Better rules and supervision will make ESG ratings reliable

  • ESG ratings today are opaque and hard to compare. Under-resourced rating providers are measuring E, S and G in one rating using different methodologies. This has contributed to friction and misunderstandings between civil society and retail investors on one side, and professional investors and corporates on the other.
  • In a new policy brief, Finance Watch recommends ESG rating agencies analyse environment, social and governance separately to end the confusion. For each, it should be clearly stated what is being assessed – financial returns or real-world impact.
  • The policy brief comes at a key moment, with a legislative proposal on corporate ESG ratings expected from the European Commission on 13 June. Ahead of the proposal, Finance Watch also calls for new rules to ensure ESG ratings are transparent, align with the EU taxonomy, are supervised by ESMA, and are free from conflicts of interest.

Environmental, Social, and Governance (ESG) ratings should give investors transparent and reliable sustainability information that helps them meet their investment goals, whether that be financial returns or a more sustainable world. This is currently not the case because no standard ESG rating exists. Rather than providing clarity, ESG ratings currently cause confusion. In a new policy brief, Finance Watch, the pan-European NGO advocating to make finance serve society, has identified the main reasons for this confusion:

First, many ESG ratings providers focus on serving professional investors interested in limiting ESG-related risks and seizing ESG business opportunities. This creates friction with end customers, the majority of which choose ESG investing so their savings can contribute to making the world more sustainable.

Second, ESG rating agencies group environment, social and governance factors into a single rating, which can result in inconsistencies – a company with good social policies but a negative environmental impact could end up with a high ESG rating. Moreover, ESG rating providers use different methods and weights to aggregate E, S and G parameters into a single rating, making them hard to compare.

Third, most rating agencies focus on the relative ESG performance of a company, not the absolute. While useful to understand where one company stands in relation to its peers, focusing on relative ESG performance alone means polluting companies can still appear in ESG portfolios, further demoralising retail investors and sparking greenwashing accusations.

Finally, due to their business model, ESG rating providers lack human resources. This shortage of staff limits their ability to conduct on-site visits, talk to management, understand a firm’s strategy or cross-check facts and therefore accurately evaluate a company’s impact on society and the environment. To deliver ratings that properly capture the strategy and business plan of a company, ESG rating agencies would need to employ 5 times more analysts than they currently do, and each analyst should examine no more than 20 percent of the number of companies they currently follow. Today, an over-reliance on public information and company questionnaire responses increases the risk of misjudgement, as illustrated by the Orpea scandal, whereby the nursing care provider with an excellent ESG rating from most providers was mistreating elderly people.

Ahead of a legislative proposal by the European Commission on corporate ESG ratings in June, this policy brief from Finance Watch urges EU legislators to introduce new rules and strengthen supervision to end the confusion.

Thierry Philipponnat, chief economist at Finance Watch and author of the policy brief said:

“We need to clarify the objectives of ESG ratings, if anything, to pacify the debate around ESG investing. If it’s unclear to investors and stakeholders why a company has a high ESG rating, they can feel they’re unfairly being asked to take this information on faith rather than fact. To end accusations of woke capitalism on one side and greenwashing on the other, we must start with better rules and supervision of ESG ratings.”

Finance Watch has put forward five recommendations for EU policymakers:

First, oblige ESG ratings agencies to provide individual, standalone sustainability ratings for environmental, social and governance factors. For each, it should be clear what is being assessed – financial returns or real-world impact.

Second, link environmental assessments to the EU taxonomy and highlight any significant divergences. Environmental assessments are not required to align with the EU taxonomy of sustainable economic activities, but any differences must be clearly explained to ensure a basic level of consistency. For example, if a company is 2 percent aligned with the EU taxonomy but has been granted an E status by an ESG rating provider, why and how this difference has occurred must be communicated.

Third, make ESG rating more transparent. It should be mandatory for ESG ratings providers to publicly disclose their methodologies, material objectives and whether ratings are absolute or relative. Rating agencies should also make it clear which data sources are being used and whether or not this data has been audited.

Fourth, prevent conflicts of interest. ESG rating providers should be banned from selling consultancy services to companies they are rating and from rating their own shareholders. To ensure independence, no legal or natural person should hold a participation over 5% in more than one ESG rating provider. ESG rating providers must also put in place internal controls and processes to prevent and control possible conflicts of interests.

Finally, increase supervision. The provision of ESG ratings in the EU and their use by investors should be overseen by the European Securities and Markets Authority (ESMA), the EU Authority in charge of regulating and supervising financial markets.

Finance Watch argues that following these recommendations will help ESG ratings better meet the needs of ESG investors and other stakeholders, including regulators, while also supporting the EU’s transition to a sustainable economy.

 – Ends –

Notes to Editors

About Thierry Philipponnat, Chief Economist at Finance Watch

After graduating from Institut d’Etudes Politiques de Paris and training as an economist (Master’s degree in economics), Thierry Philipponnat started a career in finance in 1985, holding different positions in commercial and investment banking. He then crossed into the NGO world, campaigning and lobbying on behalf of Amnesty International, with a particular emphasis on corporate social responsibility and on the impact of the financial sector on human rights.

In 2011, he founded the European NGO Finance Watch in Brussels, which he managed as its first Secretary General until 2014. In October 2019, Finance Watch appointed Thierry Philipponnat as its Head of Research and Advocacy, and in January 2022 as its Chief Economist.

He is the author of numerous books and articles, and regularly offers comment in the media on a wide range of financial topics, appearing in the Financial Times, Reuters, Politico, Euractiv and more. Most recently he was interviewed in LesEchos, Handelsblatt and Newstalk.

To arrange an interview with Thierry Philipponnat, chief economist at Finance Watch, at Finance Watch, please contact Alison Burns at alison.burns@finance-watch.org or call on +32 (0)471577233

About Finance Watch

Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.

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