The ESG Ratings Debate Heats Up

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Regulators are sharpening their focus on the growing importance of ESG data providers due to the subjective nature of how ratings are calculated. Last week, however, leading ESG ratings providers such as MSCI and the London Stock Exchange Group hit back at the European Union’s consultation on regulating the sector despite agreeing there was a need for some form of EU-level intervention.

Instead of full-blown regulation of ESG data providers, both said a code of conduct would be more appropriate for firms in the space, a view supported by Morningstar, owner of Sustainalytics. S&P Global did not respond to the question about whether it supported regulatory intervention but added that many problems stem from the “lack of standardized non-financial disclosure by companies”.

The responses come following the consultation from the European Securities Market Authority (ESMA) which found almost all respondents 97% believe that ESG data providers should be subject to minimum disclosure requirements in relation to their methodologies. According to ESMA, there are currently 59 ESG data providers operating across the EU, all with different methodologies and ways of interpreting data from companies. The European Commission launched the consultation in April, requesting feedback on measures including transparency and methodologies adopted by ESG rating providers. The regulation of data providers and the need to provide transparent and consistent ESG data has been a hotly contested topic in recent months.

In July, the European Securities and Market Authority (ESMA) said it was seeing “growing momentum” among regulatory bodies to address the issues of ESG rating providers after their shortcomings were again exposed in recent industry feedback. Overall, the consultation received 168 responses from ESG rating providers and ESG rating users including private companies, central banks, public authorities and non-government organizations from across Europe. The consultation found 81% use ESG ratings mostly or exclusively from large market players, while 60% agreed the current market conditions make it difficult for smaller market players to enter the market. 83% of respondents said a lack of transparency on the methodologies used is an issue in the ESG data provider space while 80% warned the market is prone to potential conflicts of interest.

This view has been supported by local regulators such as the Financial Conduct Authority (FCA) and the Autorité des marchés financiers (AMF) with the UK regulator stating there is a “clear rationale” to introduce regulation of ESG data providers. “This regulation should include transparency requirements on methodologies, the underlying data used (source and nature) and the objectives of the products (notably risk or impact),” the AMF stressed. “It should also include requirements for conflict-of-interest management, internal control procedures and enhanced dialogue with companies that are subject to ESG ratings.”

Although there are many organizations that provide ESG ratings, there is currently no one standard approach. ESG ratings providers use internal guidelines to inform their ratings, and therefore weight is placed on varying factors dependent on the providers, resulting in a lack of consistency across the board.

ESG is a highly subjective topic in itself but it is logical that some form of regulation is required to ensure ESG data providers are fully transparent with their methodologies. Companies need a greater understanding when looking to improve their ESG credentials, the recent Elon Musk heated exchange with S&P would potentially have been avoided.

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In late July The Financial Markets Standards Board (“FMSB”) published a Spotlight Review which examined ESG ratings methodologies and data collection processes. The rapidly growing market for ESG-related products and the desire of financial institutions to manage their exposure to ESG-related risks has heightened the importance of, and demand for, ESG ratings.

This paper seeks to facilitate greater transparency of ESG ratings methodologies and data collection processes to enhance understanding of ESG ratings and facilitate comparability across ratings providers in wholesale financial markets. The Review builds on an existing body of work produced by regulators, standard-setters and industry participants. The Spotlight Review highlights the varied use cases of ESG ratings, issues associated with limited transparency and market understanding of ratings, the different objectives of rating products, the diversity between products with similar objectives, the impact of controversies on an issuer’s ESG rating can be material but little-understood, efforts to increase issuer ESG disclosure are likely to improve the quality of ESG ratings and greater transparency helps to drive market solutions.

Most passive index tracking investors would probably support regulators sharpening their focus on the growing importance of ESG data providers due to the subjective nature of how ratings are calculated, a process that is at odds with rules-based index-tracking ESG passive products such as ETFs.

Some investors though are being vocal about their view that regulating ESG data will not solve sustainability challenges citing that trying to quantify sustainability is difficult and even dangerous. ESG issues and Sustainability are ultimately a complex societal challenge, and it is human nature to try and understand complex challenges by boiling them down to simple and understandable concepts, scores and ratings. If we can measure it and we can see it, then we can analyse it and manage it. But in the world of sustainability, everything is uncertain, changeable and open to interpretation. A significant proportion of ratings and data in the world of sustainability and ESG is not data, it is opinion. It will clearly be challenging for regulators to try and regulate opinion.

Across different investor pools a commonly held believe is that there needs to be continued changes to behaviours and incentive structures. Companies need to provide open, honest and accurate information to end users about the impacts of both their business operations and their products and services. Data providers need to have clear and transparent methodologies. We need a competitive marketplace for sustainability analysis that fosters deeper investment insights and avoids monopolies. We need investors with the skills and capacity to look critically at sustainability ratings and ESG data, and to use them with precision and purpose rather than for convenience or to “fit” current perceived end investor’s buying motivations.

More forward-thinking investors are increasingly building out their own ESG and Sustainability research, data analysis and risk control functions. Third party provider’s ratings and data may remain an important input into their processes but driving their own analysis is now very much their key objective.

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