Ashley Alder, Chair of IOSCO and CEO of the HK SFC, calls for greater consistency and transparency for ESG ratings and data.
The global surge of investment into sustainable finance has led to a proliferation of firms offering ESG scores and ratings. In the absence of consistent corporate disclosures on ESG matters, investors have been referencing these ratings to distinguish sustainable opportunities that align with their preferences from the remainder of the investment universe.
As a result, investors have increasingly relied on unregulated ratings firms and data providers to assess, among other ESG factors, the impact of climate change on a company as well as the company’s own impact on the environment. These ESG ratings and data products now underpin a wide range of financial products, from indices to derivatives and are actively used by market participants such as asset managers in their investment decisions.
Risk of greenwashing
This information is crucial in light of the estimated US$130 trillion of private sector funding pledged to achieve 2050 net zero GHG emissions targets. Accurate, comparable data is critical to prevent misallocation of capital away from transitional activities and any exposure of sustainable finance to the risk of greenwashing.
Unfortunately, the information these firms provide is often based on highly inconsistent data sources and very different methodologies with little transparency on how they are produced. This has led to companies receiving vastly different ESG ratings depending on which provider is rating them, with sometimes little or no explanation of the reasons behind this lack of consistency. A study by the MIT Sloan Sustainability Initiative has, for example, found that correlation among traditional credit ratings was 0.92, but for ESG ratings it was much lower at 0.61.
Users of this information — and the companies being rated — have therefore raised important questions about its consistency, comparability, completeness, transparency and reliability.
The International Organization of Securities Commissions (IOSCO), the global standard-setter for securities markets, has now published important recommendations to foster confidence in this key link in the sustainable investment chain.
First, ESG ratings and data providers should have strong, transparent governance practices and fully disclosed, well-defined assessment methodologies. This will help address the difficulty investors have in evaluating the range of ratings and third-party data underlying investment products that purport to be sustainable.
A wide spectrum of considerations fall under the broad ESG banner, meaning assessment methodologies may vary dramatically if they are intended to measure different aspects of ESG. This can lead to a myriad of ratings for the same underlying company. While some may see this as a sign of the immaturity of the current ESG ratings environment, ratings providers have suggested there are in fact benefits to this lack of consistency. Investors that choose to invest through a specific aspect of the ESG lens should not be misinformed because of poor methodology management, hence the importance of being transparent with investors.
Second, ESG ratings and data providers should identify and address conflicts of interest. For example, serious issues can arise when a firm acts as a consultant to a company to which it also assigns ostensibly independent ESG ratings, such as when it advises on how scores can be shaped or improved.
Third, information underpinning ratings and data products should be reliable and accurate. Importantly, definitions of ESG-related factors should be clear and aligned with what any rating or score intends to measure.
Considering the growing influence of these measures of ESG performance, IOSCO’s recommendations should be adopted by ratings and data providers as an urgent priority; failing to act now risks harming the credibility of the sustainable finance industry as a whole.
Unified sustainability reporting standards
We do recognise that these providers themselves are faced with challenges as companies fail to make consistent and comparable sustainability disclosures. We believe that this can only be fully addressed through the development of a unified set of sustainability reporting standards. This is why the creation of the new International Sustainability Standards Board (ISSB), which will sit alongside the existing International Accounting Standards Board, is of such significance.
As announced at COP26, the new Board will work towards issuing a series of comprehensive global baseline standards, starting with climate. The objective is to respond to the demands of investors and other market participants – including ESG ratings and data providers – for the type of real economy information that is crucial to the whole sustainable finance effort. As IOSCO also announced at COP26, it will operate through a technical expert group with a view to endorsing the global baseline standards for its membership of securities regulators.
An important aspect of IOSCO’s assessment that will inform its decision on the endorsement of ISSB standards will be considering how this global baseline can be built upon by its member jurisdictions, as they are looking towards disclosures beyond enterprise value while ensuring ongoing interoperability in order to address the issues of inconsistencies and fragmentation for investors globally.
Securing a sustainable future
This is the beginning, not the end, of the journey; IOSCO will continue to work with its membership of capital markets regulators across developed and developing economies to help the sustainable finance industry to channel the vast amount of funding needed to secure a sustainable future for generations to come.