The market for ESG ratings is “fertile ground for potential conflicts of interest” according to financial regulator and watchdog the European Securities and Markets Authority (ESMA).
In its biannual market risk commentary, released last week, ESMA said that the coexistence of ESG ratings with other business lines such as credit ratings, benchmark construction, consulting services or asset management, could result in providers being influenced by outside factors like liquidity, when rating companies or instruments such as green bonds or sustainability-linked loans.
“Even though ESG rating service provision is typically carried out in separate legal entities, commercial interests or regulatory requirements concerning other business activities may lead to conflicting priorities. The risk of ratings inflation from such potential conflicts of interest may contribute to a lack of comparability and trust,” ESMA said.
In addition, the regulator warned that oligopolies created by “large companies buying their way into the market” could “lead to significant consumer detriment including pricing above competitive levels, risk of collusion, entry carriers, and reduced innovation and efficiency”.
Smaller, specialised ESG research and ratings houses like Oekom, Vigeo Eiris, Trucost, Beyond Ratings, Sustainalytics, Vivid Economics and Clarity AI have been hoovered up by larger service providers and asset managers in recent years.
This comes at a time when investors are increasingly dependent on major providers to define ESG risks in the absence of a regulatory framework to do so and significant disagreements on ESG ratings between different providers, ESMA said.
Using ESG indices as an illustrative example, the regulator noted that while growing volumes of passive investor capital were being allocated to such products, the markets remained highly concentrated with 17 out of the largest 20 ESG ETFs in December 2020 tracking ESG indices from the same provider – MSCI.
While ESMA did not say how it plans to address the issues it highlighted, it has backed calls to regulate ESG ratings and assessment tools in a letter to the European Commission earlier this year. The watchdog specifically requested the creation of a common definition of ESG ratings covering the spectrum of available products to address greenwashing, capital misallocation and products misselling, echoing a recent call to action by Dutch and French regulators.
Commenting on the report, Lydia Sandner, the Associate Vice President of ESG Ratings and Regulatory Affairs at ISS’s ESG arm, said that it applies research methodologies and processes that “mitigate potential conflicts of interest, as the analysts must and do apply exactly the same processes, timelines and clearly defined assessment rules to all issuers without any exemptions and irrespective of the company that is the subject of the ISS ESG coverage”.
According to Sandner, ISS has already implemented a firewall separating research and analytics teams from its ISS Corporate Solution subsidiary which serves corporate issuers.
MSCI declined to comment.
In the same report, ESMA presented the results of a preliminary study on climate risk which found that portfolios tilted toward polluting assets would result in losses ranging from 8% to 19% of affected assets, while losses in green funds range from 3% to 7%.
“These findings provide support for ongoing EU regulatory and supervisory initiatives on sustainable finance,” said ESMA.