The ESG Ratings and Data Products Ecosystem
The ESG information supply chain starts with investors’ need for data that spans the Environmental, Social, and Governance aspects of corporate activity. Companies produce sustainability reports with data on each ESG metric. Commercial and non-profit organizations use the data to issue ESG ratings based on their assessment of how companies address ESG risks and meet sustainability goals. The ESG information engine has kicked in and seems to be working like a clock.
However, the ESG rating ecosystem is now coming under criticism from various quarters. There is no standard rating methodology that the rating agencies follow. There is often a difference in the rating each agency issues to the very same company. There are doubts about sources of ESG data and potential conflicts of interest in the rating process.
An estimate by KPMG puts the number of ESG ratings and data products providers worldwide at 160. The European Union might be home to 30-40 other smaller providers of ESG ratings, data, and research, according to a recent European Commission report. As for revenues from ESG ratings and data services, a UBS study states they could more than double by 2025.
Some of the more popular ESG rating services are ISS ESG (by Institutional Shareholder Services); Moody’s; MSCI; S&P Global; Sustainalytics (a Morningstar division); Bloomberg ESG scores; Fitch Climate Vulnerability Scores; FTSE Russell’s ESG Ratings; CDP’s climate change, forests, and water security scores.
Concerns Regarding the ESG Ratings Ecosystem
- The European Securities and Markets Authority in a March 2021 report spoke about the risks posed by the ESG rating ecosystem. ESMA said the absence of common definitions on ESG risk gives rating agencies the room to decide on the definitions, affecting the comparability of ESG ratings. Secondly, there is an issue with the “transparency of methodologies that underpin ESG ratings”.
- A November 2021 report by the International Organization of Securities Commissions (IOSCO) titled Environmental, Social and Governance (ESG) Ratings and Data Products Providers pointed out concerns “about the management of conflicts of interest where the ESG ratings and data products provider or an entity closely associated with the provider performs consulting services for companies that are the subject of these ESG ratings or data product”.
- Between April 4, 2022, and June 10, 2022, the European Commission ran a public consultation to understand the ESG rating ecosystem and how credit rating agencies incorporate ESG risk into their assessments.
- In June 2022, the UK’s Financial Conduct Authority published a feedback paper to its consultation on ESG integration in UK capital markets where it supported the idea of bringing ESG rating and data providers under its purview.
Divergence in ESG ratings – The Solution
Sustainability Reporting in a Structured Format can help the ESG rating process
Companies getting started with ESG reporting have a number of sustainability accounting standards to choose from. Some of them are the SASB Standards (by the Sustainability Accounting Standards Board); The International Integrated Reporting Framework (<IR> framework); Task Force on Climate-related Financial Disclosures (TCFD); Global Reporting Initiative (GRI); Carbon Disclosure Project (CDP) Guidance.
Some of these standards have digital versions called taxonomies, which convert sustainability concepts into machine-readable labels or tags. Companies can create HTML documents and embed those machine-readable labels against each of their disclosures to produce a digital ESG document. The digital tags are in a language called the eXtensible Business Reporting Language (XBRL).
Machine-readable ESG data is easier to pull into Excel spreadsheets for analysis and comparison across companies and sectors. Contrast this with PDF reports that lock up the information contained in them. To access the information in PDF reports, users need to manually copy and paste each disclosure into spreadsheets. Therefore, when companies produce machine-readable ESG reports, they make material ESG information available to ESG rating agencies in a readily usable format.
Moreover, machine-readable ESG reports are highly structured and granular. Digital taxonomies force companies to be more specific about their performance on ESG factors. This has an effect on the transparency of ESG reports, and consequently, that of ESG ratings.
Currently, most companies prepare ESG reports in PDF format. However, digital ESG reporting mandates are being implemented in most jurisdictions, and over the next couple of years, ESG rating agencies can expect to have more structured ESG information at their disposal.
A Globally-Accepted Sustainability Framework can help the ESG rating process
If structured ESG reporting can improve the transparency within the ESG rating ecosystem, here’s something that can take things a notch higher: A single globally-accepted framework for ESG reporting to be based on.
Currently, companies have the option of choosing the sustainability framework they prefer. However, this poses a problem for the stakeholders of ESG information. They receive reports that are based on diverse standards and cannot effectively compare disclosures across companies and sectors. What would assist with comparability is reports based on a single set of ESG reporting standards.
Efforts to create such a baseline ESG framework are underway, being led by the International Sustainability Standards Board (ISSB).
