ESG Ratings – Improvements on the Horizon?
Summary:
ESG ratings have started to address shortfalls in scoring methodology and overall transparency.
Key improvements include clearer definitions, more transparent scoring methodology, and public access to ESG scores.
Looming ESG regulations are a key driver of change, with initiatives underway in Japan, the UK and India.
Greater ESG ratings transparency is paving the way for expanded data collection that companies will need to monitor.
ESG ratings and data are used by investors to evaluate the environmental, social, and governance (ESG) performance of companies. In recent years, ESG investing through the use of ESG metrics has gained significant traction, however, there has been an increasing demand for improvements to be made to the ESG ratings space. Some of the concerns raised by market regulators, companies, investors, and NGOs include:
A lack of transparent methodologies and definitions
A need for regulatory oversight given the impact of these ratings
A presence of perceived conflicts of interest for ESG agencies also offering corporate consultancy services
A lack of agency-to-issuer communication (while ensuring impartiality)
A need for increased standardisation of topics/definitions across agencies
A misalignment between agency assessment cycles and issuer reporting cycles resulting in old data being assessed
How are ESG agencies responding?
Due to increasing pressures and the expectation of upcoming regulatory changes, leading ESG rating agencies such as MSCI, S&P ESG and Sustainalytics have been introducing a number of enhancements. These include increased methodology transparency, expanded ESG data collection on priority ESG topics (e.g. climate), and the introduction of more flexible ESG assessment periods for companies (see Figure 1).
Source: Leaders Arena
Market leader MSCI is proposing many changes to its ESG scoring methodology. In 2022, although not for the first time, MSCI invited companies to a consultation on its methodology updates for 2023 and beyond. Changes discussed included the introduction of company-specific assessments which better reflect industry niches, increased consideration of geographical and market context in assessments, and increased expectations on management of risks across material issues.
Elsewhere, rating agencies have started to improve communication on methodologies, which includes expanded definitions to help companies better understand expectations and how they are being assessed.
Over the past few years, ESG rating agencies including MSCI, ISS ESG, Sustainalytics, S&P ESG and Refinitiv, among others, have also been making company high-level ESG ratings publicly available through their websites. This has made it easier for companies, investors and other stakeholders to quickly access both headline ESG ratings and in some cases climate-specific ratings. We expect to see further transparency enhancements to continue.
Looming regulation as a key driver of change
One of the main driving forces of these changes, and future improvements, is looming regulation of the ESG ratings space in several key global jurisdictions. Over the past few years, there has been a growing call for more consistent, reliable, transparent and accountable ESG ratings, and several regulators are getting ready to step in to ensure this. Potential changes include the introduction of ESG ratings oversight bodies and related code of conducts, increased disclosure/transparency requirements for companies and ESG rating agencies, and liability-based regulations (see Figure 2).
The European Securities and Markets Authority (ESMA) and International Organization of Securities Commissions (IOSCO) have been at the forefront of criticism and research in the space. For example, IOSCO’s ESG Ratings and Data Products Providers report of 2021 pointed out a need for greater transparency, including clarity of definitions and measured data, concerns about potential conflicts of interest where agencies also provide consultancy services, and suggests a potential for introducing regulation of the ESG ratings space [2]. In 2022, ESMA also echoed this sentiment, citing a lack of transparency of methodologies and potential conflicts of interest given the high number of agencies providing ESG ratings on an issuer-pays basis [3].
In response, regulators in Japan, UK and India have begun developing working groups and codes of conducts for ESG ratings. Japan’s Financial Services Agency (FSA) is expected to be the first financial market regulator to issue guidelines for ESG data and ratings providers as it began finalising its draft Code of Conduct in December 2022 [4]. Similarly, the UK’s Financial Conduct Authority (FCA) announced late in 2022 the formation of a group to develop a Code of Conduct for ESG data and ratings which would also provide regulatory oversight in line with IOSCO’s recommendations [5]. Elsewhere, India’s market regulator has recently announced plans to adopt a principles-based approach in its first set of rules for ESG ratings [6].
Source: Leaders Arena
Additional drivers beyond regulation
Another powerful long-term driver in this space comes from the increased use of artificial intelligence (AI) and more sophisticated data analysis techniques, such as machine learning and natural language processing (NLP) to evaluate a company's ESG performance and identify trends and patterns. While AI may not completely take over the human aspects of ESG ratings, analysis, and communication, it will likely play a much larger role in future data collection and analytics. In the past 5 years, there has already been a growing number of AI-powered ESG rating agencies entering the space such as Clarity AI and ESG Book (formerly Arabesque S-Ray).
Additionally, there has been an ongoing expansion of ESG data products aligning with developing reporting regulations and emerging ESG risk topics. In particular, some agencies such as MSCI have expanded their data collection to reflect data points from the EU’s Sustainable Finance Disclosure Regulation (SFDR) which collects sustainability-related portfolio data such as on biodiversity targets and policies, and disclosure of gender pay gap, among many others. We are already noticing additional coverage by ESG rating agencies on ESG emerging risks such as biodiversity, which has been identified as a priority topic for 2023, as investors seek to gain a better understanding of company exposure and management of these risks.
Overall, it is expected that ESG ratings data sets will continue to align with new reporting standards, frameworks and growing ESG trends as they develop.
What does this all mean for companies?
Given the extent of the changes taking place in the ESG ratings space, we expect to see them become more standardised, transparent, and sophisticated in the years to come. However, for the time being, many of the issues associated with ESG ratings will remain as regulation and oversight of the space will take time to evolve, will differ among countries, and ultimately may not produce the desired results. It is also unlikely that there will be a perfect solution with regards to standardisation and consistency across ESG ratings providers’ methodologies in the short-to-medium terms. Even with advances in the ratings agency space, as data collection expands, companies will want to keep a close eye on potential data inaccuracies and seek to engage in data verification to rectify any issues.
Therefore, companies should look to expand resources to monitor the growing range of ESG data sets being collected and seize the growing opportunities to provide feedback and engage with data providers.
At Leaders Arena we have a dedicated team of ESG consultants and analysts who support companies’ efforts to monitor, verify and respond to ESG ratings and controversies. We support companies in verifying their ESG ratings data and identifying reporting improvements that will maximise their scores overtime. You can find more details on our website or email our Head of ESG Ratings support for any enquiries.
References
[1] EU Sustainable Finance Disclosure Regulation (SFDR)
