August 18, 2022

Investments In ESG Are Regulated In The Wild West

4 min read
Investments In ESG Are Regulated In The Wild West

ESG financing is reaching a turning point. Environmental, social, and governance (ESG) indicators are now commonly used in lending and investment choices, which has led to heightened scrutiny as a victim of its own success. Market players are demanding fewer lies and more honesty, as evidenced by recent crackdowns on purported greenwashing by BNY Mellon, DWS, and Goldman Sachs.

ESG is today hailed as a $40 trillion sector, up from being a niche driven by a group of mission-aligned investors. These days, ESG ratings are created to clarify what, given ESG risks, opportunities, and impacts, makes a smart investment. Applying negative filters to unethical operations to actively pursue a societal objective with the capital invested are only two examples of ESG tactics.

However, ESG ratings are the Wild West of time investment because of the wide variations in their scope, assessment, and weighting considerations. As a result, ESG evaluations are frequently incomplete, inconsistent, and difficult to understand.

The Wild West of regulating ESG investments

In a recent comment letter, we make the case that, despite the temptation for regulators to standardize the ESG rating industry, it would be preferable to enact a set of minimal protections that promote competition and guard against methodological laxity and conflicts of interest like those seen in the Credit Rating Agency (CRA) model.

The selling of auxiliary services to ESG rating providers must be prohibited, and techniques and conflicts of interest must be made transparent. These are the two most important steps that can be taken to increase confidence, competition, and clarity for ESG ratings.

The CRA approach is plagued with inconsistencies and has demonstrated that organizations who pay to be rated typically earn better ratings. We simply need to consider the 1960s and 1970s, when Moody’s Investors Service adopted the issuer-paid approach before S&P Global Ratings followed suit and the issuer’s ratings increased as a result.

India just passed a transparency law in 2018 to make information about ancillary charge payments to the CRA public. Researchers later discovered a three-notch rating increase for businesses that pay for auxiliary services. ESG rating providers must be prohibited from offering supplementary services to those they evaluate, and they must also be required to declare if a rating was requested and whether the organization being rated paid for it.

By allowing those operating in the public interest to coexist with those acting in commercial interest, it is crucial to level the playing field. The growing convergence of the ESG rating industry is particularly alarming among CRA parents and affiliates. Sustainalytics was acquired by Morningstar, Four Twenty Seven by Moody’s, Trucost by S&P, and so on. Non-profit organizations and other organizations, however, also offer an ESG rating and ranking service in the public interest.

Methodologies, including questionnaires, should be made public to create a level playing field. Whether a third party might recreate the ESG rating using the information provided is one way to gauge methodological transparency. The inclusion of ESG signifiers would also improve market transparency.

The Wild West of regulating ESG investments

Credit ratings now frequently use the “sf” abbreviation to designate structured finance ratings after it was invented in Europe. For ESG ratings, a similar descriptor could be used to indicate whether the rating is “inward” (meaning the impact of the outside world upon the rated entity), “outward” (meaning the impact of the rated entity on the outside world), or “circular” (meaning it is co-dependent, circular, or non-binary).

The requirement of absolute measures in place of, or in addition to, intensity metrics would be another approach to prevent misleading information. The practice of comparing ESG impact indicators to capital deployed or other similar criteria relativizes the effects on people and the environment while simultaneously favoring larger corporations in ESG ratings. For instance, if a tonne of arsenic pollution originated from a corporation with $5 billion in yearly sales or one with $1 million, it would still have an effect on the community’s health.

Finally, if there is aggregation, breaking down the E, S, and G scores would let the user understand how well the rated object performs on each. Some ESG ratings manipulate the system by concentrating just on one or a small number of ESG factors when the user frequently expects something more thorough. The ESG market would benefit from the increased trust if it was clear what was being graded and in what categories.

Undoubtedly, excessive regulation in this developing industry would be detrimental. In a market where oligopolies are already developing, very strict requirements could restrict competition, stifling much-needed innovation. We recommend minimal precautions rather than strict taxonomies because of this.

Regulators now have the chance to define the baseline protections of the ESG rating sector in a way that benefits people and the environment after learning from the mistakes of the CRA industry.

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