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Regulation will wreck ESG

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There are growing calls to build all-encompassing regulatory structures around environmental, social and governance ratings and disclosures. This is the wrong course of action and will undermine efforts to achieve the overarching goal, which is fighting climate change.

Among the latest moves, the International Organization of Securities Commissions is pushing securities regulators around the world to regulate ESG ratings providers, while the European Central Bank is expected to provide a framework for ESG disclosures over the next few years.

These might sound like great initiatives that will help to combat so-called greenwashing, but in reality they will do more harm than good.

Regulation is too blunt a tool for a set of instruments that are, by their very nature, highly bespoke. A fashion company and an oil major are not going to be able to implement the same measures to reduce their carbon output, and they are going to need to show investors what they are doing in completely different ways.

Cramming ESG criteria into prohibitive, binary regulations — where you’re either inside the rules or not — will stifle the very innovation that is needed to address significant ESG problems.

This is particularly true for such a young feature of the markets as ESG criteria. As mainstream products, green bonds have been around for less than a decade; sustainability-linked bonds for less than three years. Issuers and investors are still working out how best to place financial tools into service in the fight against climate change. Bringing the hammer of regulation down on the market at this stage will stunt its evolution.

Investors do frequently complain about major discrepancies between ESG ratings agencies, which use a range of different criteria and disclosures. They also complain that some do not return calls, while others provide so much information that it becomes almost useless, because the important is buried among the unnecessary.

This is where the market should be trusted to police itself. The creation of market-driven standards will take place gradually in real time. If investors do not like a practice, they will not buy a particular bond, and that practice will not be used again. Likewise with ineffective ratings providers.

This gives issuers ample space to try new things. When Swedish clothing retailer Hennes & Mauritz brought its first ever bond to the market in February, the company included a sector-specific key performance indicator linked to the amount of recycled material in its products. Investors lapped it up, and since then, other issuers have been emboldened to use KPIs that are tailored to their sectors. The market worked.

Away from ESG, the bond market has proven trustworthy in coming up with its own answers to thorny problems. In the move away from Libor, issuers have long since settled on using Sonia compounded in arrears for their floating rate notes. Sonia FRNs are now commonplace — no extra regulation necessary.

Moody’s expects $850bn of sustainability bonds to be printed this year, a record. Investors and issuers are being bombarded with new data points, constantly seeing what works and what doesn’t.

It will take some patience, but for ESG investing to be truly effective, the market must be trusted to find its own way.

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