Why it’s a good thing for businesses

The European Commission has introduced the first ever set of rules focused on regulating environmental, social and governance (ESG) ratings providers. The aim of the new ESG Ratings Regulation is to improve the credibility, transparency and comparability of ESG ratings by analyzing the methodologies of rating providers and screening providers for potential conflicts of interest.

The initiative was launched to address a scenario that was increasingly becoming almost a wild west in the ESG ratings market, which the European Commission described in its original proposal as follows: “The current ESG ratings market suffers from shortcomings and does not function well, needs investors and rated entities regarding ESG ratings are not satisfied and confidence in the ratings is being undermined.”

Under the new rules, all ESG ratings providers operating in the European Union (EU) will be supervised by the European Securities Market Authority (ESMA), the same agency that oversees the regulation of financial markets in Europe. For entities based outside the EU, their ratings will need to be endorsed by an EU-regulated credit rating agency. The UK quickly followed the EU’s lead, indicating it would introduce its own regulation of ESG ratings in the coming months. Other jurisdictions, including India, Japan and Singapore, have also introduced voluntary codes of conduct for ESG assessors.

Consistency and transparency are good for business

Here’s why these are positive developments for the companies covered by these ratings. First, regulation should provide some coherence to a process that has been chaotic and fragmented at best. A 2022 analysis by researchers from MIT Sloan and the University of Zurich that looked at the similarities and differences in ESG ratings from six different rating agencies found almost no correlation between them. This is because different rating agencies consider different factors, different weightings for each factor and different measurement methods.

Under the new EU regulation, rating agencies will have to clearly disclose how their ratings are calculated, whether they take into account dual materiality and how they separate environmental, social and governance factors that are independent of each other. So even if the ratings given by different agencies are not the same, regulators, companies and investors will have a degree of transparency about how those ratings were obtained.

Additionally, the move will likely result in some consolidation in a space that is currently crowded with vendors. Analysis by Deloitte in 2021 found that there are around 600 different ESG ratings providers in the market, often issuing different ratings for the same entities. Under the new EU mandate, rating entities will have to adhere to a strict independence code, publish detailed methodologies on their websites and submit to ESMA supervision – each of these levels of additional scrutiny is likely to drill down the list of profitable credit rating agencies to a list of around 10 or 15 major players. In fact, as ESMA points out, a trend towards consolidation in this space has already started to take shape.

Why is it important?

In line with the new corporate sustainability reporting requirements introduced by the Corporate Sustainability Reporting Directive (CSRD), the Corporate Sustainability Due Diligence Directive (CSDDD) and the new global sustainability standards developed by the Council International Sustainable Development Standards (ISSB), large companies operating in Europe must disclose more information than ever about the environmental impact of their activities, social issues and management practices. Importantly, these rules apply not only to companies themselves, but also to the supplier networks they use around the world.

As a result, many of these companies require suppliers to provide ESG ratings as part of their due diligence to ensure they meet certain ESG standards. However, with dozens of different rating providers to choose from and very little standardization between them, many providers have found themselves having to contract with several different rating providers, depending on each client’s requirements. With companies paying anywhere from $220,000 to $480,000 for a self-assessment, these costs add up quickly.

By increasing the transparency of the rating process and contributing to the consolidation of the number of rating agencies in the market, these new regulations should help companies and their suppliers better establish more standard ways of assessing ESG. This additional layer of transparency should also help provide some consistency in the disclosure process of what and how companies disclose their sustainability risks, which in turn will help investors and consumers gain a clearer picture of what corporate sustainability really means. Most importantly, however, this evolution will shift the focus away from overly reductive numerical or letter grades and onto the underlying methodology and goals that provide real insight into corporate sustainability.

Questions remain about the future of ESG ratings

The jury is still out on how exactly the ESG CRA space will evolve over the next few months as these regulations begin to be adopted by EU member states. While it is unlikely that we will see the creation of nationally recognized credit rating organizations (NRSROs), as happened in the 1970s with the official designation of major credit rating agencies, there will likely be a hierarchy that will develop over time. start-up companies and investors gravitate towards different suppliers. We may also see some segmentation whereby different ratings providers begin to specialize in certain industries where they may have deeper expertise or unique methodologies.

Whatever the case may be, the gradual maturation of this space will ultimately benefit enterprises and other stakeholders who want to be able to objectively measure corporate sustainability risk and compare companies’ progress on their journey to creating more sustainable operations. Ideally, it should also reduce some of the operating costs associated with sustainability compliance.