Potential “Greenwashing” and Industries at Risk Show Why ESG Rating Agencies Have a Massive Role to Play, But Can They Do It?

Today’s post reacts to an article in the Financial Times from Monday, entitled ‘Oil and Gas Lobby moves to embrace green investors’. There are some really concerning elements to the article (what it reports, not how it reports them) and the thought occurred that ESG rating agencies (aka Sustainability Rating Agencies, like Sustainalytics or MSCI) will have a massive role to play in guarding against so-called ‘greenwashing’ – where an entity would dress up their operations solely to look good to ESG investors, rather than actually committing to the principles – and, more importantly, whether they have the fortitude, capability, and authority to take on that vital role.

 

The article focuses on the development of a ‘ESG Centre’, a new initiative put together by the Independent Petroleum Association of America. The IPAA has enlisted the help of FTI Consulting, who as a business advisory and public relations firm, are now advising the trade body and its members of how to better appear open to ESG ideas in order to access the capital that comes with it. The article notes how, in a recent webinar, one participant asked ‘can I use ESG to improve my access to capital?’, whilst a senior FTI director stated that ‘this is not any longer a nice-to-have, but it’s critical to long-term stakeholder confidence, investor confidence. This is a new asset class’. However, rather than embody the principles of ESG and what it is supposed to represent, the trade body are unashamedly looking to exploit the opportunities that come with being perceived as being pro-ESG, with FTI telling the webinar that it is a misconception that energy companies would not score well with ESG ranking firms: ‘if you look at the ESG ratings, they are predominantly based on disclosure and how you manage risk. Not necessarily how much risk you are exposed to’. This may well be the case of course, and we shall return to this point next, but at the same time as plotting to exploit the rewards that come with being positively regarded in the ESG sphere, the trade body is actively backing the Trump Administration’s attempts to weaken designations of critical habitats that protect endangered species. They continually talk of the ‘environmentalist’s agenda’, which has led to the Environment Defense Fund stating that ‘if IPAA were genuinely committed to improving environmental and social outcomes, it would immediately cease its years-long effort to attach sensible standards that cut pollution and protect nearby communities’. Furthermore, the IPAA and FTI have worked together before, on a lobby campaign to open access to fracking opportunities.

 

It may be expected that trade bodies such as the IPAA would use their resources to lobby for their own position; whether one likes it or not, that is the role of lobbying within a society. However, whilst the IPAA’s clear agenda to stop anything environmentally-focused from taking hold is a clear sign that any future marketing noise about their respect for ESG should be instantly questioned, if not dismissed, perhaps this is not the point. Perhaps it is the case that the system around such bodies needs to be up to standard, in order to constrain any iniquities that present themselves. In that role stands the ESG rating agencies (I will continue to use this term for ease, as the FT does, but the terminology is unhelpfully interchangeable). FTI have made clear to their IPAA’s members that the agencies exist to signal to investors that one can be trusted to act in accordance with ESG principles, but that there are ways to do this which do not detract from one’s core principles. Take for example the discussion about disclosure, and the signalling of risk management. This is entirely true. However, other research has demonstrated that there are inherent conflicts of interest, and organisational pressures, which issuers like the members of the IPAA can exploit for their own ends. The first is the fact that many of the leading ESG rating agencies operate on an issuer-pays basis, so these IPAA members will be the ones who are paying for the ratings to be produced. Whilst one may argue that this conflict and its effects are lessened in the ESG rating market, as opposed to the credit rating market, I would disagree – the ESG rating agencies are fighting more intensely for market share and losing out to a competitor could be fatal in the current market. Furthermore, a number of leading ESG rating agencies are now aligned to the leading credit rating agencies, and poorer ESG rating decisions may have an effect elsewhere for the group (separation of companies should see this result be particularly rare, but analysts and senior raters are all human). In addition, research conduct by the SustainAbility Institute declares that, for issuers, the ESG rating market is unnecessarily complex and duplicative. There is also the real issue of a lack of comparability and differing methodologies and processes plaguing the sector. With all of this considered, who is to say that an ESG rating agency would not succumb to temptation/pressure and allow an energy provider, say, to greenwash in order to access the ESG capital that they need (and this need is increasing all the time)? Would that agency lose reputation? Potentially not, because they are all so new and it is difficult to compare, how would an investor know not to trust a certain agency before a calamity occurs? As the ESG sphere continues to grow, the hypothesised role of the ESG rating agencies grows larger, but the question becomes whether they can stand up to that pressure?

 

I argue that they will not be able to. The pressures being exerted on the sector are real, and will have an effect. This potentially hastens the scenario I have been talking about for a few years, in that the rating agencies will become to the go-to sector for this type of information, and the CRAs will simply devour the ESG rating agencies. I say this for two reasons. First, the CRAs and their model is better suited to the system – there are less of them, they have a much longer tradition which, rightly or wrongly, can be used to rely upon, they have the resources and then some to fulfil the role, they are subjected to a much more stringent (although still weak) regulatory framework, and all of the information can be injected into the credit rating process. Second, this has happened before in a bourgeoning market. In the 1960s, the National Credit Office, an offshoot of Dun and Bradstreet, was the dominant player and was, fraudulently, providing its highest ratings for commercial paper-backed products, like that marketed by Penn Central. Once Penn Central remarkably collapsed in 1970, investors were spooked (because of the high ratings that were assigned) and flocked towards anything that could be used as an alternative. I have argued elsewhere that the credit rating agencies who, at the time were close to failing, were waiting with open arms and subsequently began charging issuers for the privilege of obtaining ratings (alongside the threat of the Xerox machine, as the CRAs began charging municipal issuers towards the end of the 1960s). Why would this not be repeated now? This potential greenwashing, and the potential for ESG rating agencies to forego their reputation and position in order to capitalise on the needs of the issuers to signal to the market, is the perfect cocktail of ingredients that can bring about the end of the industry, just as it did for the market-leading National Credit Office; from that point on, Dun and Bradstreet dwindled in comparison to the credit rating industry. Yes this is all hypothetical, but can and may happen. The option of how it plays out belongs to the ESG rating agencies, and it is difficult to predict which way it will go.

 

Keywords – ESG rating agencies, business, credit rating agencies, oil and gas, @finregmatters