When is an Asset Manager an ESG Ratings Provider?

Lewis Saffin, Associate at Herbert Smith Freehills, highlights the key takeaways for asset managers from incoming ESG rating regulation in Europe.

Having the support of the European Council and the responsible European Parliament committee, the final compromise text in relation to a regulation on ESG rating activities (the regulation) is expected to start applying 18 months after its entry into force following formal approval and publication. Once live, the regulation will represent the first compulsory rules governing ESG rating activities in Europe.

ESG rating providers are the primary focus of the proposed regulation. However, alternative investment fund managers, UCITS management companies and portfolio managers which use ESG ratings for their products and services carried out in or marketed into the EU (collectively, asset managers) may be in scope if they procure these ratings from third parties or generate them using proprietary ESG methodology.

Asset managers should consider:

whether they are subject to regulatory obligations as an ‘ESG rating provider’ for the purposes of the regulation; and whether they are subject to disclosure obligations as the provider or user of ESG ratings. Can an asset manager be an ‘ESG rating provider’?

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 broadly defined and 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 from the substantive licensing, organisational and methodological obligations for ESG rating providers which could be availed of by asset managers.

Relevant exemptions for asset managers

The main carve-outs from the regulation which will be relevant to asset managers relate to:

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 (the Sustainable Finance Disclosure Regulation; SFDR) and Regulation (EU) 2020/852 (Taxonomy Regulation).

Moreover, where an asset manager issues an ESG rating which is both (i) incorporated in a product or a service which is already regulated under EU law; and (ii) disclosed to

Take Five: Twin Peaks

A selection of the major stories impacting ESG investors, in five easy pieces. 

Developed countries have belatedly reached a target for climate finance, only to be set a new one for nature.

Ten years after – It might have taken them a little more than a decade, but at last they got there. Developed nations mobilised US$115.9 billion of climate finance for developing countries in 2022, it was revealed this week, exceeding for the first time the US$100 billion annual level set in Copenhagen in 2009. According to the Organisation for Economic Co-operation and Development (OECD), last year saw a record 30% annual rise in climate finance, meaning the target – originally unveiled at COP 15 – was reached two years late. The total includes more than US$20 billion in attributable private finance, as well as bilateral and multilateral public sector funding, plus export credits. Importantly, adaptation finance accounted for US$32.4 billion of the total – three times the 2016 level. Discussions on a New Collective Quantified Goal (NCQG) on climate finance for the post-2025 period, which made little progress at COP28, should progress next week’s Bonn Climate Conference, where the agenda will also include carbon credits, adaptation finance and the Global Stocktake, ahead of COP29. In anticipation of the NCQG, the OECD released an analysis recommending use of public sector interventions to directly or indirectly finance climate action. But measures to support the goals of the Paris Agreement must now sit alongside those needed to realise the objectives of the Global Biodiversity Framework (GBF). At a Nairobi summit that concluded yesterday, the UN Convention on Biological Diversity called for investments of at least US$200 billion a year from all sources, and for reform of US$500 billion in harmful subsidies to achieve the GBF’s Goal D: invest and collaborate for nature. These and other recommendations will be discussed at COP16 in Colombia in October.

Gap analysis – A lack of progress on gender equality in the workplace has been underlined by the International Labour Organization (ILO) in a report reflecting fewer jobs and lower pay for women, especially in low-income countries. According to an update to the ILO’s annual World Employment and Social Outlook, the ‘jobs gap’ – which measures the number of persons without a job but who want to work – stands at 22.8% for women in low-income countries, versus 15.3% for men. This contrasts with a gap

A Level Playing Field for Green Claims

Dr Torsten Schwarze, Partner at Morgan Lewis, explains how two EU directives will shape Europe’s legal framework to restrict greenwashing.

The European Commission has initiated two directives with the intent of clarifying and unifying the EU’s legal framework on environmental claims: the EmpCo Directive and Green Claims Directive.

ESG compliance is becoming increasingly important for companies, and the development of technologies and products to help reduce their carbon footprint has become a priority for many. Progress in this area is actively marketed by many companies hoping to achieve competitive advantages by labeling their products as ‘green’, ‘sustainable’, ‘recyclable’, or ‘climate neutral’.

Not surprisingly, such general green claims are often the object of litigation, as plaintiffs allege such statements as being misleading, deceptive, or simply false. While the German courts are still struggling to find common ground on these issues and a clarifying decision of the Federal Supreme Court (Bundesgerichtshof) may not be expected before June 2024[1], Brussels has initiated two directives aimed at clarifying and unifying the legal framework on environmental claims.

The first – Directive (EU) 2024/825 of the European Parliament and of the Council amending Directives 2005/29/EC and 2011/83/EU as regards empowering consumers for the green transition through better protection against unfair practices and through better information (the EmpCo Directive) – aims to improve product information and ban greenwashing and other unfair commercial practices.

The commission is currently working on a proposal for a second directive on substantiation and communication of explicit environmental claims (the Green Claims Directive, and, together with the EmpCo Directive, the directives), which shall complement and operationalise the EmpCo Directive. In this article, we summarise the content of both and explain how they are intended to interact in the EU’s fight against greenwashing.

The EmpCo Directive – legislative process

Published in the EU Official Journal on 6 March, 2024 and entered into force on 26 March, 2024, EU member states will have 24 months to implement the EmpCo Directive’s regulations. Starting 27 September, 2026, the new directive must be applied by the member states.

Germany has announced its intention for a quick transposition of the EmpCo Directive by amending the German Act against Unfair Competition, which shall be accomplished independently from the legislative process regarding the Green Claims Directive, whereas other EU member states, such as Austria, plan to implement the EmpCo Directive in conjunction with the Green Claims Directive.

Content and scope of

UK Climate Failure “Chills” Investor Confidence

Whoever wins July’s general election will need to prioritise climate ambition and provide clear policy signals for investors.

With the UK High Court having now dubbed the government’s net zero strategy unlawful for the second time, the country is now considered a climate laggard, leaving sustainability-conscious investors rudderless.   The decision has been interpreted by many as yet another setback for the government’s credibility on climate change.  “[The…

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ISSB Chair: Global Adoption is “Mission Possible”

Increased interoperability between developed and developing markets, as well as with other reporting rules, remains a priority. 

Adoption of the IFRS Foundation International Sustainability Standards Board’s (ISSB) climate and sustainability reporting rules is gathering pace, with 20 jurisdictions having announced plans to implement the standards.  “When standing on the main stage at COP26 [to announce the launch of the ISSB], not everyone felt this was possible,” said…

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EU Fund Names Rules: Too Much Too Soon?

ESMA’s finalised guidance isn’t fully aligned with other jurisdictions and could be impacted by the SFDR review. 

Industry pundits are concerned that guidance on fund names for EU-domiciled sustainable products may have jumped the gun ahead of a final decision on the Sustainable Finance Disclosure Regulation (SFDR).  Published on 14 May, the European Securities and Market Authority’s (ESMA) final report on fund names using ESG or sustainability-related…

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Take Five: Bound by Destiny

A selection of the major stories impacting ESG investors, in five easy pieces. 

Public and private sector coordination provides the theme – and events of Nairobi, London and Rio de Janeiro the backdrop – for this week’s digest.

Natural allies – Just ahead of this year’s UN International Day for Biological Diversity, delegates gathered in Kenya for the first review of the implementation of the Global Biodiversity Framework (GBF) since its adoption at COP15 in December 2022. A key task during the nine-day summit is to assess how well parties’ national biodiversity strategies and action plans (NBSAPs) support the 23 targets of the GBF. For the record, just nine countries, plus the European Union, have submitted updated NBSAPs since all 196 parties committed to the framework in Montreal. “The challenge is to ensure that the global aims are translated into nationally relevant targets that consider the context and the biophysical realities of each country,” said David Cooper, Acting Executive Secretary of the UN Convention on Biological Diversity. Delegates will also discuss the means of implementing the GBF, including capacity-building, technical and scientific cooperation, and resource mobilisation – the last of these being the trickiest given an estimated annual biodiversity finance gap of US$700 billion. Investors will be paying close attention to progress on the GBF’s fourth over-arching goal, the alignment of financial flows. According to a recent blog by Emine Isciel, Co-chair of the Finance for Biodiversity Foundation, a critical factor will be reducing existing harmful financial flows. As well as robust private-sector disclosures, via standards such as those outlined by the Taskforce on Nature-related Financial Disclosures, this requires public policy reforms to redirect US$542 billion in annual agricultural, fishing and forestry subsidies that damage nature, while also misdirecting private investment. “By fostering innovations, aligning incentives and setting clear boundaries, [finance ministers] can steer sectoral pathways towards reducing negative impacts, increasing positive impacts and catalysing private finance at scale,” she said.

Two figs – Alignment of finance flows with nature goals was also front of mind at the City Week event in London, with Karen Ellis, Chief Economist of the World Wide Fund for Nature UK, flagging two areas of opportunity. To avoid the nascent market for biodiversity credits making the same mistakes as the voluntary carbon markets, she said, governments could grasp the chance to create compliance markets. These could link the supply of financial incentives to the private

Climate Data in the Investment Process

Despite imperfections, investors should not wait for regulation to offer more comprehensive solutions, says David von Eiff, Director of Global Industry Standards at the CFA Institute.

Climate change impacts, through direct and indirect channels, present us with tremendous economic risks and opportunities. While their complexity makes estimation difficult, cost estimates are generally staggering. A 2022 analysis by Deloitte projected that an increase in global warming to 3C could lead to global economic losses of US$178 trillion over the next 50 years. However, the study estimates that US$43 trillion of economic gains could be realised through a successful transition to a low-carbon economy in the same time frame.

Governments worldwide have begun adopting policies and regulations to fund the transition to net zero economies and address climate-related risks. Further, companies have begun evaluating physical and transition liabilities and opportunities. Banks and insurers are altering their businesses to address better climate change-related liability risk in their lending and underwriting decisions. Asset owners are seeking to understand how climate change may affect the value of their assets, and asset managers are increasingly analysing their investments’ climate risks and opportunities.

This increasing focus on climate-related risks and opportunities has highlighted the significance of having accessible, reliable, climate-related data to measure and analyse, which is key to understanding and effectively utilising climate data as a component of investment strategies.

Applications of climate-related data

Climate-related data are integral to investment processes, serving purposes such as risk assessment, asset valuation, and shareholder engagement. It is collected, analysed, and used not only by asset managers or lenders but also by the ecosystem that provides services to them:

Credit rating agencies, which incorporate climate risk exposure into creditratings; Index providers, which provide climate-themed indexes and often calculate climate-related metrics for conventionalindexes; Valuation service providers, which may incorporate climate considerations when valuing privateassets; ESG rating providers, which often incorporate climate-related data and opinions in their ESG ratings andscores; Sell-side research providers, some of which are integrating climate-related information into theiranalyses; and Climate-related data and research providers, which produce a wide range of company and sector-specific climate-related information, as well as a comprehensive range of market research, market intelligence, and thought leadership on climate-related

In 2022, PwC found that the data used as inputs for climate analysis as well as the level of incorporation differed significantly between service providers. This variability, coupled with limited transparency, makes comparisons difficult.

Challenges in

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Take Five: Green Means Green

A selection of the major stories impacting ESG investors, in five easy pieces. 

European regulators have ratcheted up efforts to eliminate greenwashing from the investment sector.

End of an era I – The fight against greenwashing inched ahead with the release of final guidelines for naming ESG- or sustainability-related funds by the European Securities and Markets Authority (ESMA). It had previously been possible to launch an EU environmental opportunities fund, claiming Article 8 classification under the Sustainable Finance Disclosure Regulation (SFDR), while allocating as little as 10% of assets to demonstrably green investments. ESMA has now declared that era to be over, with new guidelines and thresholds including a minimum of 80% of investments to meet funds’ environmental or social characteristics, or sustainable investment objectives. Initial reactions suggested the market has welcomed some aspects – such as definitions for what could be included in a fund with an ‘impact’ or ‘transition’ label – but is baffled by others. These include ditching plans to require funds labelled ‘sustainable’ to contain at least 50% sustainable investments as defined by SFDR – due to feedback saying this was too open to discretion – instead opting to introduce a commitment to invest “meaningfully” in sustainable investments – whatever that means.

End of an era II – Until recently, opportunistic portfolio managers could stuff their ‘green’ portfolios with tech stocks to deliver strong returns at relatively little expense to the planet. That scam has long been rumbled, but the gig is definitely up now that Microsoft – which in 2020 pledged to become carbon negative by the end of the decade – has admitted its carbon emissions jumped 30% last year, as it pursued dominance in the AI market. The upsurge – confirmed in the tech giant’s annual sustainability report this week – followed news of a deal with asset manager Brookfield to build 10.5 gigawatts of renewable energy capacity to support its plans to rely solely on clean power sources by 2030. With Microsoft having offered to relocate staff amid rising US-China tensions, its AI strategy might face as many ‘S’ and ‘G’ as ‘E’ headwinds. But a sector-wide power grab seems likely, within the context of wider demand trends, with the International Energy Agency forecasting data centres will double their energy needs to 800 terrawatts by 2026, fuelled by both cryptocurrencies and AI.

Levels of engagement – More evidence was provided this week