IOSCO Publishes its Consultation Report on ESG Ratings and Data Products Providers – Does It Go Far Enough or Is More Needed?

The International Organisation of Securities Commissions (IOSCO) has recently published the results of its initial consultation regarding the need, and the potential methods for regulating the ESG Ratings and Data Products providers that exist to meet the needs of the marketplace in its new endeavour to incorporate the concept of ESG into everything it does. The first stage of the consultation was mainly aimed at the profession, and then the direct users of the profession. Now, IOSCO is opening the consultative period to the wider public for comments on its ten recommendations. In this post, we shall examine those recommendations.

 

The report itself is, majoritively, an opening account of the new market. It is useful for the uninitiated. Whilst not necessarily diving into every complexity (which is perhaps not its aim), the report covers the different providers, the usage of the differing products, and also some of the major criticisms being aimed at the ESG rating industry, ranging from a lack of coherence to a lack of transparency. In response to its findings, the report then offers 10 particular recommendations that it hopes responses to the next phase of the consultation will help refine. Those recommendations are:

1.    Recommendation 1: Regulators may wish to consider focusing more attention on the use of ESG ratings and data products and ESG ratings and data products providers in their jurisdictions.

2.    Recommendation 2: ESG ratings and data products providers could consider issuing high quality ESG ratings and data products based on publicly disclosed data sources where possible and other information sources where necessary, using transparent and defined methodologies.

3.    Recommendation 3: ESG ratings and data products providers could consider ensuring their decisions are, to the best of their knowledge, independent and free from political or economic pressures and from conflicts of interest arising due to the ESG ratings and data products providers’ organizational structure, business or financial activities, or the financial interests of the ESG ratings and ESG data products providers’ employees.

4.    Recommendation 4: ESG ratings and data products providers could consider, on a best efforts basis, avoiding activities, procedures or relationships that may compromise or appear to compromise the independence and objectivity of the ESG rating and ESG data products provider’s operations or identifying, managing and mitigating the activities that may lead to those compromises.

5.    Recommendation 5: ESG ratings and data products providers could consider making high levels of public disclosure and transparency an objective in their ESG ratings and data products, including their methodologies and processes.

6.    Recommendation 6: ESG ratings and data products providers could consider maintaining in confidence all non-public information communicated to them by any company, or its agents, related to their ESG ratings and data products, in a manner appropriate in the circumstances.

7.    Recommendation 7: Financial market participants could consider conducting due diligence on the ESG ratings and data products that they use in their internal processes. This due diligence could include an understanding of what is being rated or assessed by the product, how it is being rated or assessed and, limitations and the purposes for which the product is being used.

8.    Recommendation 8: ESG ratings and data products providers could consider improving information gathering processes with entities covered by their products in a manner that is efficient and leads to more effective outcomes for both the providers and these entities.

9.    Recommendation 9: ESG ratings and data products providers could consider responding to and addressing issues flagged by entities covered by their ESG ratings and data products while maintaining the objectivity of these products.

     Recommendation 10: Entities subject to assessment by ESG ratings and data products providers could consider streamlining their disclosure processes for sustainability related information to the extent possible, bearing in mind regulatory and other legal requirements in their jurisdictions.

The first and most obvious thing to note is that these recommendations above are incredibly weak. However, there are two things to understand. The first is that each of these recommendations are followed by a list of questions in the report that should help respondents form more impactful responses to the shallow-looking headline recommendations. The second thing to understand is that IOSCO has no real power or authority; it is merely a network of securities commissions from around the world. This affects what it can say and promote, with the usual approach being to encourage support for developing standards. This, of course, is all that can be done really on the international stage given the importance of securities regulation to each and every marketplace in the modern marketplace – there is perhaps no organisation that could have the authority to dictate to individual jurisdictions in this particular field.

 

With that in mind, an article in Reuters yesterday noted that the aim of IOSCO and these consultations is to ‘unlock the “black box” of corporate environmental, social and governance (ESG) ratings’. To do this, the recommendations come with a list of questions. The first recommendation, which is regarding regulators, is merely a kick-start to the process of regulators starting to take action in this unregulated field. This is already having an effect, with the EU being noted as starting the procedure that will end with formal regulation of the field. The report suggests for regulators that they may want to consider aspects such as regulating against conflicts of interests relating to a lack of division between sales teams and analysts, or the conflict of interest that comes with the provision of consultancy services. It is not surprising that the vast majority of these recommendations and pointers sound like issues affecting the more established credit rating industry. The regulators in question should be more than aware of the concepts being pushed by IOSCO, given their regulatory frameworks that affect the credit rating agencies. I will conclude later that the regulators will have a job on their hands because of the need to position the regulation best given the stage of development of the ESG rating agencies.

 

The second recommendation is aimed towards the ESG rating agencies (and data providers). Suggesting that they ‘could consider issuing high quality ESG ratings…’ is clearly setting the bar very low. The questions that come with it though aim towards promoting transparency in their rating processes and in the publication of their methodologies. This needs to be a staple of the regulatory frameworks that will be applied to the sector. The next two recommendations are focused upon avoiding conflicts of interest, and preserving the perceived independence that is needed if a rating agency wants to be taken seriously by the marketplace. The added questions focus on agencies establishing clear and transparent internal processes that will guard against such failures, the likes of which have been developed by the credit rating agencies. The fifth recommendation returns to the issue of clear and transparent methodologies, particularly in relation to full public disclosure. The sixth recommendation focuses on the necessary condition that non-public information received from an issuer needs to remain non-public. The report suggests the establishment of a number of data protection mechanisms to preserve the sanctity of protecting non-public and potentially sensitive corporate information, which of course it will need to properly rate a given entity.

 

Recommendation 7 then turns to the users of ESG ratings and data. It suggests that users need to conduct their own due diligence on the rating/data entities that they will be using. This demonstrates that IOSCO foresees everything linking together, because in the attached text to this recommendation it states that users can utilise the publicly-disclosed information from ESG rating/data providers to make their informed decision. Recommendations 8 and 9 focus on the users working more collaboratively with the agencies/data providers so that they have all the information they need in order to come to a full conclusion. Recommendation 9 then turns the tables and asks the rating agencies/data providers to respond better to any issues that are flagged by their users. This can be done by establishing a designated contact point for users to utilise, for example. Finally, recommendation 10 suggests that issuers should streamline their publicly-available information so that the agencies/data providers can in turn streamline their data collection processes. This can be done by having a dedicated area in annual reports or websites, or perhaps designating a particular point of contact within the issuer,

 

Again, the above is extraordinarily basic. However, it is a start that perhaps the global securities community needs to build on. For any regulator that regulates the credit rating agencies, all of this should be second nature, given the synergies between the two industries. Yet, there are a lot of issues to work out and the report does not even hint at some of them, unfortunately. The issues that they do rightly focus on really need to be scrutinised further because the dynamics that affect the credit rating industry do not necessarily translate. Fighting for market share is much more of an issue in the ESG rating space, so conflicts like having consultancy arms as well as rating arms can be much more damaging in this nascent industry (though this is relative because, as my first book argued, the development of ancillary services in the credit rating industry has been extraordinarily damaging). An issue that has not even been mentioned is the potential for transgressive behaviour that emanates from the rating committees within the ESG rating agencies, just like their credit rating brethren. It is all well-and-good preventing analysts from being exposed to the commercial interests of the business (which is nigh-on impossible in the modern era), but that means nothing when the rating committees have the ability to be overly-subjective in an opaque manner. There really needs to be a focus on the rating committees in both fields.

 

The biggest issue that regulators will have is with regards to the stage of development in the ESG rating industry. It is relatively new and nobody is really established. Furthermore, the much more established credit rating agencies are circling and picking off substantial players in their quest, as I have predicted (as well as others), to devour the ESG rating field. Any action taken now could have particular consequences down the line. If, for example, a regulator seeks to formally incorporate the major players in an NRSRO-style ratification process, the result could be a walled-off oligopoly that results in the same problems we see now with the credit rating agencies whereby they act with relative impunity. Not ratifying key players may lead to preventing the growth (and, more importantly, the usage) of the market and, if we listen to key market participants, they do not want a large number of players. It is exactly the same dynamic that was developed in the credit rating market and continues to prevent an increase in competition even today; investors, issuers, and even regulators (though they cannot really say it) simply do not want many players in a rating market – it creates inefficiency, even more so than the inefficiency we see in the oligopolistic model. One should not envy the regulators with the task they have in front of them, but the pressure is now on them to get it right and the IOSCO recommendations do not really help; they are so far removed from the level of discourse needed to properly regulate such influential sectors. The responses that are now being requested by IOSCO need to be detailed, critical, and informed.

 

Keywords – ESG, ESG rating agencies, IOSCO, reform, @­C_R_R_I