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ESG ratings: who will watch the watchmen?

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There are hundreds of ESG rating agencies but very little oversight

ESG is everywhere. It has moved beyond a buzzword and beyond a trend, it is now the norm. Much to the chagrin of those who stand against it and what it represents, it has become increasingly difficult to ignore for issuers across the capital markets and the wider corporate world.

The rise of ESG has been rapid over the last decade. In the bond sector, just a few years ago anything green was considered novel and warranted discussion. Now, if it isn’t green, blue, sustainability-linked or tagged with some other label, it’s old hat. It sells too. There was over $1tr of green bonds issued in 2021 alone and issuers are happy to add an ESG label in tough markets to drag in extra orders from ESG-dedicated funds.

With this giddy ascension however have come accusations of greenwashing — passing something off as green that isn’t. Therefore, who exactly determines whether a bond can be classified as having met a good standard of greenness has an important job. But in this nascent market, it is unclear what standards apply to those that set the criteria.

A multitude of companies offer rating services and opinions to companies looking to identify as ESG-friendly, or print securities labelled as such. It is hard to identify a specific number of these agencies with so many popping up, but a quick google shows that estimates vary between 100 and 600.

In addition, many issuers have internal auditing systems that play an increasingly important role. The Center for Audit Quality (CAQ) deemed that 95% of S&P 500 companies publicly provide ESG information, but also stated that, in 2019, only 29% of those firms submitted their sustainability data to be verified by a third party.

This is a problem. When it comes to the environment, to social values, or to corporate governance, there should not be so much information left in the dark. Some may argue that in such early stages of a movement it is important to have a divergence of views on what counts as ESG while the market figures itself out.

There is some truth in this but having so many options means that companies looking for ESG labels are able to shop around until they find a rating that works for them.

Of course, there are industry leaders in the ESG ratings business and those that are judged best in class that credible issuers can flock to. But it wasn’t that long ago that the most credible credit rating agencies helped fuel a global financial crisis by poorly rating asset backed securities. Might is not always right in financial opinion forming.

But of course, it is the divergence of views that allows for the disparity. If the rating agencies all followed the same principles then there would be nothing for them to compete on other than the price at which they sell their services, so they offer alternatives to find a valuable niche for themselves.

The underlying purpose of these ratings is to assess a company’s ESG performance, however disagreements between these agencies as to what constitutes E, S or G means investors have very little certainty around how good the company’s performance really is.

A 2019 MIT Sloan-led paper highlighted this issue and broke it down into granular data, demonstrating significant scope, measurement, and weight divergence across all ESG ratings. The paper called for more attention to be paid to how the underlying data is generated, suggesting that if “investment choices are guided by ESG ratings… the construction of and disagreement among ESG ratings [is] a central concern”.

Morningstar’s Sustainalytics, Moody’s, Bloomberg, MSCI, and a handful of others have risen to the top of this field, but the disparities between these companies are also stark. For example, the governance of a company may be judged on its gender positivity policies, but this can be determined in a number of ways ranging from pay gaps to board composition, depending on which agency you ask.

A push towards strong ESG regulation across the world is underway. In the US, SEC commissioners Allison Herren Lee and Caroline Crenshaw raised a similar point in October 2020 when they called out auditors involved in financial disclosures, asking “Who watches the watchers?”, and it is no coincidence that they played a driving force in the advancement of the Commission’s subsequent climate disclosure proposals.

Things have progressed somewhat further in other jurisdictions, like the UK or the EU, but regulation is yet to reign ESG rating agencies in or so much as question their disparities. Strong opposition – from on as high as the US Supreme Court – means the SEC’s proposals are unlikely to materialise exactly as laid out, leaving the world’s biggest financial capital market largely unregulated.

But a patchwork approach, where one data point shows up green in one interpretation but not in another, is only going to limit the significance of the entire movement and help promote greenwashing. Without proper oversight, the watchers will be at liberty to turn a blind eye to all sorts of bad standards.

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