It has been widely reported that the number of European ETFs with an AAA ESG rating from MSCI could fall from 1,120 to just 54, while the number with no rating at all will surge from 24 to 462. This is because index providers, such as MSCI, are changing their methodologies amid concerns about greenwashing. These changes, which are due to be implemented in spring and will apply to all global mutual funds and ETFs.
What has been less well reported is the interesting role ESG ratings play in the context of sustainable finance, particularly as it pertains to structuring ESG products. When doing this, fund managers will often rely heavily on the ratings of third-party providers to assess whether a fund or company is considered ‘sustainable.’ Therefore, such significant changes to the ESG rating process are likely to have a major impact on ESG investing.
It is in this context that we have seen growing momentum among regulatory bodies to address perceived concerns around ESG rating providers. As is the case with many regulations around sustainable finance, the EU has taken the lead. However, the UK is not too far behind.
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’, 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.
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, 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. Regulators have taken notice, IOSCO issued a report in November of 2021, which highlighted 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. Similarly, the European Commission published a study on sustainability-related ratings, data, and research in 2020. The study identified several 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.
Since then, the European Commission has launched a targeted consultation on the functioning of ESG ratings, covering both ESG factors in credit ratings and ESG ratings. In August, the Commission published its summary report for the consultation, for which 168 responses were received. The Commission reported that “all respondents replied that they value and need transparency in data sourcing, methodologies, and timeliness, accuracy, and reliability of ESG ratings. Most respondents (over 84%) consider that the market is not functioning well, and all respondents (94%) consider intervention is necessary, of which the large majority (80%+) support a legislative intervention”.
The Commission is now planning its next steps, including potential legislation and non-legislative measures expected later this year.
What about the UK?
The UK is slightly behind the EU in terms of regulating ESG rating providers but, unusually, not by much. On the 30th of March 2023, the Treasury published its consultation on the future regulatory regime for ESG ratings providers which had been expected since it was announced as part of the high-profile Edinburgh reforms in December of 2022.
The consultation is the first formal act by the UK government to bring ESG ratings into the regulatory perimeter, the core proposal being that the direct provision of an assessment of environmental, social, or governance factors to a user in the UK, where the assessment is used in relation to a regulated financial product, will be brought into scope of regulation.
There are a number of other aspects to HM Treasury’s proposals worth highlighting:
- The proposed territorial scope captures the direct provision of ESG ratings to users (institutional and retail) in the UK, by both UK firms and overseas firms. However, this would not capture the provision of ESG ratings by any UK firm to users outside the UK.
- The proposed scope excludes data on ESG matters where no assessment is present. This means raw, unprocessed data is not included as well as data assessments that might be undertaken by asset managers at firm level but are not sold externally.
- Proposed exclusions to the scope also include credit ratings, investment research products, proxy advisor services, external reviews of ESG labelled bonds, consulting services and academic literature or journalism.
It’s important to note that HM Treasury’s consultation is only designed to ascertain whether, and to what extent, respondents believe ESG rating providers should be brought into the regulatory perimeter.
It will, under the post-Brexit framework being rolled out by the UK government, be the FCA’s job to develop the rules that firms will have to comply with. In this regard, Treasury’s consultation gives us a flavour of what to expect when it suggests ‘The FCA has indicated that they anticipate their regulatory approach would take the main elements of IOSCO’s recommendations as a starting point for rules’. Importantly, HM Treasury also states – ‘the FCA would not seek to harmonise the varying methodologies and objectives of ESG ratings as a regulatory outcome’.
The IOSCO recommendations give us an indication of what to expect, but it is difficult to provide any certainty until we see the FCA’s own proposal once HM Treasury brings ESG Ratings into the regulatory perimeter (assuming that is what they do).
The scope is always one of the most important questions around any regulatory action. Indications in the EU suggest that the Commission will initially only target ESG ratings instead of the broader scope of ESG data originally suggested in their roadmap (although this could be introduced by the EU co-legislators during the legislative process). This would be consistent with the UK’s proposed approach.
Additionally, we believe the European Commission will not try to introduce rules around the methodology to improve the apparent divergence seen in the market, which is again in line with what we know about the UK’s preferred approach. There is a quandary for policymakers here. Attempting to introduce methodologies will certainly have a negative effect on innovation and could introduce risks that the prescribed methodologies prove substandard. However, it will not address the concerns and risks about the comparability and quality of ESG ratings. It will be important for end users to ensure they do not treat ESG ratings as absolute, and they understand what exactly the ratings are telling them. The ability of providers and investors to use their own judgements will remain important.
By contrast, both the UK and the EU are likely looked to improve transparency for the users of ESG ratings. How exactly they will do this will only be known once specific proposals are available, but both the Commission and the UK may well look to introduce disclosure rules to increase visibility into the methodologies used, the data sources in question, and importantly to prevent or eliminate conflicts of interest. This should be generally welcomed, but some providers might be concerned about rivals seeing their ‘secret sauce’.
The HM Treasury consultation on bringing ESG ratings into the regulatory perimeter closes on the 30th of June. We then expect a feedback statement which will include the proposed legal drafting. Once the scope of regulation has been decided, the FCA will launch its own a consultation on the actual rules’ firms will need to comply with in relation to ESG ratings. The timeline for new rules remains unclear but could come as early as late 2024.
In the EU, significant progress has already been made and we expect the Commission to adopt a legislative proposal on ESG ratings sometime in June 2023.
This will be an important topic to watch for many in the industry, not only for ESG rating providers but also users of these ratings. More clarity, transparency and a regulatory framework will help support the development of robust ESG financial markets and reduce uncertainties for companies or funds as rating providers change their methodologies – although the transition to new rules and inconsistent global approaches could be painful.
 EU Commission – Study on sustainability related ratings, data and research.