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ESG Ratings Providers See Calls for Regulation Snowball

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The knives are out for ESG rating firms.

Often criticised for their lack of consistency in assessing companies’ sustainability and ESG performances, ratings providers are now the subject of regulatory scrutiny with UK officials last week saying such companies were failing green markets.

The Financial Conduct Authority (FCA) said the opacity of the methodologies of behind aggregated data-based scores and ratings is eroding trust in the markets they seek to serve. The London-based overseer said it is “carefully considering” 240 responses to a consultation it launched last year into whether it should regulate the sector.

The FCA was prompted to act by complaints that if left unbridled, ESG ratings could be used to mislead investors and promote greenwashing. Responsible investing charity ShareAction said regulation was needed to help tackle “the real and significant problem of greenwashing, which undermines not only client and public trust but also the potential of responsible investment to have any meaningful climate and social impact”.

In its most recent declaration, the FCA said it would issue a response before the end of September. The decision to consider bringing the firms within its gaze was largely welcomed by the UK’s investors, even though the Investment Association said the FCA’s proposals needed some work. The European Union has also begun a process of weighing the pros and cons of regulating the firms.

Ratings providers, including MSCI and S&P Global said they were studying the proposals.

Damning Survey

The perception that ESG ratings firms need to be monitored was hammered home by the most recent Rate the Raters survey conducted annually by sustainability consultancy ERM and the SustainAbility think tank.

Released at the end of March, the study of the views of 450 investment professionals and 1,400 corporate sustainability professionals across 29 countries, found a general dissatisfaction with ESG ratings providers.

While ratings are regarded as an essential part of investors’ due diligence processes, they were far from fully supported by their users. Among investors, more than half said they saw “greater consistency and comparability across ratings methodologies” and “improved quality and disclosure of methodology” as problems that needed most urgent solutions.

Nevertheless, more than half of respondents’ said ratings were the most important data sources used in their decision-making processes. Only in-house data ranked just a highly; third-party data was the most common source of ESG information for just two-fifths of investors.

In the survey, ISS ESG and CDP consistently achieved high scores across a range of quality and usefulness measures, followed closely by Morningstar’s Sustainalytics and S&P Global.

Higher profile

The profile of ESG ratings providers has been raised by the growing focus on sustainability investing as demand for green assets has surged in recent years. Conservative politicians’ attacks on sustainability markets, particularly in the US, have often focused on the raters, branding them as “black boxes” for their often closely guarded assessment methodologies.

While it looks likely that there will be some oversight of ratings providers, the stringency of any regulations is unclear. The IA, for instance has said the FCA’s proposals, unless properly calibrated, could place undue burdens on its members.

There are others who argue that the very inconsistency of the ratings is what gives them their value. GoldenSource vice-president of product management and regulatory affairs Volker Lainer has long argued that it is important to have specific ratings methodologies to reflect the multiple factors assessed within ESG.

“Having those different processes makes sense,” Lainer told ESG Insight last month. “You absolutely benefit from the fact that they have differing approaches.”

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