(Bloomberg) -- After years of unfettered growth, the providers of ESG ratings will soon have to adjust their businesses to comply with new regulations or face hefty fines if they fail to comply, according to a draft document seen by Bloomberg News.
The proposed legislation, due to be unveiled next week, means providers of ESG ratings that also offer other financial services will be forced to keep those businesses separate to avoid conflicts of interest. Business areas that could present such a conflict of interest include consultancy services, the issuance and sale of credit ratings, or the development of benchmarks, according to the document.
The introduction of formal rules marks a huge shift for an industry that’s mushroomed in recent years, and whose scores have been instrumental in steering vast sums of capital into investments despite the absence of meaningful regulatory oversight. Funds marketed as targeting environmental, social and good governance goals sit on more than $2 trillion in assets, Bloomberg Intelligence estimates.
An analysis of first-quarter data shows that “funds with ‘ESG’ branding logged the fastest increase since 2019,” according to Shaheen Contractor, BI senior ESG strategist.
In its draft proposal, the EU said “the current ESG rating market suffers from deficiencies and isn’t functioning properly.” As a result, “confidence in ratings is being undermined,” it said. Ratings firms will be expected to provide much more detail around their methodologies, and reveal whether any scores have been generated with the help of artificial intelligence, according to the draft.
“Greater transparency on ESG ratings will allow financial markets participants to make informed decisions on which data and services fit their needs,” said Helena Vines-Fiestas, chair of Europe’s Platform on Sustainable Finance, which advises the European Commission. “It will also encourage greater dialogue and engagement from financial market participants with data providers.”
The proposal follows a lengthy consultation process that exposed a serious lack of confidence in ESG ratings among market participants.
“The introduced measures will aim to reflect the market demand for improved ESG ratings as one of the key data points for investment decisions,” E3G, a climate think tank, said in a statement. “At the moment, around a third of consultation answers assessed the quality of ESG ratings as not good enough, illustrated by the low correlation of results from different providers.”
Stephan Kippe, head of ESG research at Commerzbank AG, said the draft proposal underscores the “general push towards ‘double materiality’ that has increasingly been part of EU ESG regulation.”
What’s more, “untangling financial interest and scoring should also improve credibility of ESG scores,” he said.
The EU’s draft proposal, which still needs to be negotiated by the European Parliament and EU member states and may yet be subject to changes before its official release, has implications for companies including Moody’s Corp., MSCI Inc. and S&P Global Inc., all of which offer ESG ratings in combination with other services.
Bloomberg News parent Bloomberg LP and affiliates provide access to ESG data products, including Bloomberg’s proprietary ESG scores. Bloomberg does not calculate ESG ratings.
In its draft proposal, the EU said an “‘ESG rating’ means an opinion, a score or a combination of both.”
The timeline for passing the proposal, which was drafted by the European Commission, is tight with EU elections scheduled for next June.
ESG ratings providers could face fines of up to 10% of total annual net revenue for violating the new rules, under the draft proposal. The European Securities and Markets Authority also could nullify authorization to provide ratings. The new legislation is likely to go into effect during the second half of 2024, according to the draft.
The EU Commission identified 59 ratings companies, roughly half of which are located in Europe. It didn’t single out any companies by name.
Providers would be required to be authorized by the European Securities and Markets Authority to operate in the EU. The proposal excludes ESG ratings designed by banks and other financial market participants intended for in-house only use.
The European Commission is set to present a sustainable package next week that also includes new taxonomy criteria covering environmental objectives and plans to boost transition finance.
(Adds detail from the proposal that regulations would apply to both ESG ratings and scores. An earlier version was corrected to say Bloomberg LP provides ESG ‘scores’ instead of ‘ratings’)
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