Providers of sustainability-related services such as environmental, social, and corporate governance (ESG) ratings must be placed under the supervision of European Securities and Markets Authority (ESMA) in order to enforce transparency on the underlying methodologies used by these providers and avoid conflicts of interest, the Dutch and French financial regulators – Autoriteit Financiële Markten (AFM) and Autorité des marchés financiers (AMF) – said in a joint paper published yesterday.

The pair want the European Commission, which already ordered a study on sustainability ratings and research in 2018, to draft a regulation to this effect.

There is a strong need among investors and asset managers for “more reliable ESG data to support the shift towards greener economies,” AFM and AMF noted in their paper.

According to a recent study by Refinitiv, 98% of global institutional investors take ESG and sustainability data into consideration when deciding to invest in a company, yet nearly 83% indeed cite a lack of reliable data as an obstacle to effective assessment.

Lack of transparency

The two regulators want the proposed regulation to focus on the “lack of transparency” of the underlying methodologies ESG rating agencies use to compose their ratings.

They noted the varying definition of ESG performance used by the different providers, which results in companies receiving very different ESG ratings depending on the provider, with the exact reasons for this rating divergence often being unclear.

“Indeed, research shows that the correlation between ESG ratings of different providers is quite low, especially when compared to the near 100% correlation of credit ratings,” the pair say.

They also said that ESG rating providers’ “constant reassessments of what ESG performance is” leads to frequent modifications of ESG ratings, which can have major implications for financial institutions.

Sustainalytics, for example, changed its rating methodology last year, resulting in significant changes in company ratings.

Greenwashing risk

The divergence in ratings between different providers makes it difficult to correctly appreciate what the ratings reflect, the regulatory duo noted. They believe this could “lead to misallocation of investments or even greenwashing.”

Furthermore, the regulatory duo said ESG rating agencies such as Sustainalytics, MSCI and ISS can also assume different roles such as consultant, data provider or rating agency, and represent diverse interests from issuers’ to investors’.

“It is therefore important that potential conflicts of interest are managed and averted, ensuring an appropriate level of market transparency.”

Andy Pettit, Morningstar’s director of policy research, EMEA, said in response to questions from IPE that the company, which owns ESG data provider Sustainalytics, supports “calls for more transparency with respect to what ESG ratings providers measure and how providers evaluate companies.”

No harmonisation

However, he appears worried that European regulators aim to eventually prescribe definitions of what criteria ESG rating providers should use in their assessments, despite assurances by the AMF/AFM that any new regulation should not interfere with the methodologies used by the rating providers.

“We strongly oppose any attempts by the European Commission to regulate the harmonisation of providers’ ESG ratings and scores. Creating a one-size-fits all scenario runs counter to ensuring vibrant and innovative markets,” Petit added.

While AMF and AFM propose an initial focus on transparency of methodologies, they are advocating a “step by step approach”, whereby the initial regulatory framework “should be periodically reviewed taking into account market developments and, where appropriate, complemented by additional measures.”

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