The ESG ratings challenge Phiroza Katrak

As investors become more sensitive to the potential physical and financial impacts of climate change and ESG risks while in response to surging demand for ESG coverage, there has been sizeable growth in the number of data and ratings/scores in this area. The providers include established players such as credit rating agencies (directly or through subsidiaries/affiliates), exchanges and trading platforms, and analytics and research companies.

What should investors relying on ESG ratings or data and wishing to better understand the inherent long-term risks and opportunities in their investments bear in mind? First, that in contrast to financial reporting for which there are global standards, ESG disclosure and reporting by companies is a relatively new development. A lack of standardised criteria and disclosure requirements mean that ratings providers’ methodologies vary in terms of the ESG topics covered by their analysis, the weighting given to the ‘E’, ‘S’ and ‘G’ pillars and their underlying ‘themes’, and the metrics used to measure ESG performance. In addition, at the current time, the activities of ESG ratings and data products providers are not generally subject to regulatory oversight.

Recognising that a lack of standards combined with little regulatory oversight in this area could present the risk of greenwashing or misallocation of assets and lead to a lack of trust in ESG ratings and data products, the International Organisation of Securities Commissions (IOSCO) conducted a fact-finding exercise and issued its report in November. The exercise revealed:

  • there is little clarity and alignment on definitions, including on what ratings or data products intend to measure
  • a lack of transparency about the methodologies used
  • uneven coverage of products offered; certain industries or geographical areas are more widely covered than others resulting in gaps for investors
  • there may be concerns about the management of conflicts of interest
  • better communication with companies that are the subject of ESG ratings or data products was identified as meriting further attention.

There are recommendations in the IOSCO report for the consideration of regulators, for ESG data and ratings providers, for entities covered by ESG assessments and for market participants using ESG ratings and data products. These include regulators focusing more attention on products and providers in their jurisdiction; providers adopting, implementing and providing transparency around methodologies for their ESG ratings and data products; market participants conducting due diligence and reviewing information which they receive and use in their internal processes.

The UK government’s paper “Greening Finance: A Roadmap to Sustainable Investing” issued in October 2021 observes that there are typically more data gaps and assumptions made in producing ESG ratings than, for example, credit ratings. As ESG ratings become increasingly important to the investment process, it is essential that data and ratings are delivered transparently and that providers have strong governance and manage conflicts of interests. The government is considering bringing ESG data and rating firms into the scope of FCA authorisation and regulation for which further detail will be issued next year. The FCA is also working with HM Treasury on the development of a sustainable investment labelling regime.

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