How regulation can help clear the fog of ESG ratings

The quality, consistency and accuracy of relevant information that banks and investors use is, of course, critical. But today, while there is a vast range of possible data sources, their accuracy and detail remain, in many cases, uncertain. However, in my view, making environmental, social and governance (ESG) information clearer and more reliable is essential. The estimated scale of ESG-related assets under management (AUM) by 2030 is predicted to be anywhere between $60tn and $80tn. That’s equivalent to a third of all global investment assets. 

With a market set to achieve this scale, we’ve seen a significant rise in the number of ESG ratings agencies. However, these agencies remain, as yet, unregulated. And too often, their sustainability assessments are inconsistent and opaque. 

Without knowing how a rating agency achieves its assessment, it is hard for banks to take a consistent view of ESG performance and risks. It’s equally challenging for companies to understand the criteria used to assess them. The absence of clarity and standardisation also makes it possible for companies to ‘greenwash’: portraying some of their activities in a favourable light, emphasising where they perform well, and downplaying other, less positive, indicators.

Based on my conversations with financial services firms across Europe, there is now a clear desire globally for regulatory initiatives that will bring great consistency and standardisation to ESG ratings. The question is, what should regulations seek to achieve? That’s precisely the challenge that the International Regulatory Strategy Group (IRSG), has set out to address in its recent report, produced in partnership with Accenture, which explores the possibilities of ESG ratings. The report calls for a “principles-based and proportionate set of rules” that seeks to create a more transparent and standardised system, without stifling the innovation that addressing such a complex market undoubtedly requires.  

For example, rather than seeking to impose a methodology on how agencies calculate their ratings, it would be preferable to make each unique methodology transparent. I think it’s essential that ESG ratings agencies are free to pursue a proprietary approach. But they should also, in my view, have to make sure that investors understand how they make their calculations and what criteria they select to arrive at a rating.

The IRSG report draws on a comprehensive analysis and survey of the ESG ratings market in the UK. And based on the findings, the IRSG has put forward five clear recommendations that regulators’ should take into consideration as they develop their approach to ESG ratings. 

• Consistency and scope: aligning on the definitions for terms used in ESG ratings is essential to enable common understanding across the industry. Agencies need to work with one another to develop consistent terminology, which the industry, regulators and policy-makers can then adopt, so that all have a common language.

• Collaboration and co-ordination: as ESG remains a fast-developing area, agencies, policy-makers and financial services businesses need to work together to help ensure that regulations reflect that relevant ratings are likely to change and develop over time. It is equally essential that these efforts are internationally co-ordinated so that similar standards apply internationally, with regulators across jurisdictions working together as the market develops.

• Transparency: understanding how an agency arrives at its rating, as well as its objectives, is vital for investors and banks to make informed decisions. That may include separating out ESG criteria as the relationship between these can be complex. An organisation’s performance in one area may have a bearing on the others. The decision to shut down a polluting asset might have social ramifications from employment being lost, for example. Transparency could also apply to how ESG ratings agencies market their products. 

• Data standardisation: the quality, consistency and availability of data used to create ESG ratings is fundamental. Improving it requires all market participants to work together. Global requirements for data collection and disclosure need to meet global standards (such as those compiled by the International Sustainability Standards Board). Standardisation could also help companies to develop a more consistent and organisation-wide approach to data collection. Today, efforts are often focused on specific areas, resulting in data silos. That could lead to challenges down the line, with multiple datasets in use throughout an organisation. 

• Investor protection: while the majority of rating agencies’ customers will be institutional investors, it is also important to address the needs of retail investors, particularly as sustainable investing becomes increasingly popular. Ratings agencies must make a clear distinction between products that gauge risk and those that assess ESG impacts. ESG risk products assess what might affect a company’s performance and ESG ratings assess an organisation’s environmental and social impact. Retail investors often confuse these two, so how ESG ratings and risk assessments are communicated and marketed needs to be carefully monitored. 

I believe that ratings agencies have an extremely important part to play in supporting a transparent and efficient market for sustainable investing. To support them to do that, it is essential that effective and pragmatic regulation can help cement their role of providing reliable and trustworthy analysis. And, in the end, that will be good for investors, businesses and the ratings agencies themselves. 

A Speaker’s Corner: A Speakers’ Corner is an area where open-air public speaking, debate and discussion are allowed. The original and most noted is in the north-east of Hyde Park in London

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