Upcoming Regulations in ESG Ratings: Three Implications for Business

The field of ESG ratings is in a phase of rapid growth—as of today, it is estimated that there are 150 different ESG data providers in the market, and these figures are expected to grow with continued consideration from investors. The estimated scale of ESG-related assets under management (AUM) is predicted to reach US$53 trillion by 2025, equivalent to a third of all global investments. 

This fast-paced development is due to an increasing regulatory focus on ESG in potential investments with the EU Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR), together with more sophisticated demand from investors for products that shift society to a greener economy and help mitigate climate change. These two drivers are only likely to increase in intensity over the coming years, leading to ESG ratings taking on a key role in the ecosystem of sustainable finance.

However, with increased influence comes increased scrutiny, and the rapid development of this industry has rendered vocal criticism. This often points to the lack of common standards, as there is no unified definition of what “ESG” should be measuring. Instead, different ESG raters provide indicators on different aspects of sustainability, and applied methodologies vary.

ESG raters often find varying conclusions, despite access to the same information, and on average, the correlation between the leading providers’ scoring of the same company can be as low as 0.54. In comparison to the regulated field of credit ratings, where correlation is close to 0.99, this stands out. Consequently, the market receives mixed signals about ESG performance, and business, in turn, gets mixed messages about what steps to take to improve their scores. Plus, there is often limited transparency around underlying methodologies due to confidentiality, which makes it difficult for companies to understand the criteria used to assess them.

All these factors have created legitimate concerns over greenwashing, questioning the reliability of these ratings and how well they reflect a company’s commitment to ESG. Consequently, voices have started to call for regulations in the industry. There is a need for more standardization, to calibrate the market so that actors are more aligned with the help of regulatory initiatives.

In 2022, Japan’s Financial Services Agency released a Code of Conduct for ESG rating and data providers. This is the first of its kind being issued by a national regulator, consisting of six principles covering transparency around methodologies and data sources, with a comply-or-explain approach. Emerging trends are starting to move in other parts of the world—for instance, the UK government has established a working group for a voluntary best practice code for ESG raters, looking to bring them within the scope of the Financial Conduct Authority. Similarly, the European Commission expects to issue regulation to monitor the reliability and transparency of ESG ratings in 2023, as part of the European Green Deal.

Regulations seem to soon be the new reality for ESG rating agencies. But what are the implications for business? Is this good news?

• Common language: Despite being rolled out in different global jurisdictions, regulatory frameworks in the making all strive for alignment of terms used in ESG ratings to enable common understanding across the industry. A cohesive terminology adopted by policymakers and regulators creates increased consistency for issuers and a chance to streamline sustainability efforts and related public disclosure.
• Increased transparency: There is an increased demand for an improved understanding of how ESG raters arrive at their scorings, and upcoming regulations all promote more transparency around methodologies, data gathering, and the weight of certain metrics to assess ESG performance. Better insight into the rating criteria enhances issuers’ understanding of what it takes to improve their scores, target selected areas, and come out stronger in the next assessment.
• Less greenwashing: One of the main objectives of regulating the ESG ratings field is to crack down on greenwashing and avoid (sometimes unintentional) misleading claims on ESG performance. Improved transparency of rating objectives and methodologies makes it more difficult for issuers to inflate their sustainability credentials, especially when overseen by a regulatory body. This puts increased pressure on companies to prevent exaggeration and instead back up their sustainability claims with hard evidence.

While upcoming regulations will serve to make life easier for rated companies, it is a double-edged sword, as it simultaneously raises expectations to deliver on sustainability commitments. But at the end of the day, this is good news for everyone. ESG ratings play an important part in supporting the sustainable investing landscape and are here to stay; seeking a more harmonized and transparent system and eradicating claims for greenwashing will help create trust in this industry.

This is a win-win not only for rated companies and investors subscribing to the ratings, but also for the ESG raters themselves.

This article was originally published at the BSR website "Sustainability Insights" and is written by Ellinor Haggebrink, manager at BSR.