2020 strategy, Enterprise 2020 highlighted the contribution of businesses to achieve the EU goals for building a 'smart, sustainable and inclusive' economy delivering high levels of employment, productivity and social cohesion by 2020.
The European Legislation Identifier (ELI) ontology is a vocabulary for representing metadata about national and European Union (EU) legislation. It is designed to provide a standardized way to identify and describe the context and content of national or EU legislation, including its purpose, scope, relationships with other legislations and legal basis. This will guarantee easier identification, access, exchange and reuse of legislation for public authorities, professional users, academics and citizens. ELI paves the way for knowledge graphs, based on semantic web standards, of legal gazettes and official journals.
European company law is the part of European Union law which concerns the formation, operation and insolvency of companies in the European Union. The EU creates minimum standards for companies throughout the EU, and has its own corporate forms. All member states continue to operate separate companies acts, which are amended from time to time to comply with EU Directives and Regulations. There is, however, also the option of businesses to incorporate as a Societas Europaea (SE), which allows a company to operate across all member states.
eIDAS is an EU regulation with the stated purpose of governing "electronic identification and trust services for electronic transactions". It passed in 2014 and its provisions came into effect between 2016 and 2018.
The Pan-European Pension Product (PEPP) or like Pan-European Personal Pension Product is a proposed pension which will be available to residents of the European Union. The PEPP is designed to give the 240 million savers in the EU a better choice in the fragmented and uneven European market, where options are nearly non-existent in some member states. PEPPs are regulated by the Regulation 2019/1238. This regulation lays the legal foundation for a single European market for personal pensions. The PEPP will be complementary to existing state, occupational and private pension systems on national level. After endorsement by the European Parliament and official adoption by the European Council the PEPP regulation was published in July 2019 and will enter into application in August 2020. The first PEPPs are expected to be offered in late 2021.
The Capital Markets Union (CMU) is an economic policy initiative launched by the former president of the European Commission, Jean-Claude Juncker in the initial exposition of his policy agenda on 15 July 2014. The main target was to create a single market for capital in the whole territory of the EU by the end of 2019. The reasoning behind the idea was to address the issue that corporate finance relies on debt (i.e. bank loans) and the fact that capital markets in Europe were not sufficiently integrated so as to protect the EU and especially the Eurozone from future crisis. The Five Presidents Report of June 2015 proposed the CMU in order to complement the Banking union of the European Union and eventually finish the Economic and Monetary Union (EMU) project. The CMU is supposed to attract 2000 billion dollars more on the European capital markets, on the long-term.
Sustainable finance is the set of practices, standards, norms, regulations and products that pursue financial returns alongside environmental and/or social objectives. It is sometimes used interchangeably with Environmental, Social & Governance (ESG) investing. However, many distinguish between ESG integration for better risk-adjusted returns and a broader field of sustainable finance that also includes impact investing, social finance and ethical investing.
↑ Busch, D., Ferrarini, G., & van den Hurk, A. (2021). The European Commission’s Sustainable Finance Action Plan and Other International Initiatives. Sustainable Finance in Europe: Corporate Governance, Financial Stability and Financial Markets, 19-59.
↑ Becker, M. G., Martin, F., & Walter, A. (2022). The power of ESG transparency: The effect of the new SFDR sustainability labels on mutual funds and individual investors. Finance Research Letters, 47, 102708.
↑ Depoers, F., Jeanjean, T., & Jérôme, T. (2016). Voluntary disclosure of greenhouse gas emissions: Contrasting the carbon disclosure project and corporate reports. Journal of Business Ethics, 134, 445-461.
This page is based on this Wikipedia article Text is available under the CC BY-SA 4.0 license; additional terms may apply. Images, videos and audio are available under their respective licenses.
