Therefore, the Financial Markets Standards Board has dedicated its latest Spotlight Review, chaired by NatWest, to ESG ratings. The paper outlines ESG ratings methodologies and data collection processes with the aim of improving the understanding of ESG ratings. 

Caroline Haas, Head of Climate and ESG Capital Markets said: “This was an excellent collaboration across the industry bringing together issuers, investors, banking peers and other market stakeholders. The Spotlight Review has been circulated to the International Organisation of Securities Commissions (IOSCO), the European Securities and Markets Authority (ESMA) and the Japanese Financial Services Agency (JFSA) and will support future regulatory and policy developments related to ESG Ratings.” 

Market participants, in line with their activities, use ESG ratings in different ways: 

Investors may use the outputs as a factor in informing capital allocation decisions, or for reporting, alignment with global frameworks, regulatory compliance, integration, (thematic) impact investment, or stewardship and engagement strategies. Issuers may use their rating to guide internal decision making and benchmark their own sustainability performance, while lenders may look at ESG ratings when reviewing their loan portfolio from an ESG or climate perspective. 

As a relatively nascent product, there are a number of issues with the ESG ratings markets. 

These include:

• Limitations in user understanding of the objectives of ESG ratings and the measurements/outcomes 
• Limited transparency and comparability of ESG methodologies 
• A lack of robustness and quality of underlying data informing ratings, compounded by issues with limited or inconsistent corporate disclosure
• Limitations in the engagement process between rating providers and rated entities (particularly in the context of correcting inaccuracies or disparities in the ratings), and
• Limited transparency around ratings being solicited or unsolicited

Rating products may have different objectives:

There is significant variation in what different ESG ratings seek to measure. Increasing user understanding of ESG ratings’ objectives is therefore important, with both the European Commission and IOSCO recommending that providers give greater transparency around the intended purpose of the rating, including its measurement objective. ESG ratings may be aimed at measuring ESG risks (referred to as ‘materiality’) or ESG impacts (often referred to as ‘double materiality’). It can also be unclear whether an ESG rating is sector-based (assessing performance relative to the rated company’s peer group) or an absolute score. The selection of the peer groups themselves can also be unclear. In the absence of an industry standard on the parameters of a particular ratings product, a sufficient level of transparency on methodologies to allow market participants to understand their purpose is essential.

There is a high level of diversity across ESG ratings for the same or similar entities:

This is in part due to differences in how risks may be measured and/or different weightings that rating providers attribute to different ESG factors, as well as differing subjective views on what ‘good’ ESG performance means. Ratings diversity is not itself problematic, provided there is adequate market understanding of the reasons for such diversity. However, limited transparency of methodology in addition to diversity can impair user understanding and therefore create difficulties with evaluating the basis for an ESG rating undermining the overarching objective of ESG ratings.

Efforts to increase issuer ESG disclosure are likely to improve the quality of ESG ratings:

The introduction of global disclosure requirements is likely to drive significant improvements in the quality and consistency of disclosures. One example is the International Sustainability Standards Board (ISSB), which aims to create global sustainability-related disclosure standards to encourage transparent, reliable and comparable reporting by companies on climate and other ESG-related matters, with guidance expected by the end of 2022. Overall, more comprehensive disclosure by issuers is key to improving the quality and robustness of data underpinning ESG ratings.

Greater transparency helps to drive market solutions independent of regulation:

Given the increasing role that ESG ratings are playing in wholesale financial markets, it is important that the ESG ratings market becomes more transparent to promote user understanding and further aid comparability across providers.

If you have questions or would like to discuss the conclusions and recommendations, please get in touch with our Climate & ESG Capital Markets Team