Regulatory efforts to bring increased clarity and consistency to the burgeoning ESG ratings market are a welcome development, writes Marie Kemplay.
What is happening?
On March 30, the UK Treasury opened a consultation on the future regulatory regime for environmental, social and governance (ESG) ratings providers, which would see ESG ratings brought within the regulatory remit of the Financial Conduct Authority (FCA). The FCA had already been working on a voluntary code of conduct for the sector since November 2022.
The UK is not the only jurisdiction introducing increased oversight measures for the ESG ratings sector — in February, the Securities and Exchange Board of India came forward with a proposed regulatory framework on ESG ratings in the securities market. After an extensive consultation last year, the European Commission (EC) is expected to table legislative proposals within the coming months. Japan’s Financial Services Agency has also published a voluntary code for ESG ratings and data providers operating within the country.
Why is it happening?
The use of ESG metrics by investors, and other financial market participants, to better understand the sustainability credentials of companies and securities has grown considerably in recent years, with them becoming almost as ubiquitous as more traditional credit ratings. Yet, despite — or perhaps because of — the sector’s rapid and substantial expansion, there are concerns about the clarity and quality of the ratings being provided.
On the face of it, there is a strong resemblance between credit and ESG ratings, as they both represent the process of distilling multiple datapoints into overarching scores or ratings. But this apparent similarity is misleading.
For instance, while it is arguably possible to effectively aggregate creditworthiness risk factors into a single credit score, assessing ESG is far more multidimensional. Components of ESG scores can pull ratings in opposing directions — for example, a business might be engaged in environmentally positive activities, but there may be concerns about how it treats its workforce. There is also arguably greater scope for subjectivity and differing interpretations when assessing ESG criteria, particularly given the novel nature of some of the factors being assessed.
More generally, there are concerns about methodological ambiguity and potential conflicts of interest, for example, where an ESG ratings provider also provides advice to the rated entity on how to make improvements to their score.
While none of this is to denigrate the work of any individual agency, or suggest ESG ratings do not provide useful information, momentum is building behind the idea that there should be greater clarity about exactly what agencies are measuring and how, as well as there being minimum standards providers should adhere to.
A November 2022 paper from the International Organization of Securities Commissions examining the sector found there is “little clarity and alignment on definitions, including what ratings or data products intend to measure”, and called for greater oversight of the industry.
What do the bankers say?
We know that ESG ratings are being used frequently. For instance, a 2020 report from SustainAbility (part of sustainability consultancy ERM) found that 65% of institutional investors it surveyed use them at least once a week.
Yet, it seems that many users still harbour reservations about them. In an EC consultation last year, more than 84% of respondents believed the market was not functioning well, with a similar proportion supporting legislative intervention.
Will it provide the incentives?
There is unlikely to be much objection from banks and other financial institutions to there being greater clarity in how this sector operates. Many major regulators seem to have already reached a clear verdict that greater oversight is needed, so the focus for ratings providers is now likely to be on pushing for that oft-prized objective in regulation — principles-based and outcomes-focused rules, rather than highly prescriptive frameworks.
There is the risk that one major area of confusion could remain unless regulators tackle it head on — the vexed issue of impact and materiality. The primary concern for corporates and financiers is likely to be how ESG factors or risks will affect a company and its financial performance, whereas the wider population will be far more interested in what impact a business has on society and the environment.
ESG ratings typically measure the former and not the latter, creating a major source of confusion about what a ‘good’ or ‘bad’ ESG rating really means. Clearing up this misunderstanding is unlikely to be the regulators’ main priority in policing this sector — but ignoring it risks exacerbating existing criticisms about corporate greenwashing.
