European Regulations May Create Higher Costs for ESG Providers, Could Benefit Large Players

Earlier this week, the European Commission issued a proposal for the regulation of environmental, social, and governance ratings providers that provide ESG opinions or ESG scores. We believe increased regulation will result in higher costs for ESG ratings providers but will also benefit large incumbent providers with more resources. By far, the company within our coverage with the largest exposure to ESG revenue is MSCI. ESG and climate revenue (including both data subscriptions and indexes) make up about 19% of the firm’s revenue and we estimate about 15% of the firm’s adjusted EBITDA. We keep our respective fair value estimates of $412, $370, and $315 on wide-moat-rated MSCI, S&P Global SPGI, and Moody’s MCO.

More regulation in Europe for ESG ratings isn’t unexpected and something that the MSCI and S&P Global management teams have alluded to. The impetus for more regulation is that the EC believes ESG ratings have become increasingly important to investors and capital markets, but that the current ESG rating market has deficiencies. First, the EC is concerned with the lack of transparency on the methodologies and data sources that go into ratings. Second, it is also concerned with the lack of clarity into the operations of ESG ratings providers, particularly as it pertains to managing conflicts of interest.

On the transparency side, the commission is proposing to require firms to disclose methodologies, models, and key rating assumptions that go into ESG ratings. To manage conflicts of interest, the commission proposes that ESG rating providers do not offer consulting services, credit ratings, benchmarks, investment activities, audit, banking, insurance, or reinsurance services. While we can’t rule out that the EC may require divestitures or ownership changes, we believe the most likely outcome is to require ESG providers to set up a distinct legal entity and operational structure from their other services.