Sustainability/ESG ratings: does the market measure up?

As we discuss below, there is a lack of consistent terminology in the market. For the purposes of this article, we use the term “ESG ratings” to describe any ratings products related to ESG or sustainability performance.

_{Policymaker investigation}

With the market for such products largely unregulated, policymakers have been taking a closer interest in the burgeoning ESG ratings industry. Key initiatives include:

• The European Commission undertook an in-depth study of the sustainability-related ratings, data and research industry, pursuant to Action 6(3) of the 2018 Sustainable Finance Action Plan (COM/2018/097). It published its report in January 2021 (EC report).
• In the 2021 Strategy for Financing the Transition (COM/2021/390), the Commission announced it would take action to improve the reliability and comparability of the ESG ratings market. A consultation on how ESG ratings are used by market participants and on the functioning of the market was recently published.¹
• The European Securities and Markets Authority (ESMA) launched a consultation on the market characteristics for ESG ratings providers in the EU (ESMA80-416-250) in February 2022. The supervisory authority is expected to report its findings by the end of Q2 2022.
• The French and Dutch financial regulators published a position paper in 2020 on ESG ratings (AMF-AFM paper) calling for EU-wide regulation of the market.
• The UK Financial Conduct Authority sought feedback in 2021 on whether to intervene in the market in their consultation on enhancing climate change disclosures (CP21/18). Its feedback is expected by mid-2022.
• The UK government announced that it was considering bringing ESG ratings providers within the FCA's regulatory perimeter in its October 2021 Greening Finance Roadmap. Further detail is expected in 2022.
• The International Organization of Securities Commissions (IOSCO) undertook research on the implications of the ESG ratings and data market for financial markets. Its November 2021 report (IOSCO report) included a series of recommendations for securities markets regulators, ESG ratings and data product providers and other stakeholders.

These are complemented by a large body of academic and practitioner research into the challenges facing the ESG ratings market.

_{Key issues within the ESG ratings market}

We summarise some of the key concerns on the ESG ratings market from the literature below.

What exactly is an ESG or sustainability rating?

There are no consistent, commonly agreed terms used to describe the products available in the ESG ratings market, or even what is meant by “ESG”, “sustainability” or “responsible investment”.

Neither is there a consistent framework for what ESG ratings are intended to measure. Ratings can relate to specific topics within the ESG universe (eg greenhouse gas emissions) or can purport to assess all aspects of “E, S and G”, with the elements assessed in the latter differing from provider to provider. There is a lack of consistency on what is being measured (eg exposure to ESG risk, impact of ESG factors or positive contribution to sustainability objectives). The sheer breadth of indicators used to measure performance also raises the question of whether ratings are sufficiently material and context-relevant.

Lack of transparency on methodology

Opacity of the methodologies underpinning ESG ratings is widely noted as a potential problem. Many ratings providers do not publish indicators or weightings, although the EC report notes that more detail may be available from some providers at an additional cost. Users have said they would like greater transparency and better access to the data sets used to produce the ratings, with rated companies concerned that methodologies do not sufficiently consider context or that they do not fully reflect ESG/sustainability performance. This lack of transparency could mean that users are not able to verify or fully evaluate the suitability of a rating for their context. Regulators have also noted they need this information to monitor the market.

The research also reveals concerns around lack of visibility on approach to missing data and changes in methodology. The AMF-AFM paper notes that it is not always clear whether ratings providers are using estimates or downgrading ratings in the absence of responses from rated companies.

Low correlation between providers

ESG ratings exhibit low levels of correlation compared with credit ratings. In one of the leading papers in this area, Berg et al (2020)² found that the average correlation from six key providers was 0.54%? (with a range of 0.38 and 0.71) as compared to a 99% correlation for credit ratings. This low correlation is broadly recognised across the market according to the EC report.

Given the comparative complexity and nascency of the ESG ratings market compared with the credit ratings market, this divergence seems unsurprising. Other factors that may be contributing to the low correlation include lack of standardisation discussed above, varying approaches to methodologies and lack of consistent, mandatory disclosure requirements. Whilst one study shows that greater disclosure could increase divergence based on largely voluntary or unstandardised corporate disclosure (Christensen et al, 2020)³ it will be interesting to observe whether the International Sustainability Standards Board's new global reporting baseline will help improve the quality of underlying data.

Conflicts of interest

Policymakers are concerned with the potential for conflicts of interest in the current unregulated state of the market. Several factors give rise to this possibility, including:

• Lack of methodology governance: Lack of robust governance, such as codes of conduct and committee structures, could result in an inappropriate application of methodologies.
• Additional services: Some ratings providers provide services such as corporate ESG strategy and verification services alongside the ratings. The IOSCO report notes that this could result in a conflict of consulting and ratings businesses are not adequately separated.
• Remuneration models: Subscription-based remuneration models (ie where the user pays for the product) create potential pressure for the provider to deliver a rating where the underlying data is not sufficient.
• Ownership structures: Conflicts of interest could arise where parent companies of the ratings provider have an interest in the rated companies.

Potential for bias

Studies have found that ESG ratings can exhibit the following biases:

• Size: Large and listed companies tend to obtain higher ratings than smaller companies.
• Geographical: Higher results appear in jurisdictions where there are more comprehensive disclosure requirements, with the EC report noting European companies often receive higher results than elsewhere.
• Industry: Ratings can be normalised by industry, however, this can mean that company-specific elements are not adequately reflected in the rating. The EC report also found a perception of bias against sectors with higher CO2 emissions.

Communication with rated companies

Rated companies are concerned about the quality of communication with ratings providers. This ranges from companies being inundated with ESG questionnaires, lack of communication over timing of ratings or how data provided will be used and lack of opportunity to review the final report for factual accuracy prior to publication.

_{Potential regulation on the way?}

Whilst no specific legislative or regulatory proposals have been announced yet in relation to the ESG ratings market, the policymaker reports point to some kind of intervention in the future.

It seems likely that some ESG ratings providers will be brought under regulator supervision. The UK has clearly signalled its intentions in this regard, and IOSCO has exhorted regulators to consider whether they have sufficient regulatory oversight of providers. The tenor of EU policymaker commentary suggests they are concerned about the concentration of major ratings providers outside of their jurisdiction. It will be interesting to see whether the EU will require EU financial institutions to use ESG ratings from ESMA registered/certified providers, akin to the Credit Rating Agency Regulation (Reg (EC) 1060/2009, as amended) approach, or if it will decide that certain systemically important providers must come under EU supervision, similar to derivatives central clearing counterparties.

Some of the issues identified with the ESG market will sound familiar to those with experience of the regulation of benchmarks and proprietary indices in the past decade. It is conceivable that policymakers could introduce similar interventions, such as:

• transparency requirements around methodological and input data approaches;
• clearer disclosure of what the rating intends to measure;
• requirements to identify and manage potential conflicts of interest; – introduction of internal governance and oversight structures; and
• mandatory complaints procedures.

Whether these would take the form of regulation or a set of IOSCO principles akin to the Principles for Financial Benchmarks is unclear at this stage. Policymakers could also seek to encourage industry-led solutions such as codes of conduct or a standardised definition of terms.

Whilst policymakers appear to be alive to the dangers of suppressing innovation or market concentration with a heavily prescriptive approach, there have been some calls for regulatory intervention to encompass the wider range of ESG data products, including controversy alerts, screening and taxonomy-related tools.

ESG ratings have a critical role to play in achieving sustainability objectives, but that rising importance makes it increasingly likely that regulatory intervention is on the way. Given the global nature of the demand for metrics on ESG/sustainability performance, a fragmented regulatory regime could impede one of the ultimate objectives of sustainable finance regulation – that is, channelling capital flows towards the transition to a sustainable economy. Policymakers will need to walk a fine line between enhancing the transparency and robustness of the market and adding another hurdle in the path to a sustainable future.

Author: Kelly Sporn

¹ Updated from the original journal article to reflect that an expected consultation had been published.

² Berg, F, Kölbel, J and Rigobon, R (2020) Aggregate Confusion: The Divergence of ESG Ratings. Available at: dx.doi.org/10.2139/ssrn.343853

³ Christensen, DM, Serafeim, G and Sikochi, A (2021), Why is Corporate Virtue in the Eye of the Beholder? The Case of ESG Ratings. Available at: https://doi.org/10.2308/TAR-2019-0506