ESMA now wants to regulate ESG rating agencies

The implementation of the European Green Deal will be expensive. Even before the pandemic, an investment volume of at least one trillion euros over the next ten years (from 2020) was estimated for this. In addition to public funds, the second pillar is to consist of private investors. 

The financial industry plays a key role in this. With the “Renewed Sustainable Finance Strategy” – RSFS for short – the EU plans to strengthen sustainable investments, to align the frameworks in such a way that green financing can be provided, and to introduce the minimization of climate and environmental risks via the financial system, thus contributing to a “greening of financing.” LBBW provides information about that.

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Market participants other than banks are also in the focus 

These include, in particular, the rating agencies. “Both the classic credit rating agencies (CRA) and the ESG rating agencies enjoy special attention here,” said Alexandra Schadow, Senior Investment Analyst at LBBW. The EU is set to become climate neutral by 2050. 

ESMA is moving ahead: ESG rating agencies should be regulated

As part of a consultation on the RSFS from April 8th, 2020 to July 15, 2020, the EU Commission explicitly asked about ESG rating agencies, which have so far been completely unregulated. This concerns both the market concentration of the rating agencies and the quality of the analyses. The results of the consultation, in which a total of 648 organizations and individuals participated, were presented on February 10th, 2021. ESMA (European Securities and Markets Authority) also participated. In addition, it already wrote an open letter to the EU Commission on January 28th, 2021 with the clear demand to regulate ESG rating agencies.

ESMA’s open letter to the EU Commission

At the core of ESMA’s argument is the growing importance of sustainable finance. Reliable assessments with high quality based on robust information are needed to assess and evaluate sustainable investments. Without legally binding rules, the risk of misallocation of capital, the sale of false products, and so-called “greenwashing”.

ESG ratings are highly dispersive

ESMA highlighted that the agencies’ ESG ratings have a very high dispersion compared to credit ratings. That in turn can have very different consequences when they are used; for example, in the composition of an ESG benchmark index that is based on ESG ratings. 

Ultimately, ESMA calls for the following points to be considered in a regulation for ESG ratings:

1. general legal definition of what an ESG rating is and what it says.

2. any legal entity publishing ESG ratings should be subject to mandatory registration and public oversight.

3. specific minimum requirements for ESG ratings should be formulated with reliable data basis and robust methodology.

4. consideration of the current competitive situation with large and small providers in the formulation of regulatory requirements, whereby regulations can be eased for smaller competitors.

ESMA calls for regulatory action

ESMA gets support from participants in the consultation. An overwhelming majority of 74 percent believe the EU should take action regarding sustainability ratings and research. The greatest desire here is for the formulation of minimum standards for transparency and quality. In addition, ESMA is concerned about the high degree of consolidation that ESG rating agencies have now achieved. Here, ESMA is in good company. During the consultation, out of a total of 400 participants, 30 percent were rather concerned and 18 percent very concerned about the emerging oligopoly.

Concentration as in the traditional credit rating business

Indeed, in our view, the development in recent years is remarkable and shows many parallels to the competitive landscape of classic rating agencies. The ESG ratings market is highly dynamic, and especially since 2018, the big players have been swallowing the small ones. Not only classical rating agencies are getting involved, but also other financial information providers. This can be observed very impressively.

Rules are justified

ESMA is addressing two main “pain points” regarding the future of ESG ratings. First, the management of financial flows into sustainable projects and ventures, which is a key concern of the European Green Deal, should be flanked by an adequate ESG rating system. On the other hand, ESMA observes the oligopolization of the market for ESG ratings with concern. 

Uwe Burkert, Chief Economist and Head of Research at LBBW, said: “In our view, both concerns are understandable. The risks of greenwashing and misallocation of capital must be avoided at all costs, in our view. And an oligopoly, similar to the case of the classic credit rating agencies, must be avoided in the interest of the diversity and innovative capacity of a still young market segment. However, consolidation is already well advanced, and the rating agencies and other large financial service providers will not give up this lucrative future topic without a fight. Rather, they will try to integrate this segment more and more into their existing business model.” 

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(Featured image by pacodocus via Pixabay)

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