Experts Predict Concentration in the ESG Rating Universe, and Find Faults with the ESG Push


Today’s short post reacts to a webinar held recently by Funds Europe, which focused on ESG Reporting Standards as the EU’s Sustainable Finance Disclosure Regulation (SFDR) went live in March. During the webinar, the issues of ESG Rating Agencies came to the fore, unsurprisingly. Familiar issues were put forward, but predictions from experts matched the conclusions that I also came to in my recent book – Sustainability Rating Agencies vs Credit Rating Agencies: The Battle to Serve the Mainstream Investor.

 

The article that reviews that webinar (found here) reviews each of the sentiments from the participants, starting with Andrew Parry, the head of sustainable investments at Newton Investment Management, who suggests that the reason that people buy things like investment products is for return, not to be exposed to increased information on that product. He goes on to state that a survey of Newton’s clients found that only 23% of their client base actually knew what the term ESG meant.  This led to his fear that pushing for ESG-related informational disclosure loses sight of the goal of ESG and limits the investment opportunities in this area. It is suggested in the article that the aim should be to reduce the focus on reporting, and instead focusing on being transparent and engaging more with companies in their portfolio. This makes sense, but the calls for limiting reporting are more in line with the generalised lack of enthusiasm for regulation and bureaucracy in general, perhaps.

 

However, Mikkel Bates, the regulatory manager at FE fundinfo which is a fund data platform, turned attention to the ESG rating agencies when finding issues in the new sustainability push towards the financial sector. He suggested that whilst options are usually good for companies and investors who may want to find gaps to exploit, utilising a wild market for ESG ratings to help reporting standards was not appropriate for the marketplace. With the variety of approaches and reporting methods, he suggested that investors and companies will be unsure as to what constitutes good practice in the ESG realm, and what does not. Oliver Oehri, co-head of the ESG product group at FE fundinfo, concurred. With all the variety in one corner, and the need to signal in the other, Oehri comes to same conclusion that I did, in a sense: ‘as for the ESG rating agencies, there is likely to be continued consolidation in the sector until it resembles the credit rating world where there are three dominant players, all using the same basic methodology, and investors take either an average or lowest score’. This consolidation is crucial if the mainstream investor base is to get what it requires from the sector. My conclusions went further, arguing that this consolidation will merely result in herding the sector’s participants to the door of the credit rating agencies, who have the resources to devour the consolidated group (or what is left after the credit rating agencies have picked off the stragglers from the larger herd).

 

It is interesting that the field is starting to realise this predictable outcome. The need to signal is paramount, and a wide variety of rating issuers is not conducive to such need. However, there is an important lesson to learn here for regulators. Credit rating agencies existed long before even the earliest formalised regulatory structures (particularly in the US) and this has almost become an underlying sentiment to how to the two interact. Yet, for the ESG rating universe, this is not the case. Regulators must therefore get well ahead of the curve and design a regulatory framework, based on a purely pessimistic footing, that focuses on preventative measures to guard against conflicts of interest inherent within a consolidating rating universe. A rating scandal akin to the financial crisis-era scandal can be particularly damaging to the trust and belief that will be required to make sustainable investing truly mainstream. Regulatory bodies must focus on this issue before the consolidation and predicted devouring by credit rating agencies is complete, otherwise the horse would have bolted before the stable door could be shut.

 

Keywords – credit ratings, ESG, ESG rating agencies, @C_R_R_I

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