How should we regulate ESG research?

Craig Coben is a former global head of equity capital markets at Bank of America and now a managing director at Seda Experts, an expert witness firm specialising in financial services. Petra Dismorr is chief executive officer of NorthPeak Advisory, an ESG advisory firm.

Environmental, social, and governance (ESG) standards have become crucial for the investment-management industry. Big investors apply ESG criteria on a regular basis, and global ESG assets are projected to reach $50 billion by 2025. 

As more investors incorporate ESG factors into asset selection, the firms tasked with giving an ESG rating to a security have come to wield enormous influence in investment decisions and capital flows. They also, incidentally, command high profit margins.

But, as Uncle Ben tells Spider-Man, “with great power comes great responsibility” — and now even greater regulatory scrutiny. On 30 March the UK Treasury announced a public consultation to determine how to regulate ESG ratings providers. 

This comes on the heels of growing exasperation from other international watchdog bodies about the lack of transparency of ESG ratings.

ESG ratings have become a flashpoint for political controversies as well. Some GOP politicians in the US complain the ratings are a “Trojan horse” for bringing leftwing ideology into investment decisions. Other critics say ESG ratings facilitate “greenwashing”, citing firms awarded strong ESG ratings which engage in what they see as unsustainable activities. 

These criticisms reflect a widespread misunderstanding of what ESG ratings are solving for. Contrary to popular belief, ESG risk ratings “are not a general measure of corporate ‘goodness,’” according to MSCI, but instead “focus on financial risks to a company’s bottom line.” Sustainalytics’ ESG ratings capture “an issuer’s exposure to material, industry-specific ESG risks and an issuer’s management of those risks.” 

That’s not to say that impact-focused ratings providers don’t exist, but rather that risk mitigation and impact are two distinct things. Mainstream ESG ratings don’t measure a company’s effect on the environment or society, but rather how ESG factors can affect financial performance. 

ESG is thus best understood as good business practice, and another lens for viewing investment risks and opportunities.

Criticisms of ratings go beyond politics, however. Investors and issuers alike complain that ESG ratings are expensive, subjective, inconsistent, flaky, and mostly unregulated, as well as rife with conflicts of interest. It’s difficult to understand, for example, how one ESG ratings firm could score collapsed crypto firm FTX higher for governance than ExxonMobil. 

And ratings vary enormously between providers. Whereas credit-rating agencies such as S&P and Moody’s agree usually (not always) on the letter category, the panoply of ESG arbiters often come out with wildly and widely divergent ratings. As a blog post at the CFA Institute explains:

MSCI, S&P, and Sustainalytics are all comprehensive ESG ratings. They should have a high correlation. But MSCI’s correlation with both S&P and Sustainalytics is below 50%. The S&P and Sustainalytics correlation is higher but still lower than expected . . . All told, the results . . . are conflicting and contradictory.

Diversity of opinion may sound good, but the inability for outsiders to understand the reasons for massive discrepancies make ratings look arbitrary. As data platform Integrum says, ratings should be a “glass box”, not a “black box”.

Watchdogs have a few different models in considering how to regulate ESG ratings. They can treat ESG ratings as akin either to broker research reports or to credit rating agencies.

The idea behind the broker-research model is that opinions and methodologies vary so much between ratings firms that it is best to leave it up to investors to decide which factors to weigh in making an investment decision. As two strategists at Dimensional Fund Advisors write, the ratings should be viewed not as objective ratings, but as opinions — not unlike the buy/hold/sell opinions that have been issued by sellside analysts for decades.

The ESG rating would be just one more viewpoint to consider or disregard in making an investment decision.

In that case, concerns about conflicts of interest would need to be addressed by financial regulators. Just as sellside research analysts have to remain walled off from investment banking, ESG ratings firms would have to ensure their independence from related companies pitching business. There would be little content regulation of the ratings themselves.

The problem with this approach is that it abandons any public good that would come from ESG ratings. Just as investors have beefed up their internal research teams, the burden would fall on them to assess ESG metrics with no industry-wide framework. This is particularly problematic because much of the information used in ESG judgments is not available publicly, making atomised evaluations by hundreds of investors even more likely to be inaccurate than they are today.

At the other end of the spectrum, financial regulators would treat ESG arbiters as something like credit rating agencies (CRAs). Rules applicable to CRAs generally impose strict requirements, including registration and ongoing supervision, to ensure that credit ratings are reliable and credible. US regulations even bestow special legitimacy to “nationally recognised securities organisations”, whose ratings are often used for regulatory purposes. 

Reliance on CRAs has drawn controversy since the 2008 financial crisis, but this model of regulation provides at least a blueprint for ESG ratings’ oversight, and the potential for a common approach between firms. Like CRAs, ESG ratings firms provide information to investors that can be decisive — and (dis)qualifying — in investment decisions, even if the risks they evaluate are different. 

Under this regime, new rules should include requirements for transparency and conflicts of interest, as well as standards for data collection, materiality, methodology and objectives. The new regime will also require collaboration with other stakeholders, such as companies, investors, and trade groups, to agree on best practices.

That would mean a regulatory framework would need to be tailored to the specific characteristics of ESG ratings, reflecting the unique challenges, such as the lack of standardisation in data and the difficulty of comparing ESG performance across different sectors. Regulation will not mean across-the-board uniformity. Investors will still have to maintain internal research teams, just as today they perform their own credit analysis on CRA-rated bonds, but will benefit from a shared framework.

The credit-ratings model of ESG regulation may ultimately be more sensible. ESG ratings will always have critics, but if responsible investment is a public policy imperative, then the authorities will have to legitimise ratings, with clear rules for evaluating the E, the S and the G. The analogy to credit rating agencies isn’t perfect, but it points in the direction of common principles, while allowing some diversity of opinion.