India: Setting The Benchmark: India's First-Of-Its-Kind Legislation On ESG Rating Providers

1. INTRODUCTION

Ascertaining the environmental, social, and governance ("ESG") profile of a potential investee is a complex task, often requiring dedicated personnel and subject-matter expertise. Investors, especially asset management companies and institutional investors, typically rely on research products, usually in the form of ratings, scores, or opinions, offered by third-party agencies called 'ESG Rating Providers' ("ERPs").¹

On July 04, 2023, the Securities and Exchange Board of India ("SEBI") amended the SEBI (Credit Rating Agencies) Regulations, 1999 (the "CRA Regulations") to introduce a regulatory framework for governing entities engaged in the business of issuing ratings based on ESG parameters (the "Amendment").² Post the Amendment, ERPs will be required to seek registration with SEBI prior to commencing business. With this, India becomes one of the few jurisdictions to regulate ERPs, ahead of developed jurisdictions such as the European Union ("EU"), United States, United Kingdom ("UK"), and Singapore. The Amendment has been notified in the backdrop of the consultation papers titled 'ERPs for Securities Markets' (the "Consultation Paper I")³ and 'Regulatory Framework for ERPs in Securities Market' (the "Consultation Paper II")⁴ released by SEBI on January 24, 2022, and February 22, 2023, respectively.⁵

This article critically analyses the Amendment and attempts to compare it with the proposed legislations in the EU⁶ , the UK⁷ and Singapore⁸ . We also delve into the impact of the Amendment on ease of doing business as well as its lack of technological foresight. The schedule to this article provides a comparative analysis of the Amendment and the proposed legislations in the EU, the UK, and Singapore.

2. OVERVIEW AND CRITICAL ANALYSIS OF THE AMENDMENT

The Amendment sets out the regime governing ERPs, which we have summarized and analyzed below.

2.1. Scope of the Amendment

2.1.1. Scope of products and services regulated under the Amendment

Any person who is engaged in the business of issuing rating products marketed either as opinions about the ESG profile or exposure to ESG risk of an issuer or a security, issued using a defined ranking system of rating categories ("ESG Ratings"), is required to seek registration under the CRA Regulations.⁹ Entities offering ESG Ratings shall be considered as ERPs, whether or not such products are explicitly labelled as ESG Ratings. SEBI has thus adopted a functional definition of ESG Ratings. This is in line with the proposed regulation of the EU titled 'Regulation of the European Parliament and of the Council on the transparency and integrity of ESG rating activities' (the "Proposed EU Regulation")¹⁰ and the UK's consultation paper titled 'Future regulatory regime for ESG ratings providers' (the "UK Consultation Paper")¹¹.

ERPs can provide ratings basis, both, ESG profile or exposure to ESG risk, and impact of the ESG profile of an entity on society, climate, and the environment. Thus, a wide spectrum of ESG products, including both risk-based and impact-based ratings, are covered. The Amendment provides a prescriptive list of products that ERPs must offer, without incorporating necessary flexibility in terms of the range of products which may be offered without requiring registration. In contrast, the Proposed EU Regulation specifically excludes nine ERP products from its scope.¹² These include private ESG ratings not intended for public disclosure, raw ESG data, second-party opinions on sustainability bonds, a third-party providing ratings released by an authorized ERP, and ESG ratings issued by public authorities.

Similarly, the consultation paper released by the Monetary Authority of Singapore titled 'Proposed Code of Conduct for ESG Rating and Data Product Providers' (the "Singapore Consultation Paper") excludes ratings that take into account the ESG profile of an entity to assess its creditworthiness, and research analysis or reports relating to any investment product issued by a financial advisor.¹³ Likewise, under the UK Consultation Paper, certain products and services are proposed to be excluded from the scope of the regulation. These exclusions encompass ESG ratings provided by not-for-profit entities, credit ratings which consider the impact of ESG ratings on creditworthiness, investment research products, consulting services related to ESG, as well as academic research and journalism. ¹⁴

2.1.2. Eligibility Criteria¹⁵

To be eligible to register as an ERP, an entity must, amongst other, meet the following criteria. It must be:

1. a company incorporated under the Companies Act, 2013, and shall have specified ESG rating as the main object in its memorandum of association; and
2. exclusively engaged in the business of issuing ESG Ratings of: (i) issuers, or securities listed, or proposed to be listed on a SEBI recognized stock exchange; (ii) issuers, or products, as may be required by any other financial sector regulator or authority; or (iii) any other product or issuer, as may be required by another financial sector regulator, as may be specified by SEBI, under guidelines of such regulator.¹⁶

The eligibility condition stated at paragraph 2.1.2(b) is concerning as it creates significant barriers to entry in the ERP market. Potential entrants will be required to exclusively undertake the business of offering ESG Ratings. Further, credit rating agencies and any other intermediaries registered with SEBI will not be permitted to register themselves as an ERP. In comparison, the Proposed EU Regulation prescribes a negative criterion, listing activities that ERPs cannot engage in.¹⁷ These activities include consulting activities to investors or undertakings, issuance and sale of credit ratings, development of benchmarks, investment activities, audit activities, and banking, insurance, or reinsurance activities. Barring these, ERPs are allowed to undertake any other business activities as long as there is no risk of conflict of interest with their role as an ERP. This approach minimizes potential conflicts of interest while simultaneously enabling ERPs to diversify their business offerings and manage risks.

2.1.3. Governance of ERPs registered outside India

The Amendment is only applicable to ERPs set out below:

As evident in the above matrix, an ERP located outside India must register with SEBI before offering ESG Ratings of an Indian asset class to users located in India.¹⁸ In contrast, under the Proposed EU Regulation, ERPs from non-EU countries can provide ESG ratings in the EU, without obtaining a certification, pursuant to an 'equivalence decision' between the EU and the relevant competent authority in their respective jurisdictions.¹⁹ The UK Consultation Paper has also kept this possibility open.²⁰

By introducing this registration requirement, SEBI's intent appears to be to ensure the legitimacy of ERPs and prevent entities from evading regulatory scrutiny by registering in a foreign jurisdiction while offering services in India. While this intent is fair, allowing foreign entities to operate in the Indian ERP market can bring certain benefits, such as increased quality of business offerings and innovation. Therefore, SEBI could have considered an alternative approach of allowing foreign-registered ERPs to operate in India without undergoing the same registration process as a domestic ERP. However, this should be subject to the inclusion of certain safeguards to mitigate concerns around the authenticity and competence of foreign entities.

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Footnotes

1. Paragraph 2.1 of the Consultation Paper I.

2. The CRA Regulations (along with the Amendment) can be accessed here: https://www.sebi.gov.in/legal/regulations/jul-2023/securities-and-exchange-board-of-india-credit-rating-agencies-regulations-1999-last-amended-on-july-4-2023-_73593.html.

3. The Consultation Paper I can be accessed at: https://www.sebi.gov.in/reports-and-statistics/reports/jan-2022/consultation-paper-on-environmental-social-and-governance-esg-rating-providers-for-securities-markets_55516.html.

4. The Consultation Paper II can be accessed at: https://www.sebi.gov.in/reports-and-statistics/reports/feb-2023/consultation-paper-on-regulatory-framework-for-esg-rating-providers-erps-in-securities-market_68337.html.

5. In Consultation Paper I and Consultation Paper II, SEBI had observed that the ESG rating products ecosystem faced multiple issues, including, lack of clear use of terminologies, inconsistency in disclosures and transparency of the methodology and rating process, unregulated nature of market, potential conflicts of interest, and lack of India-specific ERPs. Accordingly, SEBI had recommended issuance of regulations for governing ERPs.

6. The Proposed EU Regulation can be accessed at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52023PC0314.

7. The UK Consultation Paper can be accessed at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1147458/ESG_Ratings_Consultation _.pdf.

8. The Singapore Consultation Paper can be accessed at: https://www.mas.gov.sg/-/media/mas/news-and-publications/consultation-papers/consultation-paper-on-proposed-code-of-conduct-for-esg-rating-and-data-product-providers.pdf.

9. Regulation 28B(1)(b) of the CRA Regulations read with regulation 28B(1)(c) of the CRA Regulations.

10. Article 3(1) of the Proposed EU Regulation.

11. Paragraph 2.3 of the UK Consultation Paper.

12. Article 2(2) of the Proposed EU Regulation.

13. Paragraph 3.6.4 of the Singapore Consultation Paper.

14. Paragraphs 3.2 and 3.5 of the UK Consultation Paper.

15. Credit Rating Agencies or any other intermediaries (such as foreign institutional investors, merchant bankers, portfolio managers and investment advisers) registered with SEBI are not permitted to register themselves as ERPs.

16. Regulation 28E of the CRA Regulations.

17. Article 15 of the Proposed EU Regulation.

18. Regulation 28C of the CRA Regulations read with the fourth schedule of the CRA Regulations. The CRA Regulations contain a transitional provision i.e., a person operating as an ERP can continue to do so until January 3, 2024, or if it has made an application for registration before January 3, 2024, till the disposal of such application.

19. Article 9 of the Proposed EU Regulation. An equivalence decision would confirm that the legal and supervisory framework for ERPs in the third country is equivalent to the framework in the Proposed EU Regulation, including provisions for regular and effective supervision and enforcement.

20. Paragraph 4.4 of the UK Consultation Paper.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.