Rating agencies may be fined up to 10% of their annual turnover if they fail to disclose conflicts of interest in respect of the businesses they rate regarding ESG credentials.

This proposal has been made by the [NT1]  European Commission as part of a crackdown on greenwashing of ESG investments. The regulations, if they are approved, would apply to agencies both in the European Union and outside the bloc, with agencies being required to certify with the EU’s regulator.

What is greenwashing and why regulate?

Investopedia defines greenwashing as “the act of providing the public or investors with misleading or outright false information about the environmental impact of a company’s products and operations”.

The EU’s draft proposal states “the current ESG rating market suffers from deficiencies and is not functioning properly, with investors and rated entities’ needs regarding ESG ratings?.?.?.?not being met”. It added that “confidence in ratings is being undermined”. The UK regulator is also working on a code of conduct for ratings agencies however this would be voluntary, at least in the first instance.

The concept behind the proposed regulation is to counter greenwashing in the ever-increasing sustainable finance industry, and instead, encourage investment into genuine environmental practices and sustainable activities carried on by businesses.

Is regulation needed?

The debate of increasing regulation of business and financial services is a fiery one. One commentator, Thierry Philipponnat, chief economist at Finance Watch (NGO) noted that while it would be a positive and worthwhile move to require agencies to declare interests in the businesses they rate, “this piece of regulation barely alludes to the substance.”

“The draft rules neglected to regulate the objectives of ratings providers, such as whether ESG scores should aim to assess the financial impact of climate change on a company’s activities or the converse, and businesses’ own effect on the environment or society. Both types of objectives are currently included within the ESG umbrella.”

In the US the debate is even more polarised. An article in the Washington Post has described ESG investments as a trojan horse, stating that it is an “example of the effort to reorder our lives to fit the agenda of the far left.”

More regulation coming

Whether or not the proposed regulation is given approval awaits to be seen, however, it is likely this is just one of many proposals that will be made to regulate ESG matters. ESG reporting is already required by listed companies and this has been expanded in many jurisdictions to large business too.

Rather than regulation, voluntary codes may be the answer. The success of UK business codes and associated guidance has seen greater adherence (and is in some cases going above and beyond) the recommended standards, especially when compared to jurisdictions which have set standard requirements by law. While voluntary, many business leaders have chosen to adopt this with the belief that it is good practice and in any event, may become law in the long term.

Whatever the outcome, the debate on ESG and regulation of business and finance will continue.