Surprise Package: The Regulatory Reckoning of ESG Ratings, Shaping the EU Taxonomy and Defining Transition Finance

On 13 June 2023, the European Commission unveiled its latest sustainable finance package which covers crucial aspects of environmental, social and governance (ESG) regulation in the EU including the EU Taxonomy, ESG ratings, and transition finance. ?Prior to the release of the package, the ESG ratings industry had been put on notice as policy action for increased oversight had been gaining momentum. One of the key measures in the package is a proposed regulation seeking to address deficiencies in the operations of ESG ratings providers and enhance transparency around sustainability ratings and scores. A second part of the package expands the Taxonomy Regulation to include new criteria for economic activities related to environmental objectives. ?In its efforts to facilitate transition finance, the Commission also released a draft recommendation outlining the concept of transition finance, linking it to the Paris Agreement and EU climate neutrality. ?The latest policy initiative shows that regulators are zeroing down on a balanced approach for providing market certainty and clarity, while not stifling innovation.

Regulation on the transparency and integrity of Environmental, Social and Governance (ESG) ratings activities

The landscape of sustainable finance regulation in the EU continues to evolve, with the spotlight now turning to ESG ratings providers, and their implications on financial stability. In the latest sustainable finance package, the European Commission included a measure to regulate the ratings industry based on the recommendations of the International Organization of Securities Commissions (IOSCO).?The European Commission is proposing to establish an authorisation system for EU-based ESG ratings providers, subjecting them to formalised rules and supervision. The proposal emphasizes transparency and would require ESG ratings agencies to publicly disclose their methodologies, data sources and characteristics. The regulation would have major implications for large industry players who could face fines of up to 10% of total annual net revenue for violations and have authorization to provide ratings revoked. This marks a substantial shift in an industry that has experienced rapid growth outside the sphere of regulation.

The purpose of ESG scores is twofold, first – they establish whether a company has sound ESG management policies and internal controls and measures for mitigating sustainability-related risks; secondly – scores adjusted based on a company’s industry provide a universal rating across industries and benchmark a company’s performance relative to its peers. So far, ESG ratings criteria across the industry have been varied and seemingly opaque to users, eliciting criticism from corporates and investors alike. Black box methodologies have been a longstanding issue plaguing the industry and the European Commission's new rule would dig deeper into ESG scoring by imposing rules on organizational requirements, qualifications of personnel, record-keeping, conflict of interest prevention, and disclosure obligations. To meet these transparency requirements, providers would likely have to reform their governance structures and create guardrails against undue influence that could compromise the objectivity of scores and scoring methodology. With this regulation, the Commission's key policy objective is to provide clarity to users and improve the functioning of the European single market in relation to sustainable investments.

The new initiative specifically targets legal entities providing ESG ratings to the public or subscribers, excluding financial institutions and other market participants developing ESG ratings for internal use. With the growing importance and influence of ESG ratings, it is essential to have consistent and reliable information to guide investors and promote sustainable finance. To prevent conflicts of interest, the proposed regulation would prohibit ESG ratings providers from engaging in consulting services, investment activities, benchmark development, credit rating issuance, as well as banking and auditing activities. The regulation excludes in-house ratings used by asset managers and benchmark administrators, as they serve different purposes and do not require public disclosure. One might consider this exemption unbalanced, as the same level of transparency is not guaranteed for clients of such asset managers.

The Commission delegates supervision of ratings providers to the European Securities and Markets Authority (ESMA) based on parallel experience in the supervision of credit ratings. ESMA would have the authority to grant or deny authorizations and issue penalties or impose fines for non-compliance. As a first step towards the implementation of the proposed regulation, the European Commission has tasked ESMA with developing draft Regulatory Technical Standards (RTS) that specify the information required for the authorisation of ratings providers. These standards would cover, among others, metadata, data structure, and formats (including specifications for machine-readable authorisation forms). Non-small or medium-sized ESG rating providers are expected to apply for authorization within six months of the regulation's entry into force.

The proposal includes exemptions and a grace period of 24 months for SMEs applying for authorization. Smaller ratings providers benefit from exemptions and a transition regime during the initial months. Supervision fees are proportionate to annual net turnover to promote a diverse ecosystem of sustainable finance service providers. The proposal also advocates for proportional supervision based on risk assessment, with disclosure of fines and penalties imposed by ESMA to the public in most cases.

By prioritizing public disclosure and accountability of ESG rating providers, this regulation aligns with the broader objectives of the EU’s sustainable finance framework. In furtherance of increased transparency and legislative coherence, ESMA will maintain a register of authorized ERPs on its website and ensure that information is accessible through the European Single Access Point (ESAP). Overall, this proposal reflects a commitment to building a more sustainable and transparent financial system, encouraging data-driven investment practices, and fostering the transition towards a greener future.

?EU Taxonomy Delegated Acts

?The second measure under the sustainable finance package is designed to enhance the usability of the EU Taxonomy. The European Commission has presented a positive assessment of the current coverage of Taxonomy data, which is a key pillar of the EU's sustainable finance framework. The data indicates that the Taxonomy is ‘functioning as intended’, with companies in the STOXX Europe 600 index reporting alignment with the Taxonomy for various categories. On average, these companies reported alignment of around 23% for capital expenditure, 24% for operational expenditure, and 17% for revenues. Additionally, almost two-thirds of companies disclosing taxonomy-eligible capital expenditure reported some level of alignment, while half of the companies disclosing eligible revenue also reported alignment. To further strengthen the Taxonomy, the sustainable finance package proposes targeted amendments to the Taxonomy Climate delegated Act and the adoption of technical screening criteria in the Taxonomy Environmental delegated Act.

Targeted amendments to the Climate Delegated Act would expand the coverage of economic activities that contribute to climate change mitigation and adaptation. The focus is on the manufacturing and transport sectors. The amendments illustrate the importance of manufacturing in relation to key components for low-carbon transport and electrical equipment. They also address transitional activities in the transport sector, specifically waterborne transport and aviation, where zero-carbon alternatives are not yet sufficiently advanced. These measures would "incentivize improvements beyond the status quo” while also accounting for economic activities that currently lack feasible low-carbon alternatives but are necessary for the transition toward climate neutrality. ?

Taxonomy-related enhancements extend to the adoption of the Environmental delegated act technical screening criteria. These amendments are centered around the approval of the remaining four environmental objectives covered in the Taxonomy Regulation. The Act will establish clear and defined technical screening criteria to assess the extent to which economic activities contribute to the sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, as well as the protection and restoration of biodiversity and ecosystems. The package also includes disclosure obligations for financial undertakings, set to be implemented from January 1, 2024.

Overall, the proposed enhancements to the EU Taxonomy illustrate the European Commission's commitment to continuously refining and strengthening the sustainable finance framework. By expanding coverage and defining eligibility criteria, the EU has provided clarity for sustainable finance actors operating in various sectors while also ensuring environmental protection and accountability. The amendments texts are supplemented with a notice that offers guidance on the interpretation and implementation of the Taxonomy Regulation and its connection to the Sustainable Finance Disclosure Regulation (SFDR). The guidance includes frequently asked questions related to the role of minimum safeguards, their definition, expectations for undertakings, and the qualification of taxonomy-aligned investments as "sustainable investments" under the SFDR. The Commission clarifies that investments in taxonomy-aligned environmentally sustainable economic activities can automatically qualify as sustainable investments under the SFDR.

Recommendation on transition finance

The EU’s sustainable finance regulatory framework reinforces the significance of investing in the transition of economic activities, assets, and companies to accomplish climate and environmental objectives. The newly introduced draft recommendations on transition finance in the sustainable finance package advise undertakings to evaluate their transition finance needs through a materiality assessment, taking into account sustainability impacts, risks, and opportunities. It is recommended to define transition targets and pathways based on science-based scenarios and credible transition plans. To further compatibility with EU sustainability regulations, the recommendations contain guidance for undertakings seeking to define transition targets and financial requirements within the broader architecture of EU Taxonomy, EU climate-transition benchmark (CTB) and EU Paris-aligned benchmark (PAB).

The EU Taxonomy provides a framework for undertakings to articulate transition finance needs, especially for covered economic activities under the Taxonomy Regulation. The Taxonomy can be used to plan investments and set milestones and intermediate targets for transitioning economic activities. The recommendations suggest aligning investments with the Taxonomy criteria within a short timeframe and ultimately aiming for full Taxonomy alignment. References to full Taxonomy alignment may seem ambitious. Instead, undertakings may benefit from defining an achievable ceiling for alignment, thereby restoring investor optimism in the pace of transition. Undertakings are encouraged to specify their transition finance needs in terms of capital expenditure, operating expenditure, and revenue associated with achieving climate and environmental targets, as well as revenue related to transitions.

The EU climate benchmarks, in contrast, provide useful tools for investors looking at portfolio decarbonization. The recommendations for transition finance provide that undertakings may use publicly available decarbonization scenarios and pathways, aligned with the Paris Agreement, as references to set science-based targets and determine transition finance needs. The use of EU climate benchmarks and methodologies can complement science-based scenarios and pathways, helping define individual pathways and transition targets. In summary, by aligning with the EU Taxonomy, utilizing science-based scenarios, and leveraging EU climate benchmarks, undertakings can contribute to the achievement of climate and environmental objectives while ensuring long-term sustainability and financial stability.

?It is worth noting that the European Supervisory Authorities (ESAs) and national regulators will play a crucial role in supervising and combating greenwashing practices, ensuring the integrity of sustainable finance efforts.

?Conclusion

In its current form, the package of measures underscores the need for governance on multiple fronts to ensure the principles of sustainable investing are enshrined across all Union policies. The proposal to regulate ESG ratings providers signals the reckoning of black box methodologies that obscure analysis around ESG ratings. If implemented, the regulation will probe into aspects of the ratings process including analysis and regularity of review, through a system of public disclosure. This system of checks and balances is arguably better than having a voluntary code of conduct for ESG ratings providers, but it might still leave questions unanswered for investors who want to drill down into source data. The regulation acknowledges that all ratings providers are not created equal or alike. Instead of fully-fledged reform by way of prescriptive methodological standards, ratings providers are given carte blanche for formulating unique, proprietary methodologies for assessment, provided the data and supporting analysis is sound. Those awaiting the issues of the four remaining objectives finally have clarity on assessment criteria for activities with environmental objectives with the release of the updated Taxonomy delegated acts. The addition of other climate objectives also shows that this will be a continuously evolving framework that informs other policy documents including the recommendations for securing transition finance. Framing transition finance using the vocabulary of the EU Taxonomy and climate benchmarks may be an effective way of positing sustainability initiatives for a low-carbon future. ?The three policy measures combined address a range of issues directly influencing capital allocation towards sustainable investments.

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