ESMA pulls back from ESG legislation for rating agency methodology

On July 18, the European Securities and Markets Authority published technical advice to the European Commission outlining its reluctance to compel these firms to include ESG factors in their analysis, preferring to issue guidelines for them to follow.

Credit rating agencies will not be forced to consider
environmental, social and governance issues in their reports on companies,
following a European securities regulator announcement.

ESMA said it had “assessed the level of consideration of ESG
factors in both specific credit rating actions, and the credit rating market in
general”, but found that, while credit rating agencies were taking ESG factors into
account in their ratings, each would consider them differently according to
asset class and general methodology.

It asked the European Commission to assess whether
sufficient regulatory safeguards were currently in place for other products
that will meet the demand for pure sustainability assessments.

Steven Maijoor, chair of ESMA said: “We have… issued guidelines to CRAs to ensure greater transparency around where ESG factors are considered in CRAs’ credit assessments.”

This should enable investors to immediately see if a down or
upgrade had been forced by an ESG issue.

The announcement follows a consultation period run by the
regulator, during which the European Association of Credit Rating Agencies
(EACRA) pushed back against any legislative action being taken.

The move is one of several carried out across the European
Union, alongside the European Commission’s Sustainable Finance plan.

The response from EACRA, published on its website,
acknowledged “the rising interest towards sustainable finance topics in recent
years” and noted the European Commission’s plan for financial markets to
achieve it.

However, regarding changes to its own remit, it said: “While
we believe that all financial market participants will in the long run include
ESG considerations in their activities, we believe that currently not enough
information is available to do this systematically.”

The association noted that its members were “closely
following the topic”, with some introducing special products, others presenting
ESG considerations separately, while others were doing relatively little.

Finally, EACRA said that to compel agencies to include ESG
factors in their ratings would go against Article 23 of CRA Regulation on
“non-interference with content of ratings or methodologies”.

This, EACRA said, meant ESMA was not permitted to dictate
ESG inclusion in agencies’ methodologies, but leave it to each company to
decide how they would approach the issue.

“From a technical perspective, ESG topics relate to a very
long time horizon while ratings look to a period of three to five years,” EACRA
said. “Given this mis-match in timing, an ESG topic is likely not to be the
single factor driving a rating action but only one explaining element along
several other factors. Singling out ESG factors on a systematic basis may
result in overstating this aspect.”

On this point, ESMA said it would be “inadvisable” to amend
the regulations to compel agencies to consider sustainability characteristics
in their assessments, flagging the “specific role that credit ratings have in
the EU regulatory framework for the purposes of assessing credit risk”.

However, ESMA has stepped in, to some extent, with its
guidelines for agencies to follow.

But rather than instruct on agencies’ methodology, the
guidelines focus on the impact of ESG factors on any changes in rating and how
these factors were applied to the company and its peers.

Maijoor said: “Climate change is a reality. Financial market
regulation needs to reflect this by integrating sustainability considerations.
To support the European Commission in this area we have advised on the level of
sustainability considerations in the credit rating market, indicating that as
demand for sustainability assessments increases, so does the need for vigilance
on the levels of investor protection.”