The role and use of ESG ratings and the firms that produce them, has become increasingly relevant within financial markets. A survey conducted by UBS suggests revenues generated by ESG data services could more than double globally by 2025. This rapid growth comes as a result of increasing investor need to understand the ESG performance of firms as well as regulatory and legislative moves to increase the quality of ESG data.
The challenges surrounding the provision of ESG data and ratings are documented and have also gained media attention. In March 2022, the Financial Times published an article titled “Boom in ESG ratings leaves trail of confusion” which explains that the wide variety of approaches and methods used by providers makes it harder for investors to compare ratings, make sense of them and therefore less likely that investors will price companies on their ESG performance.
Given the expected use of ESG ratings in financial markets, coupled with the comparative immaturity in these markets when compared to more traditional asset classes like fixed income or equities, it is not surprising that ESG rating and data providers are likely to receive significant focus from government bodies, national regulators, and financial organisations, in the call for increased transparency on the quality and completeness of ratings data.
In this blog, we will explore the current key challenges and considerations for firms in the use of ESG data products and ratings.
Key challenges and considerations for firms
1. Lack of transparency
Given that there are a plethora of ESG data used in assessing sustainability performance, and that ESG ratings are derived in a inconsistent manner, transparency in the underlying rating methodology to investors is essential as part of their decision making process and usage of the data. There is arguably merit for some form of uniformity of ratings like there is for credit ratings to allow investors to compare ratings provided by different providers.
Additionally,there is currently a widespread lack of transparency in the data used to determine the rating making it difficult for the users of ESG ratings to understand the weighting and completeness of ESG factors that have been considered in determining the rating. The lack of consistency between methodologies makes it difficult for ratings to be compared to each other. If companies aren’t sure how ESG ratings providers reached their outcome, it may be unclear as to how they can improve their ratings. In addition to this, ESG data providers may change their methodologies without a consultation, making the data difficult to understand and hard to compare over time.
ESG data providers should consider their disclosure of methodologies to users, including their policies on methodological review, to enhance transparency to the market. Users should consider the due diligence they perform on their data providers, whether it sufficiently meets their needs and whether obtaining further information on methodologies means they can perform quality checks on data they receive.
2. Reliability of ESG data products and ratings
To inform investor decisions, ESG data products should be reliable, however, IOSCO found that users of ESG ratings do not tend to verify the data products they use, or carry out appropriate due diligence. The lack of transparency in how ratings are determined arguably means it would be practically impossible to do and also very resource intensive.
Users should look at where and how ESG data is used within their organizations and the level of due diligence they perform on data providers to gain comfort on the data they receive. Users should consider if they can identify any discrepancies in data received and essentially whether they can rely on the provider.
IOSCO also identified that there is an increasing use of machine learning, artificial intelligence and natural language processing by providers to efficiently obtain ESG related data. Providers should properly assess the processes by which they are comfortable with the accuracy and completeness of such tools and whether the current quality controls adequately identify erroneous data.
The current level of companies’ sustainability disclosures are inconsistent and difficult to compare, it is expected that the availability and consistency of ESG disclosures will improve over time. Initiatives such as the International Sustainability Standards Board (ISSB) to develop and approve IFRS Sustainability Disclosure Standards look to harmonise and develop comparable disclosures from companies.
ESG data providers themselves should consider reviewing and enhancing their internal controls for data gathering and quality control processes. Assessing whether those processes and controls are suitably robust in order to identify potential erroneous data, be it through error or age.
3. Conflicts of interest
There is a potential of perceived or actual conflict of interest between ESG data providers and their users, given that users licence the use of data from the providers for a fee. As identified by the SEC in their 2022 Annual Staff Report on National Recognized Statistical Rating Organisations (NRSROs) providers tend to be part of larger organisations which may provide consulting services, such as assisting firms to comply with new regulatory requirements or even how to improve their ESG ratings.
The management and mitigation of these potential conflicts of interest is key to ensure that users can rely on providers and build public confidence in ratings.
ESG data providers should ensure conflicts of interest policies and controls are in place and they can adequately identify, manage and mitigate potential and actual conflicts in a timely manner. Public disclosure of conflicts of interest policies could build user confidence, for example showing the independence of the compilation, validation and dissemination of ratings from any inhouse consulting division. Users should assess their relationships with ESG data providers and whether there are any potential conflicts - if providers are providing consulting services for example.
A key challenge that rating providers and users need to consider is how ratings are used and how firms respond to their rating. Akin to the risks and issues arising from the considerations of rating methodologies of the 2008 financial crisis, there is a risk that firms will look to design their ESG strategy to achieve the highest ratings rather than achieving their overall ESG objectives (such as Net Zero) and other strategic objectives. Firms should ensure they are clear on their use of ESG ratings and consider how their performance is assessed by stakeholders. Rating providers should look at how firms react to their ratings and ensure the methodology remains resilient to actions undertaken by firms to solely impact a rating calculation.
The increasing regulatory scrutiny of ESG data providers and ratings is unlikely to abate, and firms should start considering how they will respond ahead of consultations to ensure their viewpoints and any concerns are considered. Regulated firms should expect to see queries from supervisors and ensure they consider and meet regulatory and market expectations as the market grows.
Users should consider how they use and have come to rely on ESG data and ratings, and challenge their application accordingly (for example in use of contracts or performance-related pay). Firms should assess whether they have sufficient processes and controls to ensure they are comfortable with what they are provided with and can rely on it.
The European Commission targeted consultation on the ESG ratings market, and considerations of ESG factors in credit ratings, provides an opportunity for the market to consider how to address such concerns and will be closing on 6 June 2022.