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February 5, 2024

More guidelines on ESG ratings risk fragmentation

Wind turbines in a field
ESG ratings and scores have been criticised for a number of reasons and there are often miscalculations, which can end up causing a lot of operational friction (Photo: Elxeneize/Envato)

Many countries are establishing non-binding guidelines, with firmer regulation on the horizon

There is growing scrutiny towards environmental, social and governance ratings, with a general expectation that governments will regulate this area. Meanwhile, a number of countries and industry bodies are setting out non-binding guidelines or codes of conduct, which are seen as a stepping stone to bring trust and clarity to sustainability scores and data.

The voluntary code of conduct for ESG ratings and data products providers, established by the International Capital Market Association and the International Regulatory Strategy Group, is an example in this direction.

The code, launched in December 2023, already has 10 signatories, including Bloomberg, the London Stock Exchange Group and Moody’s.

The document is based on the International Organization of Securities Commissions’ recommendations set out in 2021, with a focus on four areas: transparency, governance, systems and controls, and management of conflicts of interest.

Despite being developed by an industry group convened by the UK’s Financial Conduct Authority, the code aims to be a template for a global standard, it was stressed at an event in London presenting the code on January 31.

“This code is a global baseline and example for the jurisdictions. We’re currently working with the Hong Kong working group to see whether this code could work for the Hong Kong market as well. And even in jurisdictions where we see regulation that might not cover all providers, they could just in parallel still be used,” explained ICMA senior director for sustainable finance Simone Utermarck at the event.

Along with similar initiatives, it aims to respond to uncertainty around the usefulness of ESG scores. “The ESG score in and of itself, it’s not forward-looking. We often see companies being mislabelled into a category they’re not. It’s often hard to distinguish if the ESG risk is company level, or just a symptom of being in the industry,” says Skagen Funds head of ESG Sondre Myge.

Impact on financial institutions

The code is applicable to a range of financial institutions, investors and banks.

David Harris, head of sustainable finance strategic initiatives and partnerships at the LSEG, said during the event: “Specifically looking at banks, they are users of sustainable finance assessments — ESG data, scores, ratings — when evaluating and measuring the entities and projects that they finance, i.e. their clients. Therefore the code should be helpful for banks using this information to have better trust in it, to understand the methodologies being used by providers, and to be able to compare service providers on their offerings.”

In addition, banks can also be “rated entities” and the code also “covers the interaction between ESG providers and rated entities to make sure that, again, there is transparency of assessments and channels for rated entities to raise questions regarding their assessments”, added Harris.

The risk of fragmentation

Still, there is a danger of fragmentation at an international level, where codes of conduct and regulations could conflict with each other given differences in terminology or requirements. “This may lead to a situation where providers are needing to comply with different standards, creating more confusion and potentially leaving perceptions around greenwashing,” said Harris.

Indeed, a number of jurisdictions have proceeded to, or are looking at, regulating the sector.

In June 2023, the European Commission presented a proposal for regulation on ESG rating providers, while in the same month the UK Treasury closed a consultation on a future regulatory regime.

India is even more advanced, with its Securities and Exchange Board having published a framework in July 2023.

Meanwhile, both Japan and Singapore have released codes of conduct in the past couple of years, following the Iosco recommendations.

“We have multiple codes of conduct emerging, with regulation on the horizon. We would love a globally consistent, harmonised set of principles hosted by Iosco. I think that is the next phase of this that we would like to see,” suggested David Henry Doyle, head of government affairs and public policy for Emea at S&P Global.

“We work very closely to try not to be divergent. Of course, it’s difficult. And even some of the data we’ve had today has been about definitions. But you have to start somewhere,” said FCA director of ESG Sacha Sadan during the event.

Reliable ESG ratings and scores

ESG ratings and scores have been criticised for a number of reasons. “There’s often a lot of anecdotal evidence … which isn’t [not] valuable, but I think it’s often overvalued,” says Myge.

Moreover, there are often miscalculations, which, despite not necessarily being a big deal, end up causing a lot of operational friction, he adds.

“On data issues, we reach out whenever we spot them. So they can listen to the feedback and that’s helpful, but it shouldn’t be that way that we need to correct the errors,” Myge continues.

“We liaise frequently with the providers and say, ‘why is this company still rated at the same level of severity even though a year ago they implemented all of these changes?’

“I really do not care what the ESG score of a company is. I do want to know the underlying trends of material ESG factors, be that carbon emissions, turnover rates, whatever. Make it more of a quantitative game,” he concludes.

This article originally appeared in The Banker. 

A service from the Financial Times