Business school instant case: where next for ESG ratings?

ESG ratings are used by investors and organisations to evaluate the sustainability and ethical practices of companies. They arguably play an important role in encouraging companies to focus on sustainability and responsible business methods. Yet, over the past couple of years, there has been growing regulatory, political and academic scrutiny of the process as well as significant criticism, some of which is justified but much of which is debatable.

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As the field matures and ESG ratings become more standardised and transparent, proponents of their use argue that many of these issues are being addressed, making ESG ratings a more reliable tool for investors and stakeholders. This is being aided, they assert, by a push for regulation driven by the need for standardised and reliable ESG information to ensure transparency and prevent “greenwashing” or misleading claims.

At a time when doubts are increasingly being raised about the notion of ESG itself as an investment decision-making factor, The question is, where next for ESG ratings?

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The case for the prosecution

ESG ratings are assigned by various rating agencies and organisations which, over time, has led to a lack of standardisation in the methodology used to evaluate companies. This lack of consistency has sparked concerns about the reliability and comparability of ESG ratings. Since ratings depend on the availability and accuracy of data related to a company’s ESG performance, inconsistent or incomplete data can lead to inaccurate ratings, making it difficult for investors to make informed decisions. They often involve subjective judgments about a company’s ESG practices and different rating agencies may interpret the same data differently — leading to variations in ratings.

Mind the gap

Some companies have been accused of greenwashing, which involves exaggerating or misrepresenting their ESG efforts to boost their ratings and appeal to socially responsible investors. This undermines the credibility of ESG ratings. Since the ESG rating industry is not (yet) subject to the same level of regulatory oversight as other financial services, such as credit rating agencies, this has also raised concerns about the potential for conflicts of interest and a lack of accountability.

ESG rating methodologies are often accused of being too complex and not easily understandable to the average investor. This can lead to confusion and mistrust, as investors may not fully grasp how a company’s ESG rating is determined. Often, ESG ratings tend to focus on larger, publicly traded companies, leaving smaller companies and private firms under less scrutiny. This can result in an incomplete picture of ESG performance across the business landscape. Since agencies often have limited historical data to work with, this can also make it challenging to assess a company’s progress in improving its ESG performance over time.

All these issues have led many in business, financial and academic circles to ask what can be done to fix the problems facing the sector and what the future could look like for the ESG ratings industry, given the current ESG backlash and increasing political polarisation on the topic.

Minimising the gap

To address concerns about the lack of scrutiny and standardisation in ESG ratings, regulation and policy development has increased substantially. In November 2021, the International Organization of Securities Commissions (Iosco) recommended that regulators consider focusing more attention on the use of ESG ratings and data products. It set out guidance for ESG ratings and data products providers to improve practices related to transparency, governance, systems and controls, and management of conflicts of interest.

This acted as a stimulus for an ESG data and ratings code of conduct, commissioned by the UK’s Financial Conduct Authority (FCA), and scheduled for release in December 2023. The code aims to cultivate a more effective and transparent ESG data and ratings market by establishing explicit standards for ESG rating providers and defining their interactions with market participants.

Echoing this effort, the Monetary Authority of Singapore published a similar code of conduct for ESG ratings and data product providers, in December 2023. And last June, as part of the European Green Deal, the European Commission revealed plans to advance an ESG regulatory framework to augment the transparency and reliability of ESG ratings activities. Before that, in December 2022, the Financial Services Agency of Japan introduced its own code of conduct for ESG ratings and data providers to enhance the transparency and functionality of ESG ratings.

However, this raft of new regulation could lead to some unintended consequences for the industry. For example, enhanced regulation generally comes with higher compliance costs, creating barriers to entry for new and smaller market players, potentially reducing competition and leading to higher pricing for consumers. While the increased transparency around methodologies and data sources would no doubt lead to enhanced credibility, whether ESG rating and data users would be prepared to pay for this remains an open question.

Michael Wilkins is a professor of practice at Imperial College Business School, London