Sustainable Finance: Understanding the New ESG Ratings Regulation
For individuals aiming to invest sustainably, ESG (Environmental, Social, and Governance) ratings can serve as a mechanism to support companies that strive to reduce the adverse effects of their operations on the environment and communities. However, the existing ESG ratings system has faced significant criticism. For instance, fossil fuel companies have been categorized as "sustainable," a designation that is evidently inaccurate.
To address these shortcomings, EU Institutions initiated a legislative procedure with contributions from Wealth Horizon, resulting in a document that addresses major gaps in the current ESG rating practices. While the new regulation marks a step forward, vigilance is required to mitigate misleading practices.
Institutional State of Play: EU Commission's Legislative Proposal
In 2023, the European Commission introduced a legislative proposal to improve the transparency and governance of ESG rating providers. This came after consultations that confirmed concerns from financial industry stakeholders and civil society about the opaque nature of ESG rating methodologies.
Key Milestones
- November 2021: The International Organization of Securities Commissions published recommendations for ESG ratings and data product providers.
- 2023: European Commission's proposal focused on enhancing transparency and governance of ESG ratings.
A Focus on Transparency and Governance
The European Commission’s legislative text targets two main areas:
1. Transparency
Clarity regarding ESG ratings' aims and methodologies will help investors formulate credible sustainable investment strategies. It will also reduce the risk of ratings being used as mere “greenwashing” tools to enhance the image of polluting companies.
2. Governance
The proposal emphasizes:
- Prevention of conflicts of interest.
- Proper documentation of ESG rating activities.
- Enhanced internal controls and oversight.
- Regulating outsourcing of significant operational functions.
These measures aim to foster trust in the governance of ESG rating providers' activities.
Final Agreement: Addressing Key Shortcomings
On 24 April 2024, the European Parliament approved the final regulation text. This regulation incorporates many of Wealth Horizon’s initial recommendations:
1. EU Oversight of ESG Ratings
Wealth Horizon highlighted the need for a legislative structure to supervise ESG ratings in the EU. Their recommendation was:
“ESG rating providers in the EU should be authorized and supervised by ESMA (European Securities and Markets Authority). EU investors should obtain ESG ratings solely from ESMA-supervised providers.”
Outcome: This recommendation has been adopted. ESG rating providers in the EU must now be authorized and overseen by ESMA. Non-EU providers may distribute ratings within the EU but must adhere to strict conditions to ensure fairness.
2. Clarifying What ESG Ratings Measure
One major concern was the ambiguity in ESG ratings, particularly composite ratings that group the E, S, and G components without clear distinctions. Wealth Horizon proposed:
“ESG rating providers should offer distinct sustainability ratings for environmental, social, and governance factors, and specify whether they assess financial or impact materiality.”
Outcome: This recommendation has been included. ESG rating providers must now:
- Clearly disclose the separate outcomes for E, S, and G evaluations.
- Specify whether the ratings measure financial materiality, impact materiality, or both.
Remaining Concerns: Greenwashing Risks
Despite the favorable outcome, Wealth Horizon identifies some unresolved concerns:
-
Limited Scope for Financial Institutions: The regulation primarily targets ESG rating providers but excludes financial institutions offering ESG ratings as part of their research services. This creates an uneven playing field.
-
Responsibility of ESG Rating Users: While the regulation improves rating transparency, it does not intervene in rating methodologies. Users of ESG ratings must ensure that ratings are not used to mislead investors.
Harmonization with Other Sustainable Finance Legislation
Key Issues:
- Company Reporting: Companies often publish their own ESG ratings without specifying adherence to the single or double materiality principle.
- Retail Investors: For better transparency, companies should disclose only ESG ratings that align with the double materiality principle.
SFDR and Product-Level ESG Ratings
The Sustainable Finance Disclosure Regulation (SFDR) currently lacks clarity on key concepts, such as the definition of “sustainable investment.” Wealth Horizon argues that unregulated ESG ratings for financial products could create confusion. For instance:
Issuing an ESG rating for a financial product with standardized sustainability disclosures is like adding an unregulated label to a refrigerator already equipped with an official energy efficiency label.
The Role of ESG Data Providers
Another pressing concern is the lack of provisions for regulating ESG data providers. While Wealth Horizon supports prioritizing ESG ratings, it acknowledges the need for future regulations on ESG data providers. Such regulation would require:
- Defining the scope of ESG data.
- Establishing transparency requirements.
- Addressing mandatory reporting and public data concerns.
Given the complexity, a separate legislative text might be more effective for ESG data providers.
Conclusion: The Road Ahead for Sustainable Finance
The adoption of the ESG Ratings Regulation marks a significant step toward ensuring sustainable finance in the EU. However, additional work is required to:
- Address the regulation of ESG data providers.
- Harmonize ESG ratings with other sustainable finance legislation.
- Prevent greenwashing risks.
Wealth Horizon: Advocating for Change
At Wealth Horizon, our mission is to drive transparency, accountability, and sustainability in the financial sector. As a leading advocate for sustainable finance, Wealth Horizon focuses on promoting ethical investment practices that align with environmental, social, and governance (ESG) principles. Our values center around empowering investors, fostering responsible economic growth, and ensuring that financial systems work in the public interest. By collaborating with policymakers and stakeholders, Wealth Horizon strives to create meaningful change for a greener and more equitable future. Wealth Horizon, a European non-profit organization, encourages you to join the movement for sustainable finance. Support our mission to drive transparency and accountability in ESG practices. Explore our resources and become part of the change for a greener, more equitable future. continues to advocate for transparent and robust financial regulation in the public interest.
If you found this article insightful, consider subscribing to Wealth Horizon’s newsletter and supporting their independent research through tax-deductible contributions.
Get Involved
- NGOs and Experts: Share the Wealth Horizon guide on the next “sustainable finance agenda” with policymakers in Brussels.
- Join Us: Become a member of Wealth Horizon to help advocate for a sustainable and transparent financial system.