Calls for ESG Rating Agency Regulation Grows Louder in Europe, But Could It Actually Save the Industry?

The ESG Rating Agencies, or Corporate Sustainability Systems as they have also been labelled as to convey the differing elements of the industry, are becoming ever more important in theory. This is because, as Refinitiv found recently, 98% of global institutional investors are now actively considering ESG in their investment decisions. However, there are massive issues within the industry and its multitude of models, which has now led the Autoriteit Financiële Markten (AFM) and Autorité des marchés financiers (AMF) to issue a joint paper calling for regulation at the European Level. However, what would a new regulatory framework look like, what could it achieve, and what effect would it have on the development of this relatively nascent industry?

 

Whilst the EU have started a study on the ESG rating marketplace and its intricacies, as of yet the market is essentially unregulated. The market they exist to serve is exploding and growing at an incredible rate but, just like the credit rating industry prior to the Financial Crisis, the ESG rating industry remains unregulated. There are a number of reasons for this. The development of the sustainable finance movement has been relatively rapid, and is still very much in its infancy despite the numbers and rate of incorporation being reported; therefore, a regulatory regime to accompany the new market is still be developed, critiqued, and pushed through the politicised processes on both sides of the Atlantic (and elsewhere). The ESG Rating market itself is particularly fragmented, with there not even being uniformity in the members of the industry; some provide ratings, some rankings, some information for indices. Some focus on particular elements, some focus on the broader ESG picture. There is not even agreement on what to call them: ESG Rating Agencies, Corporate Sustainability Systems; or Sustainability-related Service Providers. This has led to some serious issues which are, as of yet, particularly unresolved.

 

It is hard to rank the issues in order of severity because the marketplace needs them all to be resolved as soon as possible. For example, as there is no standard for what ESG means, and how it should be integrated into a risk assessment, the variance is proving to be massively problematic. Agencies understand ESG very differently, and consider companies and countries in very different ways upon that varying foundation. Not only that, but there are massively variable methodologies being employed and, as the AMF and AFM argue, the lack of regulation enforcing the publication of methodological processes means that investors do not really know, for sure, how the agency they are using arrived at their result. When the details are published, they are laden with platitudes regarding how important one element is over another. There are also differences in how agencies retrieve their information, with the common method being to scour publicly-available information, but others integrate the views and reporting of companies more. Some use qualitative methods to gather this information, some use more quantitative methods. Even more so, agencies are slaves to the level of disclosure on offer, and there is no regulation enforcing certain levels of non-financial informational disclosure. The EU is pushing ahead with such regulations, whilst the US is actively rejected such regulatory approaches. Because of this variety in available information – either because the companies do not have the resources to make it available, do not know how to disclose it properly or for the best, are overwhelmed with the multiplicity of requests for information from the many ESG rating entities, or otherwise – the dearth in information has been identified to lead to firm-size bias, and something called the ‘rater effect’ whereby agencies will rate favourably the companies who disclose more, even if such positive considerations do not warrant the higher rating. There is the potential that competitional effects are at play, with the battle for market share being particularly acute in this industry.

 

To resolve these issues, the two entities argue that there needs to be an adhoc regulatory framework established that would be led by ESMA and, essentially, mirrors the framework applied to the credit rating industry, albeit with more flexibility to account for the nascency of the industry and the market they exist to serve. This all makes sense. The framework, requiring registration, inspection, and enforced transparency, would be the perfect vehicle to install standards that can then shape the interaction between the investors, the issuers, and the agencies. However, it all sounds very familiar. This dynamic that the two entities have identified has been played out before in the credit rating arena, and the regulators have essentially been left embarrassed by their failures. Whilst the regulations have sent a message to the credit rating agencies that the bloc, and the US will not tolerate the levels of transgressive behaviour on show before the Crisis, the environment has changed so much that the actual integrity of that message has not really been tested – I argue that the agencies’ behaviour was aligned to the systemic and cultural behaviour that led to the Crisis (although the cultural underpinnings of the rating industry mean that it was primed to take advantage). Two of the main aims of the regulations on both sides of the Atlantic was to increase competition to break the oligopoly, and to remove reliance on the agencies. Every legislator and regulator have failed on these counts. The Big Three are even more powerful, have garnered more revenue and profit, and saw off the majority of even vague competitional threats. In terms of removing reliance, the marketplace is using the agencies even more, in spite of the removal of regulatory references to them. Further still, regulators in the US have disregarded the order and still refer to the agencies, even a decade after Dodd-Frank. This is all because of misunderstandings, plain and simple. The legislators and regulators understood the rating dynamic as they wanted to understand it, not as it is. The market does not want increased competition. The market uses the rating agencies and their products actively, not predominantly because of the informational value of the ratings (which many have argued is negligible) but because of the role the ratings play – they allow multiple parties to signal to other parties information needed to maintain the flow of capital – that is all. There is not, as of yet, anybody else who can fulfil that role. This is not a new problem, and I have shown again and again that this is a systemic dynamic that causes such issues, not a regulatory or agency issue.

 

Therefore, it is likely that such regulations will not address systemic issues in the ESG rating arena. However, regulation my paradoxically save the industry. In my forthcoming book Sustainable Rating Agencies vs Credit Rating Agencies: The Battle to Serve the Mainstream Investor, I argue that the credit rating industry is actually perfectly constituted to serve the growing ‘mainstream’ of investors looking to incorporate ESG into their investment processes. They are small in number – thereby reducing multiplicity – they are well known to the marketplace and their practices are familiar, they have a regulatory framework surrounding them already, the cost of dealing with them to acquire such information will be reduced if it is aligned to credit risk assessments, and they have vastly more resources to invest in the collation and development of this information (as proven by S&P’s proposed acquisition of HIS Markit at $44 bn). They also have the issuer-pays model established across the board, meaning a uniformed access to the information required from issuers. The ESG Rating Agency industry cannot compete, and its structure simply does not allow it to serve the new mainstream investor base as it would like, or needs to. The devouring of the ESG rating industry by the Credit Rating industry is already underway as I have predicted (think Sustainalytics being bought by Morningstar), although I predict it will increase tenfold in the coming years as more of the investment marketplace turns purposefully towards ESG (the Biden Administration, if it turns course away from the Trump Administration), may hasten this development even further. That may only leave the developers of indexes, which contains some substantial players that the credit rating agencies may not bother with i.e. MSCI. Other than that, the ESG rating market is up for grabs. However, if a regulatory framework can be developed which can mandate transparency, develop agreed-upon standards of understanding ESG, develop consistent methodologies and transmit these to the marketplace, and guard against conflicts of interest, then the ESG rating agency may bloom into its own flower; however, that is quite a challenge for regulators and I question whether that level of regulatory performance is even possible, even if there is an appetite for it. Let it be said however that I am not talking up the credit rating agencies, but they are natural vehicle for what the mainstream investor base want. Time will tell of course, but that time may be sooner than people may think.

 

Keywords – ESG rating agencies, credit rating agencies, ESMA, regulation, @finregmatters