Concerns Raised over ESG Ratings, but Why?

An article in today’s edition of the Financial Times, entitled ‘Heavy flows into ESG funds raise questions over ratings’, attempts to shine a light on the business of ESG rating agencies, or Sustainable rating agencies, as the process of incorporated ESG (Environment, Social, and Governance-based) considerations into investment decisions is becoming more mainstream. However, upon reflection, the sentiment of the article is a little understated so, in this post, we will assess the article closer and think more about the trajectory of this industry (particularly in relation to the much larger credit rating industry).

The article begins my making valid points regarding the increasing importance of such ratings, with the discussion focusing on the fact that a growing number of investment indices are now focusing on the ratings much more as well as banks now offering better borrowing terms for entities that can demonstrate stronger ESG scores. I analysed this trend in my recent book The Role of Credit Rating Agencies in Responsible Finance (available in preview here), as well as in an article entitled Sustainable Finance Ratings as the Latest Symptom of ‘Rating Addiction’ and it is indeed true that a number of elements are fuelling this mainstreaming of the ESG considerations, rather than traditional models such as thematic or ethical investing: a reaction to the Crisis-era version of investing; entities such as the PRI; the entrance into the field of the large credit rating agencies, which has essentially formalised and certified the niche investment models for the mainstream investors (as there is less focus on purely ethical or thematic investment principles and more on the returns-based aspects). However, the article quickly shifts towards research conducted by MIT Sloan School of Management (in August of last year) that suggests that there is a large divergence between the ratings of the sustainable rating agencies, and especially when compared to the credit rating agencies – who themselves are ostensibly incorporating ESG into their rating decisions much more – with the example of Facebook being docked points and concerns raised from Standard & Poor’s, whilst MSCI maintain average ratings.

Yet, Berg, Kölbel, and Rigobon (the scholars from MIT and the University of Zurich) attempt to ‘quantitatively disentangle’ the divergence witnessed between the ratings of the top five sustainable rating agencies, which they find can be substantial. Their analysis leads them to conclude that the divergences witnessed in the field are because of an inherent issue – ESG ratings are very subjective, and the differences in underlying methodologies between the agencies is at the core of the divergence. The sentiment is that the methodologies are so radically different between the sustainable rating agencies, as opposed to the credit rating agencies for example (whose ratings on entities are often much closer), that it is difficult for investors to know which is useful and which is not. The FT article then looks at issues that underpin this divergence, including potential informational disclosure-based issues which may impede a ‘full’ rating, for example. Furthermore, the President of MSCI is cited as an example of the tone of the argument, when he mentions that homogeneity witnessed in the credit rating agencies is not, and should not be aimed for in the sustainable ratings industry. However, how true is that sentiment?

It is interesting to note that, for the credit rating industry, increased competition was identified as an early post-Crisis solution to the perceived ills within the industry. This then led to a number of regulatory initiatives aimed at increasing competition, including the Rule 17g-5 Program from the SEC (an article I produced in 2018 reviews the Program here) which aims to increase the informational flows within the industry from issuers, so that agencies can offer competing unsolicited ratings to act a check on the paid-for agency’s ratings – although, the SEC recently admitted that this Program has not been the greatest of successes. Other regulatory focuses have resulted in similar failures, which I argued in my first book entitled Regulation and the Credit Rating Agencies: Restraining Ancillary Services is based upon a fundamental misunderstanding of the rating agencies, their function, and their actual importance to the marketplace. I have since developed this discussion in a forthcoming chapter within Regulation and that Global Financial Crisis: Impact, Regulatory Responses, and Beyond within which I suggest that the ‘regulatory licence’ that scholars have argued permits rating agencies to continue is now better described as a ‘market licence’ i.e. it is the market that permits the agencies to grow, and in fact always has – regulators have merely reacted to market preferences. It is these preferences which are the key, and that sentiment is being displayed in the FT article; the market does not want too much competition when it comes to third-party verification, as it quickly becomes a hindrance. The sentiment of the article and the MIT-based research was that the divergence between the ratings is because the underlying methodologies of the leading five sustainable rating agencies cannot be standardised. Whilst industry officials may suggest that this standardisation should not be desired, that is not them speaking from an investor’s viewpoint. For the investor, the viewpoint is very different. The rating feeds into a wider consideration, and divergences increase doubt, which potentially increases risk which is the opposite of the function of any rating agency.

Ultimately, it is telling that when there is no competition, there are concerns and when there is too much competition there is concern. This Goldilocks-like situation has developed because the fundamental dynamics of the marketplace are being ignored because of the outcome, which is not progressive and certainly not appropriate for regulatory purposes. What would be more appropriate is embedding into the understanding that a. the marketplace actually wants third-party verification, but increased competition increases divergence which destroys the point of having that verification, b. a clearer regulatory aim is required in order to increase the likelihood of regulation being successful. A clear aim with regards to credit rating regulation would be to reduce transgressive behaviour, especially in the field of structured finance. One way to do this would be to apply an element of personal liability to the rating committees of the rating agencies on structured finance ratings, with a particularly high bar for that liability – the emails correspondence obtained after the Financial Crisis with analysts admitting that anything submitted would more often than not get high ratings would be a good example of that high bar. However, I absolutely acknowledge that this is likely very unworkable indeed, and for a number of reasons (internal communications would grind to halt, the rating agencies would vehemently defend their position either by way of abstaining from providing certain ratings [thus closing an important marketplace] or lobbying, and it would need a regulatory appetite the like of which we have not seen before). However, the principle of the discussion is important – a misaligned or mis-articulated regulatory focus will always result in unsuccessful regulations, and that is clearly the case in the rating industry. The lessons from the much smaller sustainable rating industry are clear: the regulatory focus on affecting the competitive structure within the rating industry has been a waste. Placing this ‘market-licence’ theory at the core of the regulatory mindset would be a good start moving forward, although the toe-in-toe-out approach currently being taken with the removal of regulatory reference but continued regulation does not suggest that any successes will be expected soon; it is likely the very opposite.

Keywords – sustainable rating agencies, sustainable ratings, ESG, credit ratings, @finregmatters