Maybe Capital Markets lawyers can finally feel like super-heroes

Background

If we are to achieve the UN Sustainability Development Goals set in 2015 (the 2030 Agenda for Sustainable Development)¹ then capital flows must be channelled towards sustainable investments. This must be a two-fold approach – not just removing obstacles to investment but also disincentivising investments that adversely impact achievement of these goals. 

The “Study on Sustainability Related Ratings, Data and Research” commissioned in 2021²  identified conflicts of interest, a lack of transparency and accuracy of ESG rating’s methodologies, and no clarity over the terminology used by ESG ratings providers as key barriers in the market. Yet if these ratings are to be meaningful, ESG ratings need to be:

• independent; 
• comparable where possible; 
• impartial; 
• systematic; and be of meaningful quality.
  
   

How is the Council proposing to achieve these goals in practice?

1. Verification: Whether the rating is user-paid or issuer-paid, it should be possible for users (investors) to verify the data used by the ESG rating provider in producing their rating. To achieve this the dataset used to issue the rating must be available upon request. This doesn’t however mean that a user, or issuer, can influence the outcome of the rating. It is a verification exercise, designed to drive transparency, not a means to undermine independence in the ratings process. The annex to the regulation sets out the type of data which needs to be provided, but it will be interesting to see the regulatory technical standards (RTS) on the format and detail of this information.  
2. Territorial scope: To avoid mis-alignment of regulations within member states, the concept of “operating in the Union” will be used. Providers established in the Union are deemed to “operate in the Union” when they issue and distribute their ratings to undertakings operating in the Union (including third-country issuers whose securities are admitted to trading on EU regulated markets). Conversely, rating providers established outside the Union will only be caught if they issue and distribute ratings to EU undertakings (again, including those admitted to trading in the EU).
3. Meaning of rating: Bonds, even green bonds, are out of scope to the extent that they do not contain an ESG rating, so merely including investment research or identifying sustainability goals, risks, or ESG impact does not bring them within scope. Likewise, ratings that are exclusively used for accreditation or certification purposes are outside the scope, as are privately issued ratings.
4. Disclosure: For there to be sufficient, and meaningful, transparency investors need to receive information about the methodologies that have been used. The disclosure obligations contained in Regulation (EU) 2019/2088 will therefore also apply to ESG ratings. As noted in point 1 on verification, we will need to await the more detailed RTS to understand how far this disclosure will go. However, it is clearly set out in the proposed regulations that there will be no obligation to disclose information that qualifies as a trade secret or constitutes intellectual capital. That’s a tough balance to strike – enough information to create trust and transparency, but not so much as to give away the “secret sauce”.
5. Separation of E, S and G: Rather than providing a single ESG rating, separate Environmental (E), Social (S) and Governance (G) ratings should be provided. If aggregated ratings are provided, they must disclose the rate and weight of each component part with sufficient detail to allow comparability.
6. Annual review: Rating providers must review their methodologies on an on-going basis, and at least annually.
7. Double-materiality: ESG ratings should disclose whether they address the material financial risk to the rated item (or issuer) and the material impact of the rated item (or issuer) on the environment or society in general, or whether they only address one of those dimensions. The ratings may also take account of other dimensions, but this needs to be disclosed. Again, this goes to the heart of transparency. Users must have detailed information on methodologies, models and rating assumptions to be able to perform their own due diligence.
8. International Agreements: Amongst the information to be provided, disclosure should be made of whether the rating considers alignment with the Paris Agreement (for the E factor), alignment with International Labour Organisation core conventions (for the S factor), and alignment with international standards on tax evasion and avoidance (for the G factor).
9. Independence: Not only must rating providers avoid potential conflicts of interest (and manage conflicts where unavoidable), they must also keep records of all significant threats to their independence. To mitigate conflicts, the same entity³ will not be permitted to offer other services (such as credit ratings, benchmarks, audit, banking, insurance, consulting etc). This is applied at the entity level, not the group level, so provided clear barriers to information flows exist so as to avoid conflicts, it should be possible for a separate entity within the same group to provide those services.
10. Personal conflicts of interest: ESG rating agency employees will be held to high standards of independence, requiring disclosure of any self-review, self-interest, advocacy or familiarity stemming from financial, personal, business employment or other relationships.
11. Temporary regime: To properly ensure a competitive market-place, smaller ESG rating providers will be subject to a reduced framework of rules until their turnover reaches a sufficient threshold.

What happens if it goes wrong?

ESMA will not just be responsible for the initial authorisation of the ESG rating providers but will have power to require disclosure of information and fully investigate potential breaches, including by way of entering premises. The maximum fine, where intent has been shown, is set at 10% of the total annual net turnover.  

Conclusion

Are these measures sufficient to drive confidence (and ultimately money) into ESG investment? Time will tell. So much, as ever, is in the detail, and the ways in which the rules can be circumvented. Legislatures often lack the practical experience, and insight, to create meaningful regulations, and market drivers are more complicated. 

Looking to the past, in the financial crises and after-math of 2008 capital markets lawyers were certainly one of the villains. Maybe it is time to dust of those capes, spin around and become the super-heroes we all once dreamt of being and start contributing to saving the planet.