Regulating ESG Rating Providers in India

– SEBI approves regulations for ERPs through amendments to CRA Regulations

– Payal Agarwal, Deputy Manager (payal@vinodkothari.com)

As ESG and climate change concerns assume global priority, there is a growing interest among businesses to claim their offerings, products or structures to be green.  This  growing interest of a variety of stakeholders has led to the emergence of ESG Rating Providers (“ERPs”) for ranking an entity’s ESG profile, providing “green” or other coloured labels, or giving other affirmations as sustainability or sustainable-linkage. Unlike credit ratings, ESG ratings are currently not within the direct domain of securities regulators; however, to the extent ESG ratings relate to securities offerings or financial products, the securities regulators claim to have jurisdiction., he International Organization of Securities Commissions (“IOSCO”) has been working towards evolving recommendatory standards. IOSCO published its final report on Environmental, Social and Governance (ESG) Ratings and Data Products Providers (“IOSCO Consultation Report”) in November, 2021.

Following the same, SEBI released a consultation paper on Environmental, Social and Governance (ESG) Rating Providers for Securities Markets (“ERPs Consultation Paper”) on 24^th January, 2022, and on the basis of the public consultation as well as global regulatory developments, had proposed a draft regulatory framework for ERPs (“Draft ERP Framework”) on 22^nd February, 2023. Recently, on 29^th March, 2023, SEBI has approved to bring a regulatory framework for ERPs in India, by inserting a new chapter to the existing SEBI (Credit Rating Agencies) Regulations, 1999 (“CRA Regulations”).

Meaning of ESG ratings

The IOSCO Consultation Report refers to the term ESG ratings as “the broad spectrum of rating products in sustainable finance and include ESG scorings and ESG rankings.”

In the Indian context, SEBI proposes to define ESG ratings in the below fashion –

“Environmental, Social, and Governance ratings”, or “ESG ratings” refer to the broad spectrum of ratings products that are marketed as providing an opinion regarding an entity that is listed or proposed to be listed on a stock exchange recognized by the Board, or a security, that is listed or proposed to be listed on a stock exchange recognized by the Board, about its ESG profile or characteristics or exposure to ESG, governance risk, social risk, climatic or environmental risks or impact on society, climate and the environment, that are issued using a defined ranking system of rating categories, whether or not these are explicitly labelled as ESG ratings.”

From the aforesaid definition, the following characteristics of ESG ratings can be inferred –

• “Entity”-specific or “security”-specific: The ESG ratings can be either “entity-specific” or “security-specific”, i.e., such ratings may provide an opinion either about an entity or a security that is listed/ proposed to be listed on a recognised stock exchange in India.
• “Risk” ratings or “impact” ratings^[1]: The ESG ratings provide an opinion on the ESG profile or characteristics, and may either refer to the ESG risks faced by the entity or the impact it may have on the environment and the society, or both.
• Defined ranking system: The ESG ratings shall be issued using a defined ranking system of rating categories.
• Labelling not relevant: Such an opinion shall qualify as ESG ratings irrespective of the existence or absence of the explicit label of ESG ratings. 

Who are ERPs?

ERPs are independent agencies that provide unbiased ratings to the entities based on various ESG parameters that helps investors in analysing their investment decisions in light of the non-conventional or ESG performance of the investee entity. There are various ERPs operational worldwide^[2]. Contrary to what one may think at first blush, ESG rating providers are not the same as credit rating agencies (see below under Eligibility). 

Draft regulatory framework for ERPs

While SEBI has approved a regulatory framework for ERPs, the fine text of the same has not yet been released. Therefore, we resort to the Draft ERP Framework, as was proposed by SEBI through a Consultation Paper.

As mentioned above, SEBI proposes to regulate ERPs through amendments to the existing CRA Regulations. A new chapter IVA is proposed to be added, making it mandatory for all existing as well as prospective ERPs to register with SEBI and comply with the additional requirements therein. Further, the following existing chapters of the CRA Regulations shall apply on such ERPs –

• Chapter I – Preliminary chapter containing definitions
• Chapter V – Procedure for Inspection and Investigation by SEBI
• Chapter VI – Procedure for action in case of default
• Chapter VII – Power to relax strict enforcement of the Regulations

Further, Chapter IVA provides for the eligibility conditions for registration, categories of ERPs, continuous compliance, transparency and disclosure requirements etc. These are discussed in detail in relevant heads below.

General eligibility conditions for registration as ERPs

The general eligibility conditions proposed for an entity to be registered as an ERP include the following –

• The applicant shall be mandatorily registered as a company incorporated in India.
• The applicant has specified ESG rating activity as its main objects in its Memorandum of Association.
• The applicant shall submit its business plan pertaining to ESG rating activities including details of the following –
  • a target breakeven date,
  • target revenue and number of clients, within two years of obtaining registration as an ERP, and
  • projected cumulative cash losses (along with the activities/ areas) until the target breakeven date
• The applicant shall submit a declaration to not undertake any activity other than ESG rating of an entity/ a security that is listed/ proposed to be listed, or of any other product/ service/ activity as may be required by any other financial sector regulator and specified by SEBI.
• The applicant shall not be a CRA or any other intermediary registered with SEBI, however, a SEBI registered CRA may act as a promoter of an ERP. 
• The applicant and its promoter is a ‘fit and proper’ person as per Schedule II of SEBI (Intermediaries) Regulations, 2008.

In addition to the aforesaid, certain eligibility criteria is based on the category under which registration is sought by an ERP, as discussed below.

Categories of ERPs

SEBI proposes two categories of ERPs for registration, differentiated on the basis of the activities undertaken, or the products/ services permitted to be offered by them. Such a categorisation has been proposed to encourage start-ups/ new entities to join the ESG rating industry. A tabular comparison of the two categories can be referred below –

Basis of comparison	Category I ERP	Category II ERP
Minimum Net worth	Rs. 5 crores	Rs. 10 lacs
Eligible entities	Subsidiary of SEBI-regd. intermediary, or of foreign ERP	not specified
Services offered	Certification of green debt securities[3] proposed to be restricted to Category I	All ESG ratings except certification of green debt securities
Eligible promoter	An entity regulated by financial service regulator, a foreign ERP, SEBI-regd. CRA, or an entity having continuous net worth of minimum rupees 100 crores as per its audited annual accounts for the previous five years prior to filing of the ERP application with SEBI	not specified
Manpower requirements	At least 10 employees, with at least one specialist in each of the following areas: (i) governance, (ii) sustainability, (iii) social impact or social responsibility, (iv) data analytics, (v) finance, (vi) information technology, (vii) law	At least 5 employees, with at least one specialist in each of the following areas: (i) governance, (ii) sustainability, (iii) social impact or social responsibility, (iv) data analytics
Remote work	Adequate office space required	Not mandatory
Registration fee	Rs. 10 lacs + Rs. 5 lacs	Rs. 1 lac + Rs. 50,000

Transparency and disclosure norms

For the purpose of ensuring transparency and confidence in the ESG ratings, certain mandatory disclosures are proposed for the registered ERPs through their website. These include the following :

• Adequate public disclosures through its website on the methodologies and processes adopted for its ESG rating products including the following –
  • Category-wise weightage of Environmental, Social and Governance factors in ESG ratings, and
  • Weightage of high-level themes or key issues in each of the three factors.
• Category of ERP the entity pertains to in all its website disclosures;
• Use of proper terminologies for ESG products, including specific display that ESG ratings are different from credit ratings (if the ERP is a subsidiary or associate of a CRA);
• Change in ESG rating methodology along with consequential change in ESG ratings, including the extent of change in rating due to such change in methodology;
• Disclosure of ESG rating, its type (risk-based, impact-based or otherwise), scores on E, S and G parameters including hyperlink to the implemented methodology;
• Annual evaluation report on ESG rating methodologies against the output they have been used to produce, in the format to be specified by SEBI;
• Average one-year ESG rating transition rate over a 5-year period, in the manner to be specified by SEBI;
• General nature of compensation agreements with clients, including disclosure of whether assigned ESG ratings were solicited/ unsolicited;
• Disclosure of the ESG rating assigned to an entity/ security that is listed to the stock exchanges, as well as through press releases and website, including changes on periodic review.     

Dealing with potential of conflict of interest

In order to avoid the existence of any conflicts of interest or undue influence, SEBI has put up certain restrictive conditions with respect to the group structure of the ERPs and dealing with such entities. These include the following –

• An ERP shall not hold, directly or indirectly, 10% or more of the voting rights and/or shareholding in another ERP;
• An ERP shall not have any representation on the board of another ERP;
• No ERP shall rate an entity/ its securities if such entity is –
  • a borrower/ subsidiary/ associate of the promoter of ERP having common directors and/ or employees, except for common independent directors in some cases
  • promoted by the ERP itself or its associates
  • having common Chairperson, director or employee with that of the ERP

IOSCO recommends best practices for asset management and ERPs

Following the Consultation Report released in 2021, in November 2022, IOSCO also published a call for action for Good Practices, in two separate sections – one for asset managers, and one for ESG ratings providers, to serve as a guidance for standards setting bodies and industry associations.

The recommendatory good practices for asset managers include the following –

1. Clear expectations for asset managers regarding the: (a) development and implementation of practices, policies and procedures relating to material sustainability-related risks and opportunities; and (b) related disclosure.
2. Clear expectations regarding product-level disclosures to help investors better understand: (a)sustainability-related products; and (b) material sustainability-related risks and opportunities for all products.
3. Common sustainable finance-related terms and definitions, including those related to ESG approaches, to ensure consistency throughout the global asset management industry and comparability among sustainability related products.
4. Promoting or participating in financial and investor education initiatives relating to sustainability.
5. Clear expectations regarding due diligence and/or the gathering and reviewing of information on the ESG ratings and data products that asset managers use in their internal processes.

The recommendatory good practices for ESG ratings and data providers include –

1. Adopting and implementing written policies and procedures designed to help ensure the issuance of high quality ESG ratings and data products based on publicly disclosed data sources, where possible and other information sources where necessary, using transparent and defined methodologies.
2. Adopting and implementing written policies and procedures designed to help ensure that their decisions are independent, free from political or economic interference, and appropriately address potential conflicts of interest.
3. Identifying, avoiding, or appropriately managing, mitigating, and disclosing potential conflicts of interest.
4. Making adequate levels of public disclosure and transparency a priority for their ESG ratings and data products, including their methodologies and processes.
5. Adopting and implementing written policies and procedures designed to address and protect all non-public information received related to their ESG ratings and data products. 
6. Improving information gathering processes with entities covered by their products.
7. Responding to and addressing issues flagged by entities covered by their ESG ratings and data products while maintaining the objectivity of these products.

Regulatory control over ERPs: Global Scenario

Proposals to regulate ESG data providers by UK Government:

In the UK, in June 2021, the Financial Conduct Authority (“FCA”) published a discussion paper seeking suggestions on certain ESG issues in capital markets, such as enhanced climate related disclosures including the currently unregulated field of ESG data and ratings. In line with the consultations as well as recommendations of IOSCO, UK has recently rolled out a consultation on future regulatory regime for ERPs on 30th March, 2023, and the same is open for comments till 30th June, 2023.

ESMA’s market research for ERPs in EU

In the EU, ESMA, in February 2022, released a Call for Evidence on market characteristics for ERPs in the EU. It listed some questionnaires to be responded by the ERPs, entities evaluated by ERPs and users of information received from ERPs to understand the existing model of ERPs, size of entities operating as ERPs, type of entities reported by ERPs, model used (“issuer-pay” or “subscriber-pay”), reliability and requirement of ESG ratings etc, to name a few. The consultation has been closed and the outcome of the suggestions indicate incorporation of regulations pertaining to ESG ratings within the existing regulations for credit rating agencies.

Japan establishes Technical Committee for ERPs

The Financial Services Agency (FSA) has released a Report by the Expert Panel on Sustainable Finance which, among all, discusses the indispensability of improved reliance of ESG ratings and data providers and seeks to bring solutions to the existing problems with ERPs as part of development of sustainable finance. Following the recommendations, in February 2022, the FSA established a Technical Committee for ESG Rating and Data Providers. In December, 2022, Japan became the first country in the world to have a formal Code of Conduct for ESG Evaluation and Data Providers.

US recognises need for regulating ERPs

The Asset Management Advisory Committee (AMAC) of the US Securities and Exchange Commission (SEC) reviewed the matters concerning ESG and their impact on the investment products and made some recommendations. The recommendations, amongst others, included consideration of the requirement of ESG ratings, need of a benchmark for assessing ESG ratings, and the role of ESG rating systems in investment decisions.

SEC Thailand supports the cause of regulating ERPs

The response of SEC Thailand to IOSCO Consultation Report suggests establishment of a balanced regulatory ecosystem for preventing greenwashing and enhancing innovation and growth, providing regulatory support to local service providers and regulating the ERP industry through an independent supervisory body.

Current position of ERPs in India

With SEBI’s final nod for the regulatory framework for ERPs in India, any entity intending to provide ESG ratings for any entity/ security listed in India will be required to mandatorily register itself with SEBI. This does not mean that the country is completely aloof from the existence of ERPs at present. There are entities operating in India that are presently providing ESG ratings to Indian companies; generally incorporated as a division/ extended arm of CRAs. The ratings are available on a subscription basis. 

Concluding Remarks

ESG has found dominance in regulatory policy, investment decisions, annual disclosures and what not. ESG funds and ESG bonds capture a large part of the global market and are expected to witness further rise. All these factors, collectively, testify to the growing demand and importance of ESG ratings. In such a scenario, it becomes pertinent to regulate the ESG rating market. In various countries, consultations have been concluded and one can look forward to what is coming for the ESG rating providers. In the context of India, the requirement of reasonable assurance on the ESG performance of companies is increasingly obtaining regulatory space, with SEBI mandating certification for use of proceeds for green debt securities, or the requirement of BRSR Core disclosures substantiated with reasonable assurance etc.

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[1] Types of ESG ratings include –

1. Impact ratings– These ratings assess the impact of a company (both positive and negative) on the environment and society along with an assessment of its corporate governance profiles.
2. Risk ratings– These ratings deal with the ESG related risk an entity is exposed to. It assesses the impact of social and environmental issues on the company’s enterprise value, and the resilience of the entity towards such risks.
3. Customised/ benchmark related products – Apart from the full-fledged ESG impact and risk ratings, there may be ESG scores or rankings based on some specific benchmarks, such as, carbon use, greenhouse gas emissions, ESG disclosure ratings etc.

[2] Names of few ERPs may be referred here – https://corpgov.law.harvard.edu/2022/08/24/esg-ratings-a-compass-without-direction/

[3] Read more about mandatory certification of green debt securities at SEBI revises framework for green debt securities

Our resources on ESG and sustainability can be accessed at – https://vinodkothari.com/resource-center-on-business-responsibility-and-sustainable-reporting/