Finance Watch prioritises transparency and clarity in recommendations to the European Commission, after consultation highlights “significant biases”.
Forthcoming EU regulation of ESG ratings should prioritise maximum transparency by ensuring scores are split into environmental, social and governance, rather than amalgamated into one “synthetic rating”, NGO Finance Watch has argued.
“Every provider uses different methods and weights to aggregate these elements into a single rating, which makes it incredibly difficult for [investors and other end-users] to compare providers,” Thierry Philipponnat, Finance Watch’s Chief Economist, told ESG Investor.
Visibility of “all the components” before they are combined into one individual score would ensure investors have “a clearer picture” of a company’s performance across environmental, social and governance themes. A single combined score risks being skewed by a company outperforming in one area, he added.
This was one of the recommendations outlined in a new Finance Watch report, published ahead of the EU’s planned proposal on regulating ESG ratings providers. The proposal is expected mid-June, following feedback to a two-month consultation on the functioning of the ESG ratings market in the EU last year.
A majority of respondents (83%) to the Commission’s consultation said that the lack of transparency around the methodologies used by the providers is one of the major issues in the ESG ratings market, and 91% said there are “significant biases” with the methodologies used by providers.
The Finance Watch report noted that ratings providers also need to be much clearer on what is being assessed by these individual scores: risks to financial returns or real-world impacts.
“Take the example of Scope 3 emissions for car manufacturers,” said Philipponnat.
“From a financial materiality standpoint, the CO2 these vehicles emit is of less concern than the financial benefits of selling their product. From an impact materiality viewpoint, however, it is obviously a problem due to the extent of emissions in the company’s value chain.”
The report added that “many ESG ratings providers look only at financial materiality”, while the few that look at double materiality “use different methods to combine the financial and impact elements”.
EU-based investors are increasingly adopting a double materiality lens ahead of new regulations, such as the incoming European Sustainability Reporting Standards (ESRS), meaning they want to see the overall picture reflected in company ratings, the report noted.
This will require increased transparency and understanding of providers’ methodologies, said Philipponnat. Finance Watch has recommended that the EU should make it mandatory for ESG ratings providers to publicly disclose their methodologies and approach to materiality, explaining also whether ratings are absolute or relative, which data sources are being used, and whether or not this data has been audited.
“We don’t believe regulators should be telling providers how they should be generating these scores, but we do think they should require ratings providers to make sure their methodologies are clear, transparent and explicit,” said Philipponnat.
Best in class
Most ratings agencies are focused on the relative ESG performance of a company against others, as opposed to absolute performance, the Finance Watch report said.
While it is useful for investors to see how a company is performing in relation to its peers, the report argued that focusing on relative ESG performance means companies with high risks can still appear in ESG portfolios, which can spark greenwashing accusations.
“A company may be best-in-class, but it’s not a sustainable company if the whole class is underperforming,” Philipponnat added.
A related problem is that issuers can be penalised for changes in the performance of others, rather than being judged on its own merits.
A 2022 report published by the Institute for Energy Economics and Financial Analysis (IEEFA) used electric vehicle manufacturer Tesla as an example, noting that its ESG-related score “remained fairly stable” but, when compared to its peers in the automotive industry, it had fallen behind, resulting in the company’s exclusion from the S&P 500’s ESG index.
There are also biases due to geography and company size, IEEFA said, as companies that are domiciled in countries with “robust ESG regulatory reporting requirements and larger market capitalisation are awarded with favourable ESG ratings”. This ultimately underscores providers’ reliance on publicly available data disclosures, the report said, while companies that may have sound and sustainable businesses – but which disclose less – could be unfavourably rated.
Finance Watch has also called for the EU to ban ESG ratings providers from selling consultancy services to companies they are rating and from rating their own shareholders.
“To ensure independence, no legal or natural person should hold a participation over 5% in more than on ESG rating provider,” the report said, adding that providers should also put in place internal controls and processes to prevent and control possible conflicts of interests.
Further, the NGO recommended that the provision of ESG ratings in the EU and their use by investors should be overseen by the European Securities and Markets Authority (ESMA).
Almost all (94%) respondents to the Commission’s 2022 consultation said that regulatory intervention in the ESG ratings market is necessary.
“It’s not a complicated problem and the regulatory solutions are simple, as we have outlined,” Philipponnat told ESG Investor.
“Good finance – and sustainable finance – is all about trust. If we can’t trust the numbers or the ratings to make sense and be reliable, then we’re going nowhere.”