UK think tank calls for regulation of ESG ratings

The UK’s International Regulatory Strategy Group (IRSG) is calling for the ESG ratings industry to be regulated, citing concerns around transparency, a lack of consistency in the data and lack of clarity for investors.

‘ESG and sustainability are becoming increasingly central to investment decisions around the world,’ says Kay Swinburne, IRSG council chair, in the new report titled: ESG ratings and ESG data in financial services. As the shift toward sustainable investing accelerates, she says: ‘ESG ratings are a vital component of this capital reallocation, so both demand for and reliance on these products is only expected to grow.’

She notes that some of the challenges the market is facing include transparency of methodology, ratings varying widely between different providers, clarity of purpose behind different products, availability of data disclosure and potential conduct risks.

Peter Beardshaw, European and UK sustainability services lead for financial services at Accenture, which worked with the IRSG on the report, says the case for ESG ratings reform had already been made in 2020, when research revealed a low correlation for ESG ratings. Correlation between various ESG ratings could be as low as 0.38, notes Beardshaw – compared with credit ratings, where correlation is as high as 0.99.

‘Given the global push to integrate ESG into investment decision-making, this gap is hugely significant,’ he says. ‘A low correlation has three consequences. First, ESG performance is less likely to be reflected in companies’ share and bond prices. Second, companies get mixed signals from ESG ratings agencies about what steps to take to improve their ESG rating.

‘Third, financial institutions struggle to accurately reflect the ESG profile in their disclosures, pricing and capital strategies. In short, the potential to ‘green’ corporate behavior and financial markets is at risk of being eroded.’

Because of the rapid flow of money into ESG-themed funds, and the fast-expanding growth of the ESG ratings industry, the IRSG says it believes ‘regulation of ESG ratings is now desirable, to provide more transparency around the basis for ESG ratings and mitigate against potential conduct risk.’

The organization, which is sponsored by financial industry body TheCityUK and the City of London Corporation, says any new rules should be principles-based and proportionate, while adding that any approach should be global.

It notes that efforts are already under way to bring consistency and standardization to ESG ratings in other markets, saying it ‘supports global efforts to improve ESG disclosures – such as the development of the International Sustainability Reporting Standards’. It adds, however, that a cross-border approach is needed to avoid a ‘Balkanization’ of rules that create further conflicts and inflate compliance costs.

The UK’s Financial Conduct Authority consulted last year on whether there should be voluntary best practice guidance for ESG ratings agencies or binding regulation, though the outcome is not due until later this year. The European Securities and Markets Authority is also studying the sector ahead of potential regulation, while global securities body the International Organization of Securities Commissions set out its first global framework last November to prize open what it described as the ‘black box’ of ESG ratings.