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  1. Opinion
May 11, 2023

Why we must tolerate ESG rating divergence for now

Anxious about market instability and a loss of confidence, it’s reasonable to want ESG ratings to be regulated like credit. But we’re not ready to do so.

By Daniel Flatt

ESG ratings, ESG scores
Good or bad? ESG ratings are in need of regulatory oversight. But what is the best way to ensure a positive end result? (Photo by Luis Molinero via Shutterstock)
  • Regulators, such as Japan’s FSA, are happy to tolerate divergence in ESG ratings in return for high levels of reporting transparency. This view has its critics.
  • Divergence, according to the EEFA, can lead to stock and bond mispricing and potential misallocation of an asset within a portfolio.
  • Regulators in Singapore and India, for example, want to steer providers towards energy transition; the S and G are lower on the priority list.

It was in late March that MSCI caused quite a stir. The financial index and services provider announced it was going to have to downgrade the ESG ratings of roughly 31,000 funds as part of a major overhaul of its methodology.

The move came after MSCI clients expressed concerns that current ratings failed to reflect the underlying ESG narrative. Too many undeserving corporations were receiving AAA scores.

The timing aligned with plans by regulators, including the European Commission, to tighten the sector and although MSCI swears its drastic revision is not linked to any regulatory pressure, if you have to downgrade so many funds in one lot, you deserve more oversight.

The battle, however, is not about whether ESG rating providers should be regulated – that horse has bolted – but about how they should be regulated.

Take the Japanese Financial Service Agency’s (FSA) new code of conduct for ESG data providers, for example. Albeit generally well received when finalised in December last year, a crucial element of the code is the regulator’s openness toward divergence of ESG scores between competitors.

The dangers of divergence

The FSA asserts the variety of ESG evaluations and services means that differing results across institutions aren’t necessarily problematic. However, critics argue this divergence can harm financial markets; the Institute for Energy Economics and Financial Analysis (EEFA), for instance, notes the lack of comparability, transparency, and alignment in the ESG rating sector as a key shortcoming.

Divergence, according to the EEFA, can lead to stock and bond mispricing and potential misallocation of an asset within a portfolio. When a rating provider like MSCI massively downgrades ESG ETFs, asset owners must sift through their portfolios to remove funds that no longer meet internal criteria. This process can be frustrating, to say the least.

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Many institutions, including the EEFA, hope for a convergence of ESG ratings and stringent global standards for ESG reporting that mirror the “regulatory structure and consistency of credit ratings”.

On the surface, highly prescriptive regulations seem like an effective way to reduce rating divergence. However, the question remains: Are ESG ratings close enough to credit ratings for this approach to work?

The answer isn’t straightforward. Credit ratings, which evaluate a company’s ability to meet its debt obligations over a set period, rely on a well-established process. In contrast, determining a company’s carbon footprint trajectory and its alignment with an asset owner’s GHG emissions target involves numerous complex variables. Current forecasting methods are unreliable due to patchy and untrustworthy data.

Although reporting developments, such as the climate-focused TCFD and the new biodiversity equivalent, TNFD, will enhance our collective knowledge, we’re still far from having a comprehensive body of data to base our forecasts on. Therefore, we may need to tolerate ESG scoring divergence for the foreseeable future due to the lack of proven methods for setting tighter regulatory parameters.

Regulators like Japan’s FSA are therefore right to allow ESG rating providers flexibility. But this must come with the condition of clear and transparent reporting. We need to understand exactly how scores are calculated, the data used, and the quality of that data.

This approach provides an opportunity to learn which methodologies will prove more robust and accurate over time. Being overly prescriptive now could stymie a crucial part of the financial markets.

However, there is emerging evidence of regulators targeting specific aspects of ESG ratings for greater oversight where urgency is higher. This approach seems like a smart balance between regulation on principle and prescription.

ESG ratings to focus on transition finance

Take Singapore. In a recent speech made by Lawrence Wong, deputy prime minister, minister for finance and deputy chairman of the Monetary Authority of Singapore, energy transition and increasing “trust” in ESG ratings are major priorities.

Wong states: “One example is a code of conduct [that] is being jointly developed by MAS and the industry. This will require ESG ratings and data product providers to disclose how transition risks are factored into their products. We will conduct a public consultation on this code in the second half of the year.”

The Securities and Exchange Board of India (SEBI) is on a similar trajectory. After a public consultation, in February it published its views on regulating ESG rating providers. Albeit not obligatory, SEBI has emphasised its desire to see far more focus on intelligent measurement of transition, providing specific methods it would like to see used.

It states: “It is observed Indian companies may be rated on their current emission [intensity] levels as they begin to align their strategies with India’s [Net Zero by 2070] commitment…despite substantial reduction year on year. Evaluating Indian corporates on an absolute yardstick without recognising the efforts they make and results they achieve…may not lead to the appropriate incentives for transition finance.”

While the aspiration to achieve a minimal level of rating divergence is the right one, forcing the issue too soon may prove more detrimental to the development of ESG ratings. For now, regulators who are set on improving reporting transparency and guiding the private sector to focus efforts on areas such as transition finance, are charting a smart and sensible course.  

[Read more: More attacks on ESG ratings as sceptics sharpen knives]

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