EU, UK and other regulators intensify scrutiny of ESG rating providers

Policymakers in Europe and the UK intend to regulate the industry to boost transparency and consistency, with other jurisdictions taking similar moves, while some ESG rating agencies have already updated parts of their methodologies

EU and UK regulators are getting closer to finalising regulation on ESG ratings and the companies that provide them, though their scope and the level of enforcement are still being debated. Meanwhile, ESG rating agencies ISS, MSCI and Sustainalytics have updated parts of their individual methodologies to better reflect their latest in-house rating views.

In June, the European Commission published its proposal for regulating ESG rating providers, following earlier consultations by both the commission and the European Securities and Markets Authority on alleged dysfunctional market practices.

The aim is to improve the reliability and transparency of ESG ratings by setting clear rules on potential conflicts of interest and by giving Esma supervisory powers. The EU parliament and council are currently formulating a position on the matter.

The commission’s proposal focuses on the ratings themselves, but excludes from its remit the provision of raw ESG data that is not part of a rating service. Another crucial element of the proposed EU legislation is that rather than seeking to harmonise the methodologies underpinning ESG ratings, policymakers want to increase transparency around in-house developed methodologies.

Proposed EU rules

In its opinion on the legislation, the European Central Bank welcomes the requirement for ESG rating providers to explicitly clarify the purpose and objectives of the ESG ratings they construct. In particular, the ECB emphasises that some ESG ratings might reflect the impact materiality of certain sustainability-oriented investments, while others might focus on the financial materiality of the ESG factors underlying a given investment. 

According to the ECB, there is confusion over the extent to which ESG ratings measure an investment’s actual sustainability performance and, consequently, its impact on the real economy. The ECB says this could lead to greenwashing in instances where ESG ratings “might not match public expectations about the real sustainability impact of the financed investments”.

It highlights the aspect from the EU proposal that some ESG rating providers are also credit rating agencies, and might use ESG factors in their overall credit rating analysis. The ECB therefore envisages that the regulation obliges ESG rating providers “to communicate clearly, for instance through an explicit disclaimer, that ESG ratings, even those that are predominantly intended as risk metrics, are not direct metrics of credit risk”.

In August, S&P Global Ratings announced it would stop publishing ESG credit indicators, with the company clarifying in a comment for Sustainable Views that these ESG credit indicators were not ESG ratings as such, and that they were purely developed “as post-analysis indicators to bring in more transparency on how the ESG factors were impacting the entities we rate”. S&P declined to comment on how it views the regulation of ESG rating agencies.

When it comes to the fees that providers charge for clients’ access to ESG ratings, both ISS and Sustainable Fitch disagree with the commission’s proposal that providers guarantee that fees are “fair, reasonable, transparent, non-discriminatory and are based on costs”. In their consultation response, Fitch calls this “overly burdensome”, while ISS says this would be achieved by incentivising industry competition.

Sustainable Fitch opposes giving Esma supervisory powers, arguing the move would be “completely disproportionate in such a nascent industry”. ISS, meanwhile, favours applying different levels of disclosure when explaining the methodology to clients, rated entities or the general public.

Methodology changes

While the EU proposals include the provision that ESG rating providers should review their methodologies at least annually, some of them have recently introduced changes to their methodologies already.

In April, MSCI announced that there would be a one-time downgrade for around 31,000 funds when it raised the requirements for its top rating. It also changed how it incorporates ESG factors in swap-based exchange traded funds. MSCI said the changes were not instigated by regulatory developments in the EU or elsewhere but driven by client consultations.

Sustainable Fitch confirmed to Sustainable Views that typically it also consults with the market before it implements methodology changes, but had not made any amendments recently. 

Meanwhile, ISS has announced several methodology updates. The rating agency makes a distinction between “ratings” and “rankings” in its in-house approach.

This month, it announced it would enhance its ESG corporate rating by adding metrics and greater granularity for more than 60 cross-sector indicators, broken down into more than 500 discrete ESG raw data factors. ISS says its ESG corporate rating assesses companies’ sustainability performance based on industry-specific ESG criteria with a sector-based and materiality focused solution.

ISS head of research solutions product Brian Colantropo says the agency also provides “quality score” rankings, which differ from the ratings as they assess ESG risks through the lens of company disclosure. There is a separate methodology for the governance ranking, while the environmental and social disclosure ranking is combined. Both sets of methodologies were also recently updated.

“For the environment and social components, the ranking is performed against companies in the same sector, acknowledging comparable sustainability risks and disclosure expectations. The governance score takes into account jurisdictions instead, as laws, codes, and regulations are more material than sector classification when looking at that pillar,” Colantropo says.

Meanwhile, Sustainalytics has made changes to its methodology in response to Russia’s invasion of Ukraine. It has introduced the concept of “systemic event indicators” to its ESG risk ratings methodology. “We define a systemic event as a sea change event that is somehow unpredictable in nature and that affects larger groups of companies at the same time and across a multitude of ESG issues,” the company’s analysts said in a March 2022 note.

Of the others agencies, Moody’s told Sustainable Views that it had not implemented any recent changes to its ESG methodology. Data provider Bloomberg, which also has an ESG score service, declined to comment, while FTSE Russell and Refinitiv did not respond to requests for comment. 

UK regulation

Following moves by EU regulators, last year the UK Financial Conduct Authority announced it intended to develop a voluntary code of conduct for ESG rating agencies, while it awaited further action from the Treasury.

The Treasury eventually ran a consultation setting out its proposals from March until the end of June this year, with a final version reportedly expected to be released by the government early in 2024. According to the Treasury, market participants have raised concerns about ESG ratings in relation to providers’ methodologies and objectives, “which can be opaque and lead to confusion about what a rating implies”.

The consultation proposed that ratings with one or more environmental, social or governance characteristics – whether they are labelled or not – would be regulated. Unlike the EU proposal, it also referenced ESG data, which the Treasury said it will monitor alongside the Financial Conduct Authority, and consider the need for further intervention.

“As reliance on ratings agencies has grown, it has become increasingly apparent that issues exist around the reliability, coverage and transparency of the data being provided,” says Alexandra Mihailescu Cichon, chief commercial officer at ESG data company RepRisk in a statement. 

“We regularly hear from investors that data is the biggest obstacle to integrating ESG into their portfolios. While there is value in different types of ESG data, the users of such data require greater clarity and transparency – particularly when it comes to the methodology of providers and on the topic of potential conflicts of interest,” she adds.

Arthur Carabia, director of ESG policy research at Sustainalytics, which was bought by data provider Morningstar in 2020, says: “The main concern at this stage is that the UK is contemplating going beyond the EU and regulate both ESG data and ESG ratings in one single text.

“The inclusion of data in the context of the ESG rating regulation creates significant challenges that will result in confusion, impede the availability of ESG analysis, and reduce flows based on ESG data. Additional and separate regulation of ESG data requires clear purpose and adequate consultation to avoid unintended consequences,” he added.

Nick Miller, managing director for global regulatory affairs at ratings provider Moody’s, said: “It is important that rules are internationally consistent – and continue to evolve as the market develops. Looking at the market today, transparency should be a key consideration.

“The rules should seek to facilitate better understanding of what these products are designed to achieve, so users and investors can make the right choices for their needs.”

Other jurisdictions

Outside of Europe, Japan became the first country to implement a code of conduct for ESG evaluation and data providers through its financial services agency at the end of 2022. The code is voluntary and based on six principles.

Meanwhile, the Securities and Exchange Board of India has also introduced new regulation, which will require ESG rating agencies to seek registration if they want to operate in the country.

In the US, the Securities and Exchange Commission has not initiated any regulation.

Howevere, ESG ratings came under fire in a June memorandum from the Republican-led ESG working group of the US House Financial Services Committee. It said: “The widespread reliance on ESG ratings by institutional investors and the flow of funds into ESG-labelled investment products raise significant questions about the overall impact of these ratings on the market. If ESG ratings fail to accurately reflect a company’s true ESG performance or financial risks, there is a considerable risk of capital misallocation and potential market distortions.” 

The group questioned the value and usefulness of ESG ratings, due to the lack of standardised methodologies and transparency in the rating processes, adding that this leaves “companies and investors in the dark about the basis for the assigned ratings”.