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IOSCO asks whether ESG ratings and data providers should be regulated

Global regulatory body becomes latest to wade in on the debate with new consultation

The International Organisation of Securities Commission (IOSCO) is considering whether regulators should oversee ESG ratings and data providers, as part of a consultation launched today. 

The body, whose members are responsible for regulating more than 95% of global securities markets across 130 jurisdictions, is also asking market participants whether there should be stricter transparency rules for providers on data sourcing, methodologies and management of conflicts of interest., as well as improved due diligence, verification and communication with companies. 

The market for ESG data and rating products could reach $1bn this year, said IOSCO, with expected annual growth of 20% – while ESG indices could grow by 35%. Much of the sustainability-focused financial regulation currently being developed around the world relies on ESG data and ratings. Therefore, although “ESG ratings and the data market does not fall within the typical remit of securities regulators,” IOSCO said, its growing influence warrants closer attention. 

The consultation is the latest in a series of moves by regulatory groups and policymakers to improve the quality of ESG scores. 

Earlier this month, the UK’s Financial Conduct Authority said it would “gather market intelligence to gauge how well firms are supported by service providers, such as ESG rating providers", in a bid to “promote integrity in the market for ESG-labelled securities, supported by the growth of effective service providers – including providers of ESG data, ratings, assurance and verification service". 

‘ESG rating providers have become everybody’s favourite whipping boy these days, and I think that’s unfair’ – Pangora’s Mike Chen

And last December, two of Europe’s most powerful country securities regulators – France’s Autorité des marches financiers (AMF) and the Dutch Autoriteit Financiële Markten – published a position paper entitled Call for a European Regulation for the provision of ESG data, ratings, and related services, suggesting the European Securities Market Authority should oversee similar transparency and conflicts-of-interest rules to those now being considered by IOSCO. 

The pair said at the time that the proposals, which were endorsed by the European Fund and Asset Management Association, should be included in the second iteration of the EU’s sustainable finance strategy. 

The European Commission published a study in January, concluding that there was a lack of transparency in the operations of ESG ratings providers, limited comparability between ratings, and potential conflicts of interest. In this month’s revised sustainable finance strategy, it stated that: “Subject to a public consultation and an impact assessment, the Commission will take action to improve the reliability, comparability and transparency of ESG ratings.”

“The increasing demand for sustainable investments also puts the focus on the need for unbiased and reliable ESG research, based on transparent and comparable methodologies,” it added. 

Sylvain Guyoton, Senior Vice-President of Research at French sustainability ratings house EcoVadis, told RI “now is the time to regulate ESG ratings players”.

“There’s been a lot of pressure from stakeholders to improve, and I think they have, but now there needs to be some minimum legal requirements to raise the bar for everyone,” he said. However, he added, the EU must first update its corporate reporting requirements so that the quality and consistency of raw data is adequate. 

Recent academic research found that greater ESG disclosure leads to greater misalignment of ESG ratings between providers. 

“We still don’t understand what makes for ‘good’ ESG,” said Anywhere Sikochi, Assistant Professor at Harvard Business School, on a podcast discussing the research. “When you give evaluators a lot of information when they don’t agree on what to measure, and how to measure to begin with, you are giving them a lot more to disagree on.”

By contrast, he said, more information is usually good for financial accounting: “If someone says leverage is high, we all understand what that means”. 

The paper builds on a 2019 study by MIT’s Sloan School of Management, which found an average correlation of 0.61 between the ESG ratings of five of the major providers, compared with 0.99 for credit ratings from Moody’s and Standard & Poor’s. 

‘Nobody likes the data providers because they are damn expensive, and that’s not going to change’ – Rajul Mittal, Synechron

Quant investor PanAgora Asset Management recently co-authored a paper with Google on the correlation between ESG data disclosure and MSCI’s ESG ratings. It found a “quantity bias effect” – that the more ESG information a company discloses, the better the ESG rating tends to be. Conversely, when a company does not provide ESG information, PanAgora and Google found that analysts and investors presume they have something to hide and award lower ESG ratings and smaller investment allocations.

Mike Chen, Pangora’s Head of Sustainable Investing, explained that higher ESG ratings don’t automatically translate into better “ESG-ness or sustainability characteristics”. 

“We didn’t do an exhaustive survey, because there’s literally an unlimited amount of data and metrics – partly because there’s really no standard,” he said. “But we picked out a few metrics and it turns out that companies that enjoy higher ESG ratings do not always have better ESG quality from what the underlying data says.”

Chen added that, while more transparency is needed around raters’ methodologies, ESG is still “a preference” rather than a requirement, so regulation may not be necessary. 

“ESG rating providers have become everybody’s favourite whipping boy these days, and I think that’s unfair,” he said. “They do provide a lot of value.”

Ecovadis’ Guyoton told RI it had “become a fashionable sport in academia to take all the data of ESG raters and to point out the differences”, adding: “I think there’s still a lot of positive overlap and differences that can be explained.”

Rajul Mittal, Head of Sustainable Finance at Amsterdam-based consultancy Synechron, which recently published another paper on the divergence of ESG raters, said: “Nobody likes the data providers because they are damn expensive, and that’s not going to change.”

But, he added, “I highly doubt we will see a concrete regulatory regime in the near future”. Instead, he thinks the focus will be on medium-term rules on transparency for ESG ratings providers. 

Others believe the focus should be on mainstream providers, not just ESG houses. Sven Giegold, a Member of European Parliament for the Green Party, told RI he welcomed IOSCO’s consultation, but the debate needed to extend to traditional credit ratings agencies. 

“I’ve seen, with a certain level of concern, a tendency to look at regulating ESG ratings but not regulating ESG in mainstream credit rating and solvency ratings. ESG is not this special field of business, it is simply a new and increasingly important area of risk. You are basically saying there needs to be standards for specialised ratings while we keep ignoring traditional ratings for solvency, even for long- and medium-term risk.”  

He noted that oil majors tend to have retained investment-grade credit ratings despite growing discussion about their viability in a low-carbon economy. 

“This means the rating agencies are betting against climate science and this is not appropriate.”