Explainer

Regulating Ratings

ESG ratings have been criticised for inconsistency and opacity, but will regulation improve their value to investors?

Global ESG assets are on track to exceed US$53 trillion by 2025; more than one third of the US$140.5 trillion in projected total assets under management. ESG is clearly big business, but financial regulators are increasingly concerned that the rapid pace of investment is outstripping the capabilities of ratings and data providers.

There are more than 600 ESG standards and frameworks, data providers, ratings and rankings, provided by a mix of established credit ratings agencies and data vendors along with niche providers. In such a crowded market, there are no standards for disclosure, transparency and quality, which raises concerns that greenwashing may go undetected.

“The securities industry needs more regulation to help reduce the disparity in ESG data sets and ratings methodologies via standardisation,” says Virginie O’Shea, Founder and CEO of analysts Firebrand Research. “At the moment, there is a lot of interpretation going on and it is reliant on a lot of manual processes.”

More transparency will eventually help firms to establish “proper parameters” around their investments and “hopefully reduce some of the legal uncertainty,” she adds.

“This is important as ESG is becomes an integral and enduring part of the investment process, given the ongoing importance of climate and social change.”

With various regulatory bodies globally initiating consultations on ESG ratings and data, regulation is definitely on the way. This explainer considers whether new rules will help investors to better understand what is behind ESG ratings and use them effectively to implement sustainable investment strategies.

How do investors use ESG scores and ratings?

Asset owners and managers use ESG ratings to help them assess a company’s overall sustainability performance across environmental, social and governance issues. This assessment should inform their investment decisions in the same way an equity analyst’s view on a stock’s value, says Eurosif Executive Director Victor van Hoorn.

Investors with specific sustainability goals look to ESG ratings to aid their decisions in portfolio rebalancing and risk management.

In the future, says former Bank of England Governor Mark Carney, climate and ESG considerations will “likely be at the heart of mainstream investing”. Investors will tailor their investments and fulfil their fiduciary duties through better quality and more widely available data on sustainability and performance, along with artificial intelligence-based data analytics.

To some extent, ESG ratings and scores have become necessary as proxies due to the difficulties that investors have had historically in accessing comparable data on sustainability performance at investee companies. However, this situation is changing as disclosures on climate and other metrics become mandated in major jurisdictions.

The challenge of creating a functioning market for sustainable finance products “is really an issue about data and the processing of data so that market participants can work out appropriate market actions aligned with their risk appetites”, says Martin Moloney, Secretary General of the International Organisation of Securities Commissions (IOSCO).

“At the best of times, getting good quality information and processing it to understand risks and opportunities is an expensive challenge for markets, and one in which many market participants try to differentiate themselves. If, on top of that, the data you have is not good enough, markets really have a problem.”

If investors need to take a position, they will use the best available information, says Moloney. When the information is not accessible, many turn to ratings, hoping someone else has been able to do what they haven’t. “Securities regulators have always said that ratings are a good part of the market, but don’t get over reliant on them. What we have seen recently in sustainable finance is a strong level of reliance on ratings.”

What are the perceived problems with the methodologies of ratings providers?

Promulgation of different approaches, data inconsistencies, lack of comparability of ESG criteria and rating methodologies, as well as inadequate clarity over how ESG integration affects asset allocation are considerable barriers to supporting long-term value and climate-related objectives, the OECD and IMF report.

Unlike credit ratings, which assess a company’s probability of default, ESG ratings are based on a range of factors, which may differ between ratings providers. Methodologies can be focused on risk or impacts, absolute or relative performance, or other criteria. Companies can receive 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 found that correlation among traditional credit ratings was 0.92, but for ESG ratings it was much lower at 0.61.

In developing ESG scores, ratings providers have to search publicly available ESG information provided by corporates. They will then apply their own methodology to assess and score the company. Investors will often use multiple scores to assess the sustainability of their investments.

IOSCO wants market regulators to push for more transparency around the methodologies that ESG ratings and data product providers use in developing their products. However, data vendors often regard their methodologies as a competitive element and are reluctant to divulge them. Without transparency, investors are unable to challenge methodologies, says the European Securities and Market Association (ESMA)

ESG ratings often suffer from biases, weak correlations, lacking methodology transparency and potential conflicts of interest, says the European Fund and Asset Management Association (EFAMA).

While standardisation is on its way, notably in Europe, says Diane Menville, Head of ESG, Scope Group, it is early days. “ESG scores using the same methodologies – whether focused on risk or impacts, absolute or relative performance, or other criteria – and standardised data should start to converge, repeating the experience of credit ratings which have converged only over time,” she says.

There is a possibility that more institutional investors will use standardised data to create their own bespoke ESG scores, she adds, to meet the different demands and sensitivities of their clients, with divergence becoming a sign of competitive advantage.

However, if investors rely on ESG ratings that they don’t understand, they are in danger of making the wrong decisions and allocating to projects that are not sustainable or do not align with their stated ESG policies.

Just how controversial the issue of ESG ratings can be was demonstrated at the end of last year when Bloomberg published a report on MSCI’s ESG ratings methodology, which suggested that some investors were unclear on how to use the ratings.

How would regulation help investors?

Regulation could ensure data providers are required to be fully transparent about their methodologies. This would help asset managers and asset owners understand exactly how public information has been translated into digestible data.

A regulatory framework for ESG ratings would improve their reliability and accuracy, building upon the company information disclosed under the Corporate Sustainability Reporting Directive (CSRD), says EFAMA. Such a framework would contribute to a common understanding of companies´ ESG performance by information users.

IOSCO’s Moloney says regulators have multiple roles in improving the current situation. “One is to talk to the industry about the key themes of trust, transparency and managing conflicts. We can promote high standards of behaviour by raising awareness of how things can go wrong in those regards and, at jurisdictional level, by challenging behaviours that are sub-par. There are good ways for the industry to manage this kind of situation.”

Regulators can also work to change the situation by promoting the availability of better information, he adds, for example through adoption of disclosure standards. “That is an important second aspect of our approach. Unless we can get better information, the over-reliance on ratings will continue.”

Establishing minimum standards for disclosure, transparency and quality would introduce a common baseline, uncover greenwashing and low-quality approaches and enable investors to choose the ratings provider with an approach that best matches their respective ESG investment strategies and targets, Kristina Rüter, Managing Director and Global Head of Methodology for ISS ESG, the responsible investment arm of the Institutional Shareholder Services (ISS), says.

What are regulators doing to address perceived shortcomings in ESG ratings?

The European Commission committed to regulating the ESG rating sector last year. In early February, ESMA issued a call for evidence on ESG ratings in response to the EC’s announcement. Targeting ESG ratings providers, users of ratings and entities subject to ratings, ESMA says it is hoping to develop a picture of the size, structure, resourcing, revenues and product offerings of ESG ratings providers operating in the European Union.

The authority has been lobbying for action on ESG ratings for some time, concerned about the lack of a legally binding definition and comparability among providers of ESG ratings and of legal requirements to ensure transparency of underlying ratings methodologies. The risks of capital misallocation, product mis-selling and greenwashing are high in the absence of “appropriate legal tools”, says ESMA.

Elsewhere, Japan’s Financial Services Agency has established a subcommittee to formalise discussions with ESG rating and data providers on quality and reliability and the Securities and Exchange Board of India has launched a consultation proposing tighter regulations for ESG rating providers.

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