EU Sets Rules to Regulate ESG Ratings, Crack Down on Greenwashing

Environmental, social, and governance (ESG) considerations are paramount to all successful sustainability efforts. These guidelines allow large-scale decarbonization efforts to move from ideas and planning into concrete, reality-grounded strategies.

One of the largest challenges in any decarbonization benchmarking or standardization is consistency. If private organizations each put forth their “good faith” efforts on ESG requirements, how can we determine how fair and unbiased their findings are?

Consistency and fairness were at the core of the European Parliament’s recent deal among the EU countries to regulate ESG sustainability ratings for companies.

The Details of the ESMA-Governed ESG Oversight

A first for the EU, the new rules aim to increase the overall compliance and rigor across ESG investing. The standardization also removes lingering issues with current private companies such as inconsistency and inaccurate sustainability reporting.

According to the new requirements, ESG ratings provided in the EU will now face both authorization and supervision from the European Securities and Markets Authority (ESMA). The ESMA is a Paris-based, independent EU supervisory authority aimed at overseeing and protecting financial markets. The organization was established during the wake of the 2008 recession, which caused great disruption across multiple financial sectors.

ESG compliance requires a myriad of factors coming together to enable companies to follow and adopt sustainability-aimed practices and investments. Accordingly, the ESMA provides a financially-protective degree of independent oversight for all ESG agencies operating in the EU.

How the Rules Work

ESG ratings providers will now have to explicitly outline each area of ESG beyond a company's budget or bottom line. That means more direct descriptions of how factors such as environmental requirements and social factors like human rights are impacted by a business's daily operations.

Any ESG raters operating outside of the EU must have their ratings reviewed and approved by one of the EU-based regulators. This will help prevent various agencies in countries with differing laws and regulations from providing ESG approval that differs from the EU-based standards.

Rating companies will now have to be clear and distinct in their assessments for each area of "ESG." That means separating and individually rating an organization's environmental, social, and governance clearly and distinctly.

If a rating organization doesn't do this and only provides one sole ESG rating, they must clarify precisely how they weigh each of the three factors in their assessment.

Whether distinctly reviewed or compiled into one rating, all organizations must factor in human rights within how they rank a business’s social impact. Additionally, any environmental rating must acknowledge whether it adheres to the Paris Agreement on carbon emissions reduction as well.

Some Challenges to ESMA Oversight

Despite the number of benefits an organization like the ESMA provides, it is not without its critics. Most of the criticism comes from the amount of power the agency holds over the financial markets. One organization, with this much oversight, could lead to risks of overreaching its influence and power.

A very active critic against the ESMA is the UK, where they have argued that the agency’s oversight could potentially block critical financial transactions in time of crisis. The takeaway from this criticism is that one organization, with such a level of authority, could have far-reaching consequences in global markets.

Despite these critiques, the standardization of ESG compliance will aid businesses by eliminating ambiguous and shifting ESG requirements. The standardization of regulations will also ensure that greenwashing will be more directly addressed—and hopefully eliminated over time.

Overcoming Greenwashing

As mentioned, one of the loudest calls bringing these new united regulatory forces together was consistency. Consistency in this context refers to ensuring that no ESG rating agency \ allows one or another business to “greenwash” their reporting.

Greenwashing can occur in a variety of areas in ESG reporting. A few examples include the following:

• Falsely claiming certain data on sustainability progress
• Overstating methods or decarbonization tools and procedures
• Failing to acknowledge supply chain issues where human rights are violated

Perhaps the most important consideration of this ruling comes in preventing such greenwashing of reporting standards.

Prior to the ruling, independent ratings organizations used their own specific criteria to rate and review ESG compliance. Assuredly, providing fair and accurate reporting would be an important element to a company’s legitimacy.

However, that may not always be the case. Some private ESG rating companies may have a financial interest in helping their clients look better “on paper” in terms of their overall ESG considerations.

But the unfortunate reality of greenwashing is that it only looks good on paper. If companies aren’t actually moving toward sustainable operations and human rights, what good is a high ESG rating (beyond looking good on paper)?

This is why the EU has worked toward adopting a new and more regulated, transparent standard. By doing so, rating companies will all have to adhere to the same standards in how they assess companies. And this will mean less greenwashing and more intentional efforts to reach sustainability objectives.

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