Are ESG ratings reliable? The next wave of ESG regulations

ESMA has published a letter to the European Commission (EC) recommending a further wave of ESG regulation concerning ESG ratings and scores.

ESMA is concerned about the quality and robustness of ESG ratings. Unreliable scores might facilitate "greenwashing"; the problem of brown investments being misbranded and sold as green. 

Asset managers will be required to disclose ESG information to their investors via the Sustainable Finance Disclosure Regulation. However, the availability of ESG information from investee companies is currently inconsistent and in many cases unavailable. Company reporting under the Taxonomy Regulation should partially remedy that problem. The EC is considering going further by mandating a broader array of company ESG reporting under the Non-Financial Reporting Directive.

Sitting between the asset manager and investee companies are ESG rating providers that consolidate companies’ ESG information and churn out scores. ESG rating providers aim to give the market readily available means by which to judge and compare investee companies’ ESG performance.

ESMA’s letter states its specific concerns and proposes a legal framework to address the following issues:

• the lack of a legally binding definition of ESG ratings and the lack of comparability between data providers;
• the lack of transparency of the methodologies that underly ESG scores;
• potential conflicts of interest in ratings providers; and
• the unavailability of legal tools to address capital misallocation, mis-selling and greenwashing.

How might businesses be affected?

ESMA suggests that data providers should be brought under supervision and made subject to organisational and conflicts of interest rules. Smaller ratings providers could be exempted from some of the requirements placed on systemic providers.

The proposed framework, which is comparable to the EU’s credit ratings agency regulations, could have direct and indirect consequences for asset managers.

First, bringing greater transparency to ESG ratings could help asset managers to better achieve their investors’ ESG objectives, to market more reliable ESG products and to comply with increasing regulatory demands.

Second, scaling the requirements on larger and smaller ESG ratings providers might introduce more competition in the market and help bring down the high price of procuring ESG data. Conversely more restrictive regulations could reduce competition by stifling entrants into the market and thereby increase the costs of market data.

Finally, asset managers that are undertaking proprietary ESG scoring programmes might be caught by the regulations in a way that is comparable to the EU Benchmarks Regulation. At the very least, those managers that seek to license their ESG ratings and to sell them to third parties will need to register and be supervised as an ESG ratings provider.