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ESG Ratings, Data Need Greater Scrutiny from Users and Supervisors – IOSCO

Consultation offers guidance to asset managers, but highlights ongoing challenges for regulators.

Users need to rigorously scrutinise third-party ESG ratings and data services even in the event of tighter regulatory oversight, according to the Board of the International Organisation of Securities Commissions (IOSCO).

As part of a public consultation to address ongoing issues with ESG data relevance, reliability and comparability, IOSCO has outlined what users should be looking for when assessing third-party vendors. The consultation closes on 6 September.

Asset managers and other financial institutions use inputs from third-party vendors to assess the ESG characteristics of companies and financial instruments for selection or continued inclusion in the fund solutions sold to investors. Asset owners also use ESG data, scores and ratings services as part of their due diligence of asset managers ESG capabilities.

Due diligence is one of 10 recommendations in the consultation. It also covers possible regulatory and supervisory approaches to mitigating risks associated with ESG data and ratings, as well as recommendations for the third-party vendors themselves, both in their interactions with the companies they assess and end-users.

Users need to identify the sources of information used by third-party vendors to build ESG products and make sure that information is up to date, IOSCO said. Further, it’s important to identify whether “any gaps in information are filled using estimates, and if so, the methods used for arriving at these estimates”.

They should also evaluate the criteria utilised in the ESG assessment process, including the relative weightings of criteria and the extent to which the assessment depended on qualitative judgements, IOSCO said.

“Users have signalled that having multiple ESG ratings and data products can cause confusion, raising serious questions about relevance, reliability and greenwashing,” said Ashley Alder, IOSCO Chair and CEO of the Securities and Future Commission of Hong Kong.

The Organisation for Economic Co-operation and Development (OECD) has also previously noted that ESG ratings “vary strongly depending on the provider chosen”, highlighting the importance of circumventing potential greenwashing and understanding the different methodologies behind products and ratings prior to making investment decisions.

Proper due diligence will ensure asset managers and owners have a clearer idea as to the reliability and utility of the ESG ratings and products they are using. They will also be able to better compare the scores and ratings they acquire from a variety of third-parties, IOSCO said.

The public consultation follows IOSCO’s “fact-finding exercise”, which identified that a lack of transparency around the third-party methodologies underpinning ratings or data products and the “often uneven coverage of products offers across industries and geographical areas” as the main concerns of financial market participants interacting with third-party vendors.

Regulating scores and ratings

During the launch event for the public consultation, Alder pointed out that securities markets regulators currently have “limited room for manoeuvre” to regulate third-party vendors.

“IOSCO also wants its recommendations to operate in a way that helps regulators assess and potentially extend their remit. That can be complicated and may involve legislation or other collaborative actions across different jurisdictions,” he said.

Where regulators have supervisory authority over ESG ratings and data products providers, they should consider “whether the processes underlying ESG ratings and data products are subject to written policies and procedures and/or internal controls to ensure they are rigorous, systematic, and applied in a continuous manner”, the consultation noted.

Pressure for higher standards to be enforced on third-party vendors is especially rising in Europe, as asset managers are expected to comply with the European Commission’s Sustainable Finance Disclosure Regulation (SFDR). SFDR requires asset managers and other financial service providers to both categorise their ESG-labelled products and to evidence their reasoning when Level 2 comes into force next year. Justifications for these categorisations will partly be informed by third-party ESG-related scores and ratings of individual holdings within each fund.

As part of its Sustainable Finance Strategy, the European Commission has announced plans to introduce measures that improve the reliability, comparability and transparency of ESG ratings, but this isn’t expected until at least Q1 2023.

The consultation is the latest piece to the overall framework for sustainability that IOSCO is developing. The ‘Report on Sustainability-related Issuer Disclosures’, which addresses data gaps at the corporate level, and the ‘Recommendations on Sustainability-related Practices, Policies, Procedures and Disclosure in Asset Management’, which emphasises the important role asset managers play in the deployment of investor capital into sustainable finance, were both issued in June.

IOSCO sets standards for securities market regulations across 130 jurisdictions.

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