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Who Regulates the ESG Ratings Industry?

Feb. 22, 2022, 9:00 AM

Few market trends command more attention these days than “ESG” investing. Whether motivated to avoid so-called sin stocks, or hoping to do well while doing good, investors are piling into investment products and strategies built around environmental, social, and governance metrics. In the U.S., ESG investing now accounts for more than $1 in every $3 managed by a financial professional.

But who determines what makes a solid ESG investment opportunity?

An industry of ESG “raters” has cropped up that rates companies’ ESG bona fides. If you’ve invested in one of the 700+ ESG exchange-traded funds (ETFs) in the U.S., one of these ratings providers probably played a hand in determining the fund’s investments.

Those ratings providers—and the ratings themselves—face increasing scrutiny.

There are calls for the Securities and Exchange Commission and other agencies to regulate the raters. Observers worry that ESG ratings lack clarity, rely on inconsistent criteria, and suffer from conflicts of interest that plague other ratings industries.

Despite these concerns, ESG ratings providers’ services are in high demand. And for good reason. As investors struggle to find and compare “decision-useful” ESG disclosures, ESG ratings providers contrive to bridge the information gap.

Public Information Gets Sorted Into Indexes

ESG ratings providers mine public information to grade companies and sort them into ESG indexes (like sustainable impact, tobacco involvement, or women’s leadership). Investors and financial advisers, in turn, look to the ratings and indexes to develop investment strategies or create ESG-focused mutual funds, index funds and ETFs.

Until recently, the ESG ratings industry hasn’t captured much attention. Possibly because ESG indexes feels like a logical outgrowth from “passive” investing—another style of index-based investing that now captures a large segment of the market.

But the ratings that underlie ESG indexes are qualitatively different from, say, a total stock market index. Recent reporting casts doubt on the consistency and reliability of ESG ratings.

Last year, a Harvard study found that “the more information a company discloses about its ESG practices, the more rating agencies disagree on how well that company is performing along these dimensions.” An MIT Sloan School of Management paper found that ESG ratings “diverge substantially” and called information from ESG ratings providers “noisy.”

The International Organization of Securities Commissions (IOSCO) also warned of the “wide divergence within the ESG ratings and data products industry” in a report on Environmental, Social and Governance Ratings and Data Products Providers.

A driving force behind the variance in ratings is a lack of consistent and comparable ESG disclosures.

Analytical Obstacles

Indeed, ESG disclosures are a muddle of datapoints that range from “obviously material” to “nice to know.” The lack of consistent, comparable disclosures creates analytical obstacles for ESG ratings providers. In the absence of standardized disclosures, it is sometimes unclear what factors ESG ratings providers consider, or how they weigh those factors.

The resulting ESG ratings are seen as inconsistent. In fact, Businessweek dubs ESG ratings a “mirage,” and suggests that the ratings methodologies employed by ESG raters simply measure the wrong factors, resulting in curiously favorable ratings for certain companies—“almost 90% of the stocks in the S&P 500 have wound up in ESG funds built with MSCI’s ratings.”

Matt Levine predicted this outcome several years ago. He joked about creating an “S&P ESG Fund” that would rely on a proprietary ESG ratings system, but would nevertheless invest in all of the S&P 500 companies. “[I]t doesn’t matter how [companies] do on the ratings,” he said. “Everyone gets in.” That way, Levine reasoned, investors get what they really want: a belief that they’re investing in ESG-conscious companies and exposure to the S&P 500.

Levine’s fictional ESG Fund points up real concerns that hang over the ESG ratings industry—concerns about data inputs and conflicts of interest that call into question the precision and usefulness of ESG ratings.

Two potential solutions to these concerns are obvious: Change the disclosure framework to require consistent, comparable ESG disclosures; or regulate the raters to drive transparency and reliability.

SEC Priorities

The SEC is keenly aware of investor demand for ESG information, and ESG disclosures count among SEC Chair Gary Gensler’s regulatory priorities. But the SEC is unlikely to make sweeping changes to its decades-old, materiality-based disclosure framework just to accommodate investor demand. The SEC will likely require “climate risk disclosures” soon, and it may tack on other reporting requirements (like “human capital” metrics), but there is little appetite for overhauling the system.

Regulating the raters may present a path for the SEC to indirectly induce ESG disclosures where it otherwise cannot, or will not. But regulating the raters is not without challenges.

Concerns about transparency and conflicts that underpin calls for regulatory oversight of ESG ratings providers smack of longstanding complaints about U.S. credit rating agencies and other index providers. The SEC has largely failed to allay concerns about those ratings industries through rulemaking or oversight, and would need to develop a clear path to police ESG ratings providers.

Along that path, the SEC—perhaps, in cooperation with standards-setters like the International Sustainability Standards Board—must devise definitions, metrics, or methodologies for ESG ratings providers, and heed IOSCO’s call to monitor conflicts of interest and promote transparency.

If the expectations are clear, companies may adapt their disclosures to the raters’ requirements. Indeed, companies that want to tap ESG investing capital—which may hit $53 trillion by 2025—will have to at least consider reporting metrics that conform to the new standards.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Kurt Wolfe is of counsel in Quinn Emanuel’s SEC Enforcement Practice. His practice focuses on government and internal investigations, regulatory enforcement inquiries, and securities litigation. He is also a co-host of PLI’s inSecurities podcast.