ESG Ratings – What is next in the EU?

ESG Ratings – What is next in the EU?

‘ESG’ will soon become the dominant mode of investing in Europe. European-domiciled ESG assets are poised to reach up to EUR 9.0tn by 2025, accounting for about half of all European Mutual Fund assets.[1]  The pace of evolution that ESG investing has seen is unprecedent but raises a number of important questions regarding its growth, including concerns about greenwashing.

This article seeks to touch on one such question – namely, what is the role of ESG ratings within the context of ESG investing, and what can we expect from policy makers and regulators in the EU.

Background

The dominant metric used in sustainable investing is an ESG rating that measures how companies perform on diverse Environmental, Social, and Governance attributes. Investors and asset managers rely on these ratings to assess whether to invest and evaluate company ESG performance over time. Therefore, ESG ratings have an increasingly important impact on the operation of capital markets and on investor confidence in sustainable products.

It is important to note here, that most ESG ratings will not capture companies’ sustainability impact. As highlighted by the Bloomberg article ‘the ESG mirage’[2], the ratings are designed to calculate the potential impact of Environmental, Social and Governance impact on the company, not the other way around. This is known as the financial materiality approach, which has attracted criticism.

Issues

One of the primary issues identified by market participants for ESG ratings is the lack of consistency – different providers often evaluate the same company differently due to different methodologies. These different methodologies can be reflected in the low levels of correlation between the ratings they provide. MIT research,[3] for example, found that the correlation between six major ESG ratings agencies, including MSCI, Moody’s and Refinitiv, to be 0.61 (with 1.00 representing a perfect correlation and -1.00 a perfect negative correlation). This divergence can create confusion for sustainable investors and companies subject to ESG ratings alike. It is also a key concern for regulators globally.

An additional issue is the lack of transparency around methodologies and the data sources ESG rating providers are using. This concern was also raised by IOSCO, which in November of 2021, issued a report[4] highlighting the lack of clarity and alignment on definitions, including on what ratings or data products intend to measure and a lack of transparency about the methodologies underpinning these ratings.

EU regulators have also taken notice – the European Commission published a study[5] on sustainability-related ratings, data and research in 2020. The study identified a number of issues in the functioning of the market of ESG rating providers, including transparency around data sourcing and methodologies, issues in terms of timeliness, accuracy, and reliability of ESG ratings, biases based on the size and location of the companies and, importantly, conflicts of interest.

Policy response

In its Strategy for Financing the Transition to a Sustainable Economy[6], the Commission noted the need to look at ESG assessment tools. The Strategy highlighted the increasing use of these tools in the market and the need to improve the reliability, comparability, and transparency of ESG ratings due to the importance of these ratings.

The Commission has since launched a targeted consultation on the functioning of ESG ratings[7], covering both ESG factors in credit ratings and ESG ratings. In August, the Commission published[8] its summary report to the consultation for which 168 responses were received. The consultation found that “almost all respondents replied that they value and need transparency in data sourcing and methodologies and timeliness, accuracy and reliability of ESG ratings. The large majority of respondents (over 84%) consider that the market is not functioning well and almost all respondents (94%) consider intervention is necessary, of which the large majority (80%+) support a legislative intervention”.

The Commission is now planning to finalise its impact assessment by the end of this year. Depending on the learnings of the impact assessment, possible legislative or/and non-legislative initiatives are expected by the first half of 2023.

What to expect?

The scope is always one of the most important questions around regulatory action. Early indications suggest that the Commission will only target ESG ratings instead of the broader scope of ESG data as detailed in the roadmap, although this could be introduced at a later stage in the legislative process by the co-legislators. This is important because ESG data providers that do not provide ratings will be out of scope. Moreover, internal ESG ratings that are being used by asset managers for portfolio management purposes will also be out of scope as the focus seems to be on ESG ratings that are being sold as a service.

Additionally, on the question of divergence and transparency, we believe the Commission will not try to introduce one set framework or methodology to improve the apparent divergence seen in the market. While divergence remains an issue, attempting to introduce methodologies will almost certainly have a very negative effect on innovation- and lead to risks if set methodologies prove substandard. Instead, it will be important for end users to ensure they do not treat ESG ratings as absolute, and instead use different ratings to inform their own ESG process.

The Commission will, however, look to tackle the issue of transparency in the market. The details of this will only be known once the proposals are available, but it’s fair to say the Commission may look to introduce disclosure rules to increase transparency around the methodologies used, the data sources in question, and importantly to prevent or eliminate conflicts of interest.

ESG ratings are not captured by any current regulation or guidelines in the EU, but the Commission has a number of options they could pursue. These range from recommendations and non-binding principles to full-scale regulatory intervention (light or fully fledged), leading to a broad legislative process which could set rules regarding the authorisation of ESG rating providers, transparency of their methodologies, rules on conflicts of interests as well as the introduction of a supervisory regime.

One option is, of course, to do nothing. However, this is, without a doubt, the least likely scenario.

Co-authoring by Brandon Bhatti and Claudia Grau

[1] PwC Luxembourg – https://www.pwc.lu/en/press/press-releases-2022/european-esg-interactive-dashboard.html
[2] Bloomberg – The ESG mirage
[3] MIT – Why sustainable business needs better ESG ratings
[4] IOSCO – Environmental, Social and Governance (ESG) Ratings and Data Products Providers
[5] EU Commission – Study on sustainability related ratings, data and research.
[6] EU Commission – Strategy for Financing the Transition to a Sustainable Economy
[7] EU Commission – Targeted consultation on the functioning of the ESG ratings market in the European Union and on the consideration of ESG factors in credit ratings
[8] EU Commission – Summary Report
Author

Brandon Bhatti

I am Account Manager in Hume Brophy’s London office focused on international financial services across asset management, wealth management, banking and fintech. My role with Hume Brophy includes the development of strategic communications plans to tactical implementation and supporting businesses and organisations in their communications with their key stakeholders.  
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