On 19 November 2024, the Council of the European Union formally adopted the new ESG Ratings Regulation (the “Regulation”), following a proposal from the European Commission on 13 June 2023 and an agreement with the European Parliament at first reading. This regulation marks a significant step in the European Union’s (“EU”) efforts to regulate ESG rating activities, addressing long-standing concerns over inconsistencies, lack of transparency, and fragmented practices across Member States. This Regulation reflects the EU’s continuing commitment to fostering sustainable finance markets, in pursuit of the EU’s Green Deal objectives. It will be published in the EU’s Official Journal and will enter into force 20 days after publication, with its provisions becoming applicable 18 months later.¹

ESG ratings can play a critical role in guiding investment decisions and ensuring that capital flows towards sustainable projects and activities. Until now, ESG rating activities were not subject to any EU-wide regulation, creating discrepancies in methodologies and risks of greenwashing.

The new Regulation aims to establish harmonised standards to ensure the quality, reliability, and transparency of ESG ratings. It seeks to tackle conflicts of interest, improve transparency around methodology disclosures, and define the scope of ratings more clearly. These measures are anticipated to encourage investments, foster greater trust among investors, and promote fair competition in the market, although their practical impact will depend on how effectively they are implemented and how they are received by market participants.

According to the EU legislator, the Regulation also fits into the EU’s broader legal framework for sustainable finance, complementing the Sustainable Finance Disclosure Regulation (“SFDR”), the EU Taxonomy Regulation, and the Corporate Sustainability Reporting Directive (“CSRD”) (Recitals 35 and 37 of the Regulation)—the overall idea being to create a cohesive and transparent system for ESG compliance, reporting, and investment, strengthening the EU’s leadership in sustainable finance.

Scope of the Regulation

Material Scope

ESG ratings are defined as opinions or scores based on established methodologies and ranking systems related to environmental, social, and governance factors (see Recital 17 and Article 3(1) of the Regulation).

Certain activities are excluded from the scope, such as non-commercial ESG ratings provided by non-profits, private ratings used for internal purposes, ESG-related data that does not result in ratings, and external reviews for Green Bonds or sustainability-linked bonds. These exclusions have been set to avoid overburdening non-commercial activities.

Personal and Territorial Scope

The Regulation applies to all ESG rating providers operating in the EU, as defined in Article 2. A provider is considered to be operating in the EU if it publishes or distributes ESG ratings, either directly or via subscription, to regulated financial entities, undertakings under EU transparency directives, EU institutions, or Member State authorities, regardless of whether the provider is based inside or outside the EU.

Authorisation and Frameworks for ESG Rating Providers

To ensure credibility, transparency, and compliance with EU standards, any legal entity wishing to provide ESG ratings to entities within the EU must be authorised or recognised under the Regulation.

The European Securities and Markets Authority (“ESMA”) is the competent authority responsible for authorising ESG rating providers to operate in the EU, assessing equivalence for third-country regimes, and supervising compliance with the Regulation.

Any legal entity wishing to operate as an ESG rating provider in the EU must adhere to one of the frameworks established by Article 4. There are different formalities for ESG rating providers depending on whether they are based in or outside the EU.

• EU-based providers must obtain an authorisation from ESMA (Articles 6 et seq.);
• Non-EU providers must either rely on an ESMA equivalence decision for third countries (Article 10), apply for endorsement (Article 11), or seek recognition under specific conditions (Article 12).

Providers applying for authorisation from ESMA must submit detailed information, including their legal status, ownership structure, senior management qualifications, rating methodologies, and conflict of interest policies, and any prior ESG rating activities, as outlined in Annex I of the Regulation.

Under Article 7, ESMA must assess whether the application is complete within 25 working days, and once ESMA has notified the provider of its completeness, ESMA has 90 working days (extendable to 120 in specific cases) to grant or refuse authorisation with a fully reasoned decision. The decision becomes effective five working days after its adoption.

Article 5 establishes a temporary regime for small ESG rating providers in the Union, allowing them to operate with lighter requirements for up to three years if they notify ESMA and register before starting. After this period, they must seek full authorisation and comply with the Regulation.

Access to Information

Under Article 14, ESG ratings and related information must be accessible via the European Single Access Point (“ESAP”), a centralised platform that provides clear and comprehensive information for investors and other users. ESAP has become a key tool for sustainability- and ESG-related matters in the EU, offering streamlined access to relevant disclosures, including those under other regulations, like the CSRD and SFDR.

Obligations of Providers to Ensure Integrity and Reliability of ESG Rating Activities

Organisational Requirements for ESG Rating Providers

Under the Regulation, ESG rating providers must comply with strict organisational and governance requirements to ensure independence, transparency, and accuracy in their operations (Article 15 of the Regulation). In particular, providers are required to establish robust internal policies, including procedures and due diligence, to maintain independence from political and economic influences and to prevent conflicts of interest. Providers must regularly review their methodologies and ensure compliance through oversight.

Furthermore, under Article 16 of the Regulation, combining activities such as consulting, credit rating, and auditing within the same entity is prohibited, unless stringent safeguards are in place.

Transparency Requirements

The Regulation imposes significant transparency requirements on ESG rating providers, as outlined in Articles 23 and 24. Providers must publicly disclose their methodologies, models, and key assumptions used in ESG ratings on their websites in a clear and transparent manner. Separate ratings for environmental (E), social (S), and governance (G) factors must be provided unless aggregated ratings are accompanied by detailed information on weighting and comparability. Disclosures must be accessible in a dedicated section of the provider’s website and must include detailed information as specified in Annex III of the Regulation.

These measures aim to improve the clarity and reliability of ESG ratings for all stakeholders and prevent risks of misrepresentation or greenwashing.

Independence and Conflicts of Interest

Articles 25 and 26 impose robust measures to safeguard the independence of ESG rating providers and prevent conflicts of interest, including clear governance structures and procedures. ESMA may intervene when conflicts are inadequately managed, requiring providers to implement risk mitigation measures or cease conflicting activities (Article 25(3) of the Regulation).

Employees involved in ESG rating activities are prohibited from engaging in activities that might compromise the integrity of the ratings. Their compensation structures must not create undue influence in the rating process (Article 26(1) of the Regulation).

Supervisory Measures by ESMA

The Regulation introduces significant enforcement mechanisms to ensure compliance.

Investigative Powers

To fulfil its supervisory role, ESMA is granted robust investigative powers under Articles 32 to 34, allowing it to request information from providers, conduct general investigations, and carry out unannounced on-site inspections. These powers enable ESMA to review records, interview relevant individuals, and even request telephone and data traffic records, subject to judicial authorisation where necessary.

Several Types of Measures

When an ESG rating provider fails to comply with its obligations under the Regulation, Article 35 empowers ESMA to take supervisory measures, including suspending or withdrawing the provider’s authorisation or recognition, temporarily prohibiting the publication or distribution of ESG ratings, requiring the infringement to be rectified, issuing public notices, and imposing fines.

Fines and Penalties

Under Article 36, ESMA can impose fines on ESG rating providers or their legal representatives for intentional or negligent breaches of the Regulation. Fines can reach up to 10% of the provider’s total annual net turnover, based on the most recent financial statements, or the corresponding income in the case of consolidated financial accounts. If the provider has financially benefitted from the infringement, the fine will be at least equal to the benefit gained. It would appear that such a fine amount would still be subject to the 10% cap.

In addition, Article 37 allows ESMA to impose periodic penalty payments to compel compliance with its decisions. These penalties can be up to 3% of the average daily turnover for businesses or 2% of the average daily income for individuals.

Finally, non-compliant providers may suffer reputational damage, as ESMA is required to publicly disclose fines and penalty payments unless such disclosure jeopardises financial markets or causes disproportionate harm.

Conclusion

The adoption of the ESG Ratings Regulation marks a pivotal step in shaping the future of sustainable finance in the EU. By introducing robust standards for transparency, methodology, supervision, and accountability, the Regulation seeks to enhance trust and consistency in ESG ratings, positioning them as critical tools for guiding sustainable investment decisions.

For businesses involved in providing or using ESG ratings, the Regulation brings both opportunities and challenges, underscoring the importance of compliance and strategic adaptation. Our team is well-positioned to help clients navigate these new requirements, mitigate risks, and seize opportunities in this evolving regulatory landscape. Reach out to us to ensure your business is ready for the transition.