While European policymakers request greater transparency on sustainable investment, the role of rating agencies warrants further examination.
Under the EU’s Sustainable Finance Disclosure Regulation, investors in the most ambitious and sophisticated ESG products must be told how far a fund’s assets will align with the EU’s green taxonomy.
Since January 1, providers of these products – known as Article 8 and 9 funds under SFDR – are expected to estimate how far a fund is expected to align in a precise percentage figure in their prospectuses to the taxonomy’s first two objectives: climate change mitigation and adaptation. Currently, a 15 per cent score would be deemed excellent, according to experts, since most economic activities routinely inflict harm on the environment. Some funds say they haven’t been able to commit to any taxonomy alignment at all: their alignment level could be as low as 0 per cent.
Problem with quality
The taxonomy’s disclosure obligation came into force ahead of SFDR’s own reporting, which comes into place in 2023. But besides this misalignment, there is a more fundamental concern: the underlying ESG data is scarce and of poor quality.
Knowing that they lack robust data, many fund owners will inevitably turn to rating agencies to provide the percentage figure. Yet the established rating agencies run into similar issues; hence these third-party providers tend to give the same fund very different estimated figures.
One sustainable finance expert warns: “The quantification gives a quite unjustified illusion of accuracy. Investors and others can’t blindly stare at the figures, or take them remotely at face value.”
ESG ratings now play many roles in the financial ecosystem yet they remain largely unregulated, unlike credit ratings, and have become suspect. Parallels have been drawn between the role of ESG ratings today and that of traditional credit ratings (which were then unregulated) leading up to the global financial crash a decade and a half ago.
Inappropriate use
Martin Moloney, secretary general of the International Organization of Securities Commissions, notes how the financial crisis revealed that credit ratings were being relied on in inappropriate ways.
“The credit rating methodologies were focused on the question of the likelihood of default and yet the ratings were being used as a source almost of investment recommendations; that was overly mechanical. So it is not surprising if you see a similar pattern of use that isn’t really aligned with methodology or purpose with ESG ratings,” he says.
“What we’re saying to investors is: if you are relying on an ESG rating exclusively in order to make your decisions, then you’re not in a good position,” he adds.
The current lack of plentiful robust data means the ESG edifice is built on rather shaky foundations. Rating firms acknowledge this and some, such as Standard & Poor’s and Moody’s, have joined the Future of Sustainable Data Alliance (FoSDA) to tackle this issue.
Julia Haake, head of market strategy at Moody’s ESG Solutions notes that FoSDA is set to provide recommendations for industry, policymakers and regulators on addressing data availability and reporting issues. The idea, she says is to create “investment grade sustainability data” that is needed to achieve the UN SDGs, Paris Agreement goals and a sustainable post-COVID recovery.
But there are further problems. For the most part, ratings reflect the risk to a company’s profitability from sustainability changes such as global warming. However, they don’t always show the impact of a firm on the environment – something that may disappoint some investors. In addition, there are many difficulties in ascribing ratings. CO2 emissions, for example, can provide an overarching metric for climate, but there is no comparable measure of nature-related impacts such as species loss.
It is also hard to put a score on social issues – take the harm done two years ago by Rio Tinto’s destruction of a 46,000-year-old Aboriginal site. (An Australian parliamentary inquiry ordered the mining conglomerate to rebuild the cave system it blew up.)
Lack of transparency
On top of this, rating firms’ methodologies are not transparent. According to an Iosco report published in November, “there is little clarity and alignment on definitions, including on what ratings or data products intend to measure”.
There is also the question of how the ratings are marketed, with some firms seeing the need to flag up the way in which their ratings should be interpreted. MSCI states on its website: “[S]ome think MSCI ESG ratings are like credit ratings. Others think they should be focused on climate or rejuvenating the planet. Both interpretations misconstrue their true purpose. MSCI’s ESG ratings are designed for one purpose: to measure a company’s resilience to financially material environmental, societal and governance risks.”
Iosco’s Moloney says: “A lot of asset managers are struggling to meet the demand for ESG-focused investment mandates. Sometimes they’re doing OK, but often they’re not. And that’s why we have had to say there’s far too much greenwashing in the marketplace.”
Divided loyalties
Finally, there is the separate problem of conflicts of interest, as many rating agencies offer other products to companies.
Following publication of the Iosco report four months ago, national regulators have begun to take action. The Securities and Exchange Board of India was quick off the mark, proposing regulation of ESG rating agencies in a consultation in February, and in the EU, the European Securities and Markets Authority issued a call for evidence to map out size, structure, resourcing, revenues and product offerings of the different ESG rating in the bloc.
The US Securities and Exchange Commission is also looking into the matter, while the UK’s Financial Conduct Authority bluntly told rating agencies: “Given the potential conflicts of interest with the regulated activities, we expect you to put in place robust governance arrangements and oversee the interactions between regulated and unregulated activities (eg, ESG ratings). Further, for credit ratings, we expect you to disclose ESG risk factors according to your methodologies.”
Moody’s Haake recognises the benefits of “properly calibrated” and “internationally consistent” regulatory frameworks; she also emphasises the need for rules to adapt as ESG disclosures evolve.
While a spokesperson for S&P Global Sustainable1, the agency’s ESG intelligence arm, says that regulation mandating ESG corporate disclosures helps and that “transparency is essential so that market participants seeking to understand the underlying criteria of a [rating] or ESG index have access to the metrics and methodology being used.”
Without improvements in transparency, both on the corporate and raters side, and data quality, the risk of misinterpretation and mis-selling can only intensify – and with it, regulatory intervention.
Additional reporting by Silvia Pavoni