Throwing Out The Black Box: New Rules Proposed For ESG Rating Providers

Throwing Out The Black Box: New Rules Proposed For ESG Rating Providers

ESG rating providers are next in line to face regulators’ scrutiny. On June 13^th 2023, the EU Commission proposed new rules for ESG rating providers under the EU Taxonomy to demand transparency over objectives, methodology and quality assurance processes. The proposal aims to support private funding of transition projects and technologies, and strengthen the foundations of the EU sustainable finance framework. To do so, the European Securities and Markets Authority (ESMA) will supervise ESG rating providers to ensure clarity on the methodology, criteria and data sources behind ESG scores. The proposal will also allow the ESMA to authorize operations and charge fees to 59 ESG rating providers, including Moody’s, MSCI and S&P, to ensure transparency and avoid the risk of conflicts of interest.

The EU’s regulators are not the first to raise concerns over the validity, accuracy and reliability of ESG scores. In November 2022, the UK Financial Conduct Authority (FCA) announced plans to develop a code of conduct for ESG rating providers. While investors use ESG ratings to identify low ESG-risk and sustainable investments, the scores are often criticized for a lack of consistency across providers. This increases the risk of misleading investors about the real ESG performance of their investments. For example, the MSCI ESG scores measure a firm’s exposure to ESG risk but do not consider its environmental and social impact, and hence they do not reflect the organization’s real sustainability performance. 

To set the record straight, ESG rating providers must play a key role in providing the information to inform investors about real ESG performance. For that, regulations must enable simple comparisons between scores and show how they align with investor needs. Standardized definitions should not eliminate all differences in ESG ratings, but should increase clarity and compatibility between different ESG scores. Despite wide variations, ESG ratings play a vital role in shaping sustainable investment products, and remain a high priority and an important market for buy-side firms. 

The EU’s proposal does not come as a surprise to Verdantix, who predicted big steps towards a transparent ESG scores market in 2023 (see Verdantix Market Insight: 10 Predictions For ESG & Sustainability In 2023). While we can expect more regulations mandating disclosure of the underlying data to enable traceability and auditability of ESG scores, ESG rating providers must communicate their approach to ESG assessments as a key value differentiator. This will entail actions to prevent greenwashing and misallocation, as well as providing investors with transparent insights into ESG risks and real-time performance of sustainable investments.

To learn more about the future of ESG scores and the EU Taxonomy, see Verdantix Strategic Focus: The Future Of ESG Scores and Verdantix Strategic Focus: Unpacking the EU Taxonomy.