ESG ratings: On course for more sustainability - new regulation aims to improve quality, transparency, and comparability

As governments and stakeholders worldwide increase their focus on environmental, social, and governance (ESG) performance, the European Union (EU) has proposed regulations to improve the transparency, credibility, and comparability of ESG ratings. This regulatory environment underlines the importance of understanding ESG ratings and their potential benefits for companies.

According to the Council of the European Union in its proposal for Regulation (EU) 2019/2088, announced in February 2024, "ESG ratings play an important role in global capital markets as investors [...] use these ESG ratings as part of the process to make informed [...] decisions."1 The Belgian Minister of Finance, Vincent Van Peteghem, noted that regulated and transparent ESG ratings can significantly impact the transition to a sustainable future.2 The proposed regulation, "which aims to strengthen the reliability, transparency, and comparability of ESG ratings, also seeks to assure that credit rating agencies incorporate relevant ESG risks into their ratings."3 The proposed regulation will apply 18 months after it enters into force and must still be approved by the Council and Parliament.

A careful reading of the final compromise text of the ESG Regulation suggests that the regulation of, and the obligation for rating providers to incorporate ESG criteria into the assessment will result in companies paying more attention to ESG ratings. A cornerstone of the proposal is that there will no longer be just a blanket "single currency" for a company's ESG rating. Each ESG pillar will be assessed separately. To avoid a black box, there will in future be a precise description of the methods, which until now have differed considerably among rating agencies.

As a result of the regulatory proposals, rating agencies are proactively preparing to incorporate the planned regulatory requirements into their rating methods. For example, EcoVadis has already welcomed the EU agreement on regulating ESG rating agencies as an important step towards standardizing transparency and integrity requirements.4 The European Securities and Markets Authority (ESMA) is the body entrusted with the regulation of ESG rating agencies. Due to the reputation of ESMA, this step will also further strengthen the credibility of ESG ratings.

Using the potential of ESG ratings correctly

Strengthening reputation and trust: Companies that prioritize ESG considerations and achieve good ESG ratings can significantly improve their reputation and build trust with stakeholders such as customers, investors, and the public. For example, real estate companies that invest in energy-efficient buildings often experience higher occupancy rates and lower tenant turnover. Studies have shown that LEED-certified buildings have an average occupancy rate of 92% - compared to 88% for non-certified buildings.

Access to capital: Good ESG ratings can also open access to a wider range of capital sources, including sustainable investment funds and impact investors. Companies with outstanding ESG ratings are more likely to have easier access to green financing options and preferential interest rates for sustainable projects. Sustainable investment assets in Europe will reach around EUR 14.1 trillion in 2020. EUR in 2020.6 The global market for ESG bonds reached a record issuance of almost 1 trillion USD in 2023 (see figure: Issue volume of ESG bonds in USD billion).

Transparency as a competitive success factor: Companies that integrate ESG rating criteria into their business activities are also aligned with regulatory initiatives to promote sustainable finance. By proactively incorporating ESG rating criteria into transparent reporting, companies can demonstrate compliance with such regulations and gain a competitive advantage in attracting investors and customers seeking sustainable financial services. This is because many companies require their business-to-business (B2B) partners to provide evidence of minimum ESG ratings as a basis for their business relationships.

Innovations and new business opportunities: Prioritizing ESG factors often leads to innovative solutions and new business opportunities. Real estate companies that invest in sustainable technologies such as smart building systems, renewable energy installations, and water conservation measures not only reduce their environmental impact but also tap into the fast-growing market for green solutions. The green building market is expected to reach USD 500 billion by 2033, providing significant business opportunities for innovative real estate companies.

"Rating the Raters": New regulation will increase transparency

The proposed EU regulation on ESG ratings aims to increase the credibility and transparency of ESG ratings. The most likely scenario is that ESG ratings could become mainstream for companies as a prerequisite, in lockstep with regulatory requirements, for obtaining favorable financing and continuing business relationships. There is pressure on companies to achieve a minimum threshold in certain ratings to continue contractual relationships. By recognizing the value of ESG ratings and incorporating sustainable practices into their business operations, companies can unlock significant value, contribute to a more sustainable future, and thrive in an increasingly ESG-focused business environment.

Jens Hecht, CFA, is Managing Partner of Kirchhoff Consult and has been advising medium-sized companies for over 20 years on the preparation and implementation of IPOs as well as in the areas of investor relations, ESG, and financial reporting.

Dr. Alexander Ebolor is a Senior Consultant in the ESG/Sustainability department at Kirchhoff Consult and an expert in ESG ratings. Prior to joining Kirchhoff, he was an analyst at Morningstar Sustainalytics.