A proposed European Union shake-up of the environmental, social and governance (ESG) ratings industry will bring much-needed transparency but fall short of the standardisation some in the market say is needed to stop the scores confusing investors and companies.
The market for assessing companies' ESG performance has boomed as investors pour money into products marketed as sustainable - swelling the coffers of nearly 60 providers globally including MSCI, S&P Global and ISS.
However, eight in ten respondents to a European Commission survey last year said the system was not functioning well. Critics point towards often divergent scores for the same company and little transparency about how providers determine their ratings.
More than 90% of respondents said intervention was needed, and on Tuesday the EU announced new rules for the largely unregulated industry, including requiring providers to publish their methodologies.
The companies will be regulated by the European Securities and Markets Authority (ESMA) and - in what could force some to restructure - they must stop providing credit ratings, consulting services and the development of benchmarks, among other things, to prevent conflicts of interest.
The new rules, however, stop short of seeking to harmonise ESG providers' methodologies to ensure a "variety of approaches" is available.
'A Promising Blueprint'
"By opting for transparency over standardisation, the EU's proposals are a promising blueprint, but they must go all the way," said Daniel Klier, CEO of data provider ESG Book.
Ratings providers, he said, needed to reveal the data and information used to calculate the scores if investors and companies are to understand exactly what lies behind a rating.
"Without this information, nobody can mark ESG ratings providers' homework," he added.
ISS said in a statement on Thursday that it welcomed the EU's effort to allow for a variety of ESG rating opinions and supported it "in not setting minimum requirements on the content of ESG ratings".
MSCI said this week it was examining the potential impact of the rules on its business, while S&P Global said it was looking forward to working with policymakers.
The EU's draft legislation comes after recommendations in 2021 made by IOSCO, which groups securities regulators, to help combat 'greenwashing'. Britain launched a consultation this year proposing to regulate providers.
Baby Steps
ESG ratings typically measure a company's exposure to and management of financially relevant ESG factors - anything from carbon emissions to data privacy and board diversity. Every provider will weight these factors differently. Only a few will measure a company's impact on the environment and the outside world.
This all leads to confusion among investors who may be surprised that an ESG fund can hold oil or mining stocks, or wonder why the same electric carmaker can be simultaneously ranked as less and more ESG-friendly than a combustion engine-reliant rival.
"As long as ratings are not comparable, you have the ability to cherry pick the ratings you like," said Liberum Capital investment strategist Joachim Klement, calling the draft rules "baby steps" towards eventual standardisation.
"The long-term aim is to harmonise the way ratings work... and undermine 'greenwashing'," he said, adding that the new rules should mean lower fees for investors who use ratings.
Daniel Cash, an academic at Aston University and an expert on the industry, saw authorities' "end-goal" as mirroring the credit ratings industry, where a small group of companies dominate, meaning "much less 'noise' and much more comparability".
Not everyone is convinced about standardising ESG scoring, though, arguing ESG ratings are inherently more subjective than the quantitative scoring used to assess sovereign or corporate debt.
Sonja Gibbs, head of sustainable finance at the Institute of International Finance, said regulators in different jurisdictions needed to "take care to preserve the independence of ratings providers' methodologies". She said doing so was "crucial for sustainable finance markets".
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