On 6 February 2024, the European Council (Council) published its final compromise text, as agreed with the European Parliament (Parliament), in relation to a regulation on ESG rating activities (the Regulation). The Parliament's Economic Affairs Committee (ECON) approved this text on 22 February 2024. This text remains subject to approval by the Council before going through the formal adoption process and will start to apply 18 months after its entry into force. As and when it ultimately makes its way on to the European statute book, the Regulation will represent the first compulsory rules governing ESG rating activities in Europe or the UK. While the primary focus of the proposed Regulation is ESG rating providers, this briefing summarises the key takeaways for asset managers.
1. Takeaways for asset managers
When analysing the Regulation, asset managers should consider: (a) whether they are subject to regulatory obligations as an "ESG rating provider" for the purposes of the Regulation; and (b) whether they are subject to disclosure obligations as the provider or user of ESG ratings.
These considerations are relevant to AIFMs, UCITS ManCos and investment firms providing portfolio management services (Portfolio Managers) which use ESG ratings for their products and services carried out in or marketed into the EU (collectively for the purposes of this note, Asset Managers). They apply regardless of whether these ESG ratings are provided by third parties or are generated by the asset manager using its own proprietary ESG methodology.
1.1 Can an Asset Manager be "ESG rating provider" for the purposes of the Regulation?
The Regulation defines an "ESG rating provider" as "a legal person whose occupation includes the issuance and publication or distribution of ESG ratings on a professional basis".
"ESG ratings" are an opinion, score, or combination of the two, based on an established methodology and a defined ranking system of rating categories, regarding the ESG profile, the exposure to ESG risks of, or the impact on ESG of, a legal person, financial instrument, financial product or public body.
The broad definition of ESG ratings could potentially include any sort of ESG scoring system. As such, any Asset Manager which uses a proprietary methodology to generate ESG scores would potentially be issuing ESG ratings and fall within the definition of an "ESG rating provider". However, there are certain exemptions, which mean that not all ESG rating providers are subject to substantive obligations and these exemptions could be availed of by Asset Managers.
1.2 Relevant exemptions for Asset Managers
The Regulation sets out a number of carve-outs from its scope which will be relevant to Asset Managers, including:
- private ESG ratings which are "not intended for public disclosure or for distribution";
- ESG ratings issued by regulated financial undertakings that are used exclusively for internal purposes or for providing in-house or intragroup financial services or products; and
- disclosures mandated by certain provisions within Regulation (EU) 2019/2088 (SFDR) and the Taxonomy Regulation (Regulation (EU) 2020/852).
Moreover, where an ESG rating is issued by, among others, an Asset Manager and is both (i) incorporated in a product or a service which is already regulated under EU law; and (ii) disclosed to a third-party, the Asset Manager can also avail of an exemption. However, where this disclosure forms part of its marketing communications in relation to that product or service, the Asset Manager must comply with the disclosure obligations set out at 'Additional disclosures for Asset Managers' below (the Additional Disclosure Exemption)
1.3 Practical considerations for Asset Managers
Asset Managers need to consider these exemptions in a number of practical scenarios.
We set out below at Table 1 four typical use cases where an Asset Manager may use proprietary methodology to generate an ESG rating for its in-scope products or services and how we anticipate that it might avail of an exemption.
A key consideration here is "public disclosure". Although the Regulation is not entirely clear on this point, there is an indication in the preamble that making ESG ratings "visible for third parties" equates to "public disclosure" of an ESG rating.
This would allow Asset Managers to draw a distinction between making the actual score, opinion, or combination of the two, visible to a third party and disclosing to a third party that an ESG rating has been taken into consideration in the investment decision making process but not making the score/opinion/combination itself visible to the third party.
Table 1: Which exemption could an Asset Manager use?
| # | Use Case | Analysis |
| 1 | The Asset Manager makes the ESG rating visible to third parties in its prospectus, periodic reporting or other marketing communications. | We expect that this would be a clear cut example of an ESG rating being incorporated in marketing communications relating to a product which is regulated under EU law and has been made visible to third parties.
The Asset Manager should be able to avail of the Additional Disclosure Exemption, but would need to comply with the additional disclosure requirements. |
| 2 | The Asset Manager does not make the ESG rating of its product, or those of the product's underlying investments, visible to third parties in its marketing communications, but its marketing communications confirm that the Asset Manager takes / took ESG ratings of the underlying investments, generated by its proprietary methodology, into account when making investment decisions for the fund | No individual ESG score, opinion, or combination of the two, has been made visible to a third party, which suggests that the ESG rating itself is not intended for public disclosure or distribution.
It would follow that the Asset Manager should be able to avail of the 'private ESG rating' exemption. |
| 3 | The Asset Manager's product adopts an investment policy which restricts investments to certain securities, financial instruments or financial products with a certain ESG rating | Again, no individual ESG score, opinion, or combination of the two, has been expressly made visible to a third party. It could be argued therefore that ESG rating is not intended for public disclosure or distribution and an Asset Manager could seek to avail of the 'private ESG rating' exemption.
Even if an Asset Manager were to take the view that, where a third party could read the investment policy and apply the logic of the statement, such that the policy provides them with an implicit ESG rating for each investment, this constitutes making the ESG rating visible to a third party, they should then seek to avail of the Additional Disclosure Exemption. |
| 4 | The Asset Manager's product discloses the ESG ratings it uses as part of its periodic reporting under Art. 11 SFDR | The Asset Manager's product has made a clear public statement of its ESG rating.
To the extent that this is specifically mandated by a provision in SFDR or the Taxonomy Regulation (e.g. a statement of the degree of the product's taxonomy alignment), the Asset Manager could likely avail of the 'disclosures mandated by SFDR' exemption. If not, the Asset Manager's claim to this exemption is weaker but, in any case, the Asset Manager could seek to avail of the Additional Disclosure Exemption. |
1.4 Additional disclosure obligations for Asset Managers
To the extent that an Asset Manager discloses to third parties an ESG rating as part of its marketing communications for its regulated products and services carried out in or marketed into the EU, that Asset Manager will be obliged to include the information set out below on its website. A link to such website should be included in any marketing communications in relation to the product or service:
- an overview of the rating methodologies used (including whether backward- or forward looking, time horizon and industry classification and whether it is based on scientific evidence);
- information on the rating's objective and its assessment of risk and impacts, and whether it is express in absolute or relative values;
- the scope of the rating (i.e. whether it covers 'E', 'S', 'G' or a combination of these) and, if aggregated, the weighting given to 'E', 'S' and 'G' individually and an explanation for such weighting;
- within 'E', 'S' and 'G', a specification of the topics covered by the rating or score and whether these correspond to topics from the sustainability reporting standards under Article 29b of the EU Accounting Directive (2013/34/EU) (the EU Accounting Directive);
- whether the rating considers the targets and objectives of relevant international agreements (including, in the case of 'E', the Paris Agreement);
- an overview of the data sources used, including whether such sources include sustainability statements under the EU Accounting Directive or SFDR and whether sources are public or non-public, and an overview of data processes;
- any limitation on data sources / methodologies used for the construction of the ratings and any limitation on the information available to the ESG rating provider;
- whether artificial intelligence has been used in the collection of data or the rating / scoring process;
- general information on establishing fees to clients and the provider's business / payment model;
- the ownership structure of the relevant ESG rating provider; and
- The main risks of conflicts of interest for the provider and steps taken to mitigate these.
The European Supervisory Authorities (the ESAs) and the Commission will develop draft regulatory technical standards to specify the details of the presentation and content of the information to be disclosed pursuant to this obligation. They will take into account the need to avoid duplication with information already published in accordance with applicable regulatory requirements, including SFDR. To this end, it is expected that the ESAs will develop a set of regulatory technical standards to specify the details of the presentation and content of the information above. This will be helpful because not all of the heads of information (e.g. the final three bullets above) necessarily seem applicable in the case of an Asset Manager.
Similar information will be required when using the 'disclosures mandated by SFDR' exemption for which the Regulation introduces a new paragraph 3 to Article 13 SFDR. The ESAs and the Commission are also mandated to develop draft regulatory technical standards for the new Article 13 SFDR disclosures.
An Asset Manager can be caught in two ways: either (i) as a provider of the ESG rating to a regulated financial undertaking in the EU which discloses the ESG Rating to its investors in its marketing communications (in which case, the Asset Manager would need to collate and provide the disclosable information to that party); or (ii) as the person disclosing the ESG rating to third parties in its marketing communications (in which case, the Asset Manager would need to procure the relevant information from the provider and publish this on its website with a link to such web page in its marketing communications).
2. What is the regulatory position in the UK?
The Regulation will not apply to UK asset managers who do not operate in the EU and the UK does not yet have any similar legislation.
The UK Government indicated at the 2024 Spring Budget that it will regulate the provision of ESG ratings, where these assessments of ESG factors are used for investment decisions and influence capital allocation. It is due to provide a full response to a consultation it published in March 2023 in relation to bringing ESG rating activities inside the UK regulatory perimeter, but at the time of going to print no date has been confirmed for such a full response.
Presently, the closest that the UK has to regulation in this area is the voluntary code of conduct launched in December 2023 by the International Capital Market Association (ICMA) and the International Regulatory Strategy Group (IRSG) for ESG ratings and data products providers. Whilst perhaps loosely instructive towards a future binding approach, the ICMA / ISRG code of conduct is voluntary and, in any case, does not impose any obligations on asset managers.
3. Please note
We note that the analysis above is based on the draft legislation available at the time of publication, the application of which in some respects remains unclear. As more information becomes available, our analysis may change.
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The articles published on this website, current at the dates of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action.