Unlocking the potential of ESG ratings

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Arnaud Houdmont, Director of Communication, BETTER FINANCE, decodes the latest proposal from the European Commission assessing its promise, and its problems.

It is an undeniable reality that our planet is confronted with severe challenges, primarily driven by human-induced climate change. The global demand for sustainable solutions and the fight against climate change requires collective action from citizens, consumers, and industries.

The finance industry has recognised the increasing demand for environmentally friendly and socially responsible investment products. Individual investors, motivated by a desire to invest their savings responsibly, are actively seeking financial institutions that offer ethical funds. This has given rise to the phenomenon known as ESG investing, which stands for Environmental, Social, and Corporate Governance factors.

“The global demand for sustainable solutions and the fight against climate change requires collective action”

ESG investing emerged in 2005 following a UN request for guidelines on integrating sustainability and ethical considerations into finance. It revolves around three key criteria used by socially responsible investors to evaluate the impact of their investments. However, despite its noble intentions, the assessment of financial products through ESG ratings is not immune to flaws and deceptive practices.

A 2020 study conducted by BETTER FINANCE aimed to identify “greenwashers,” entities that falsely make environmental claims. However, the study faced significant obstacles due to substantial disparities found among different ESG ratings. The core issue lies in the lack of consensus regarding what truly constitutes a sustainable investment and how ESG criteria should be applied. This ambiguity allows for manipulation and greenwashing, thereby undermining the credibility of ESG ratings.

“The finance industry has recognised the increasing demand for environmentally friendly and socially responsible investment products”

The evaluation of companies based on ESG criteria presents numerous complexities. Very few companies can claim a flawless environmental and social track record with zero emissions. Rating companies against ESG criteria requires a delicate balancing act that takes into account numerous factors. For example, consider Company A, which has maintained near-zero CO2 emissions for years, and Company B, which has steadily reduced its emissions but still emits more CO2 than Company A. Intuitively, one may assign a higher score to Company A due to its lower absolute impact on climate change. However, Company B’s consistent efforts towards sustainability and environmental friendliness should not be overlooked and may well grant it a higher ESG Rating than Company A.

Complicating matters further, ESG rating providers often compare companies to their peers within the same industry rather than assessing them in the context of the broader economy. This practice can be highly deceptive, as a fossil fuel company may achieve a high rating within its peer group of fossil fuel companies, and obtain a higher score than, for instance, a wind-energy company with a lower ESG score compared to its renewable energy counterparts.

To address the expanding ESG ratings market, foster transparency, and provide clarity for investors, the European Commission has proposed a regulation. This regulation has both promising and concerning aspects for investors seeking ethical funds. One notable aspect is the requirement for EU-based ESG rating providers to obtain authorisation from the European Securities and Markets Authority (ESMA). Similarly, third-country entities offering these services must establish equivalence agreements with both their jurisdiction and the EU. This move aims to enhance accountability and transparency, reduce inconsistencies that breed confusion among investors, and decrease the risk of greenwashing.

“A significant shortcoming of the regulation is the lack of harmonization in the methodologies used for creating ESG ratings”

However, a significant shortcoming of the regulation is the lack of harmonization in the methodologies used for creating ESG ratings. While transparency and disclosure requirements are emphasized, ESG rating providers retain complete control over their methodologies and selection processes, providing little guidance to retail investors. Without substantial support, investors and stakeholders are left to navigate the maze of differing ESG ratings and methodologies, hindering their ability to effectively distinguish between them.

Drawing from past experiences, such as the Sustainable Finance Disclosure Regulation (SFDR), policymakers must ensure that the proposed ESG ratings adequately address investor needs for accessible and easily comparable information. The risk of ESG ratings becoming mere labelling tools, as experienced with SFDR, must be avoided at all costs. Clarity and comprehensibility should be paramount, with information presented in a manner understandable to the average recipient. Legal loopholes that allow providers to withhold information should also be avoided, as they erode trust in the ESG ratings market and undermine the purpose of the regulation.

Conflicts of interest also deserve attention within the proposed regulation. It distinguishes between investor-paid and issuer-paid ratings, recognising the potential for conflicts of interest in the latter model. To mitigate such conflicts, clear labelling of ratings paid for by issuers or fund managers is mandated in the proposed Regulation. Additionally, the separation of ESG rating activities from other potentially conflicting business activities is required, alongside the establishment of an independent oversight function. These measures aim to safeguard the independence and integrity of ESG ratings, instilling confidence in investors and ensuring they have access to unbiased information.

The proposed regulation also introduces a register of vetted ESG rating providers accessible through a European Single Access Point (ESAP) by 2028. This register aims to enhance transparency and facilitate investor access to reliable information. The regulation also mandates the establishment of complaints-handling mechanisms by ratings providers, empowering investors in case of issues with ESG ratings. These provisions represent commendable steps towards accountability and safeguarding investor interests.

It is essential to note that integrating non-financial objectives into investment strategies does not necessarily result in additional costs or lower returns for individual investors. On the contrary, ESG-rated equity funds have shown outperformance compared to mainstream equity funds over the long term. This realization should encourage investors to explore sustainable investment opportunities and promote further development and refinement of ESG ratings.

In conclusion, while the proposed regulation on ESG ratings takes significant steps towards addressing certain issues, it falls short in other crucial areas. Transparency, accountability, and measures to prevent conflicts of interest are commendable steps in the right direction. However, urgent attention is needed to address the lack of harmonization in methodologies and the potential for providers to withhold crucial information. By navigating these challenges with prudence and dedication, we can unlock the true potential of ESG ratings, empowering investors to make informed decisions and pave the way for a more sustainable and ethical future.