The Wild West of regulating ESG investments

ESG finance is at a crossroads. Victim of its own success, the incorporation of environmental, social and governance (ESG) metrics into investment and lending decisions has become mainstream practice — and with it increased scrutiny. Recent crackdowns on alleged greenwashing by BNY Mellon, DWS and Goldman Sachs illustrate that market participants are demanding fewer lies and more truth.  

What was once a niche led by a group of mission-aligned investors, ESG is now touted as more than a $40 trillion industry. These days, ESG ratings are developed to bring clarity to what constitutes a good investment given ESG risks, opportunities and impacts. ESG strategies range from applying negative screens to harmful practices to actively seeking a societal outcome with the capital invested.

Nevertheless, ESG ratings are the Wild West in investing of our time, presenting significant divergence in scope, measurement and weight factors. The result is that ESG ratings are often incomparable, incomprehensible and incomplete. 

While it may be tempting for regulators to harmonize the ESG ratings field, in a recent comment letter we argue that it would be better to enact a series of minimum safeguards that encourage competition and protect against a lack of methodological rigor and conflicts of interest as observed in the Credit Rating Agency (CRA) model.

There are two critical ways forward to achieve trust, competition and clarity for ESG ratings: banning the sale of ancillary services for ESG rating providers and requiring transparency for methodologies and conflicts. 

The CRA model is rife with conflicts and has illustrated that companies paying to be rated generally receive more favorable ratings. We need only look to the 1960s and 70s, when Moody’s Investors Service switched to the issuer paid model before S&P Global Ratings replicated; this issuer-paid model led to higher ratings of the issuer. More recently in 2018, India enacted a transparency law to make CRA ancillary fee payments publicly available. Subsequently, researchers found there to be a three-notch upgrade in rating for companies paying for ancillary services. It’s imperative that ESG rating providers not be allowed to sell ancillary services to those they rate; in addition, these providers should disclose whether a rating has been solicited and whether the entity being rated has paid for the rating.

It’s important to level the playing field by allowing those acting in the public interest to co-exist with those acting in commercial interest. There is rapid consolidation in the ESG rating field, most concerningly by CRA parents and affiliates. Morningstar acquired Sustainalytics, Moody’s acquired Four Twenty Seven, S&P acquired Trucost, and the list goes on. However, there are also non-profits and other institutions that provide an ESG rating and ranking service in the public interest. 

To achieve a level playing field, methodologies, including questionnaires, should be disclosed. One test of methodological transparency is whether a third party could replicate the ESG rating based on the information provided. Additionally, the introduction of ESG signifiers would bring market clarity. The “sf” signifier, pioneered in Europe, is now commonplace for credit ratings to indicate a structured finance rating. A similar signifier could be introduced for ESG ratings, indicating when the rating is “inward,” “outward” or “circular” looking: “inward” meaning the impact of the outside world upon the rated entity, “outward” meaning the impact of the rated entity on the outside world, and “circular” indicating a co-dependent, circular, non-binary nature of a metric.

Another measure to prevent misleading information would be to require absolute metrics instead of, or in addition to, intensity metrics. The practice of making ESG impact metrics relative to capital deployed or similar factors serves to relativize the impacts on people and planet, while also skewing ESG ratings in favor of larger companies. For example, a ton of arsenic pollution will have the same impact on community health regardless of whether it came from a company of $5 billion in annual revenue, or one with $1 million.

Finally, breaking down E, S and G scores if aggregation exists would allow the user to understand how well the rated entity performs on each. Some ESG ratings game the system by only focusing on one or few components of ESG, whereas the user is often expecting something more comprehensive. Being clear about what is being rated, and in what categories, would help improve trust in the ESG market. 

To be sure, over-regulation in this nascent field would be damaging. Very stringent criteria may reduce competition in a sector where oligopolies are already forming, leaving much-needed innovation by the wayside. This is why we suggest minimum safeguards as opposed to outright taxonomies.

Learning from the failures of the CRA industry, regulators now have an opportunity to define the minimum safeguards of the ESG ratings industry in a way that benefits people and planet.

Marilyn Waite is managing director at Climate Finance Fund.

Daniel Cash, Ph.D., is lecturer in law at Aston University’s Credit Rating Research Initiative.

Bill Harrington is a senior fellow at Croatan Institute whose work centers on boosting the sustainability of the world financial system.