By Hitesh Patel is Consulting Partner within the Banking, Financial Services, and Insurance practice at TCS in London
Introduction
The relative immaturity of the ESG ratings and data market coupled with the proliferation of rating agencies using different methodologies and frameworks with little to no consensus of what constitutes a globally acceptable standard of quality has given rise to much confusion in the market. This is not serving market participants, investors, and shareholders whose interest in ESG ratings has grown massively over the past two years.
Unsurprisingly, regulatory focus has increased in this space given its current and continued future potential to heavily influence markets, investments, and access to capital. ESG ratings play an important role in screening companies that are included in ESG indices and hence have the power to influence capital flows especially from passive investment funds.
Challenges
The sustainability information currently available serves two sets of users who are not mutually exclusive. It serves those users seeking material information intrinsically linked to the ESG factors of a company. The second set of users are those seeking information of how a company’s activities impact people, communities, society, and the environment in which they operate. The sustainability information ecosystem has been set up to meet the needs of sustainability-related financial risk management. ESG ratings are designed largely to address this perspective as they are not typically designed to gauge a company’s impact on society, but rather measure its relative exposure to various internal and external financial risks as well as opportunities.
Transparency & reliability
The relative weights of “E”, “S”, and “G” and the components within these categories vary between ratings providers. It also does not reflect the understanding or interests of the investors that are beginning to rely on them so heavily. The lack of structure, regulation, and coherence between the various ESG ratings providers is well publicised and demonstrates the immaturity in the ratings market. Ultimately, such widespread disparities create confusion and erode trust in reliability of such information.
There is a lack of consistency between the methodologies employed by various rating providers making comparison opaque. ESG data providers can also change their methodologies without a consultation. ESG data providers should consider disclosing their methodologies to their users, to enhance transparency. Equally important, users should rigorously interrogate the data and perform in-depth due diligence, using a minimum of at least two to three different providers for each underlying security before they make any conclusions on a company’s ESG rating. Users of data must have a very clear understanding of where and how ESG ratings are being used within the organisation and for what purpose and should have appropriate governance and control measures to handle data quality issues and discrepancies.
There is also an increasing use of machine learning and natural language processing by providers to extract ESG information from companies reports. ESG data providers as well as users of the data need to be comfortable with the quality and accuracy of such processes and should ensure that measures are in place to identify errors. ESG data providers should carry out a self-assessment of their processes and where appropriate tighten their governance and control processes and documentation.
Conflicts of interest
Users of ESG data should be aware of both the actual and perceived conflicts of interest in the ESG market. Some of these data providers tend to be part of advisory firms who assist clients with their ESG needs and climate strategy challenges.
It is important from the outset that the correct framework, quality assurance, governance and controls are set and understood and that conflicts of interest are minimised as far as possible to avoid a repeat of the crediting ratings and methodology issues in the CDO market observed the 2008 financial crisis.
The management and mitigation of these conflicts of interest will be important in developing trust, reliability, transparency, and confidence in the data, all of which will contribute to better outcomes for the industry, shareholders, and society. Firms should focus on their climate strategy and how they achieve their net-zero targets. Achieving “better” ESG ratings should not be the primary focus even though benefits of doing so are recognised. Being able to meet both their climate targets as well as achieving better ESG ratings may be challenging for some firms.
Designing their climate frameworks to achieve better ESG ratings rather than their ultimate net-zero goals will not lead to healthy outcomes for firms and their shareholders in the long-run.
State of the Market
There are three main types of ESG rating agencies that exist in the market currently – fundamental data providers (offers a broad range of publicly available climate/ ESG information), comprehensive data providers (offers both publicly available data and proprietary data) and specialized data providers (offers custom and specific climate related data). The UK’s International Regulatory Strategy Group (IRSG) is voicing their concerns to regulate the industry in lieu of the lack of clarity, transparency, and consistency in data for investors. The European Commission has launched an initiative to act on the credibility and quality of ESG ratings which has gained support from organisations like ESMA and EIOPA. UK’s FCA has also indicated that there is clear need for regulation on ESG ratings and will work towards the same along with the Treasury on bringing in legislation.
While ESG ratings were created in response to stakeholder response, they serve various purposes. They help in meeting investor mandates, provide third party review and verification, narrate scenarios, and anticipate future climate regulation. The ratings also help investigate how sustainable/ green the firm’s supply chain is. Well-structured ratings can help the transition of an economy into an ESG-centric one.
Volume of rating agencies
The ESG related product and services market has evolved rapidly over the last few years. With more than 600 of these products that differ in terms of size, complexity and relevance, there exists large discrepancies among the scores that corporates receive from these agencies.
While these ESG related products and services seek to achieve the same thing – successfully report the firm’s credentials, inconsistencies in the methodologies and frameworks used by these rating agencies and consultancies tell very different stories about the firm’s credentials.
One of the biggest challenges that this market faces is dearth of regulation for ESG criteria. To cite examples, Sustainalytics considers 250 ESG related issues, S&P looks at 30 focus areas while MSCI attributes 35 ESG indicators for each industry. This does not allow for easy comparison among rating agencies. In addition to this, most of the rating agencies do not disclose detailed methodology updates (tools used, factors weighed, units measured, specific indicators) which only adds to the confusion amongst market participants.
How corporates can use ESG ratings
For corporates, ESG ratings function as a beneficial tool to guide decision making and to monitor and improve on sustainability performance. It can also be used to evaluate the firm’s own ESG performance and how it compares with its competitors which acts as a stimulant to promote ESG practices. Investors use ESG scores to make financial decisions. Low ESG ratings can be a signal to stakeholders that the firm is “unsustainable” and can potentially result in a security being excluded from a portfolio, adversely impacting the business.
The way forward
Clearly the lack of standardisation and common framework gives rise to some core steps which need to be resolved collaboratively between all interested parties (the regulators, the rating agencies, shareholders, investors, and local government) if these ratings are to be used in a reliable and informative manner. Below are four steps that would help us all use ESG information more reliably and ultimately help us make better and more informed financial decisions.
- Increased transparency over ESG ratings and associated methodologies is required. Data quality standards need to be implemented globally to facilitate comparison of information.
- The market and its users are calling for an increased understanding of the varying uses of sustainability information which will require education and time.
- Independent assurance of ESG rating and data providers in a similar fashion that is done for financial reporting.
- Lastly, the development of standardised sustainable finance taxonomies to help eliminate confusion and facilitate comparison for shareholders and investors alike.
Scrutiny in this space is expected to increase and regulated firms should expect to see queries increase from their respective local supervisors. Data providers and rating agencies should conduct their own self-assessments and be prepared for challenges from the regulators. Having full documentation and showing improvement in the quality of their governance and control procedures will only help foster a healthy relationship with their local regulators and supervisors.
It would be prudent if the Reporting Standards under the CSRD are aligned with the proposed international sustainability reporting standards to ensure that consistency of information collected and used by the industry. Using the CSRD would promote the development of a consistent and uniform approach with standardised information. This would increase transparency in ESG ratings among its users, investors and market participants and would reduce the overall cost of due diligence and compliance in ESG ratings.
About the Author
Hitesh Patel is Consulting Partner within the Banking, Financial Services, and Insurance practice at TCS in London. He has over 17 years of experience spanning capital markets risk management covering market and credit risk and regulatory and risk advisory. Prior to joining TCS, Hitesh managed and led several risk and regulatory transformation engagements for Deloitte’ tier one banking clients. Prior to Deloitte Hitesh worked as a risk manager at Deutsche Bank and Barclays in London.
