New dawn for ESG ratings

ESG ratings are becoming an increasingly important issue for companies but are not without controversy, especially around regulation and potential conflict of interests when it comes to large audit firms. But with the EU finally promising ESG rating regulation, the so-called ‘wild west’ (as one risk manager called it) may be about to be tamed and offer practical and relevant solutions for investors, lenders, corporates and insurers.

There is a clear need and desire for ESG ratings, but the issue has been their perceived lack of transparency, a lack of regulation, a lack of consistency and benchmarking, and concerns over who is providing the rating. They have been described as “a compass without direction.”

The EU Commission’s executive vice-president Valdis Dombrovskis said last year: “At present, there are inefficiencies, regulatory gaps and a general lack of transparency in the market for ESG ratings. This leads to a risk of greenwashing in what is a complex market, with many smaller rating providers.”

A recent article in the Financial Times said there are two crucial differences between ESG ratings and traditional credit ratings: “Analysts are not yet subject to regulatory scrutiny on conflicts of interest, and they work in part on unaudited environmental, social and governance data, rather than in audited financial statements.”

The FT added: “There is a further potential problem for the industry – the gap between the perception of what ESG ratings assess and what they actually demonstrate. The scores are not designed to measure corporate performance on carbon emissions or pollution. Instead, the raters measure how well a company is managing environmental, social and governance risks to their own bottom line, for example from hurricanes or carbon taxes.”

The UK Treasury conducted a consultation last year on a future regulatory regime for ESG ratings providers. The government response is still awaited but in the consultation, the Treasury stated: “Despite their increasing prominence, market participants have raised concerns about ESG ratings. Some challenges raised are in relation to ESG ratings providers’ methodologies and objectives, which can be opaque and lead to confusion about what a rating implies. There are other concerns about how an ESG ratings provider interacts with the rated entity. For example, there may be potential for conflicts of interest where an ESG ratings provider also provides advice to the rated entity on how to improve that rating.”

Addressing the issues

The issue of regulation looks set to be addressed this year. At the end of 2023, the EU Council reached an agreement on its negotiating mandate on a proposal for a regulation on ESG ratings, with the aim of boosting investor confidence in sustainable products.

The Council said the new rules aim to strengthen the reliability and comparability of ESG ratings by improving the transparency and integrity of the operations of ESG ratings providers, making ratings more comparable and preventing potential conflicts of interests.

Under the proposed rules, ESG rating providers will need to be authorised and supervised by the European Securities and Markets Authority (ESMA), and comply with transparency requirements, in particular with regard to their methodology and sources of information.

The issue of conflict of interests has been addressed but appears to have been watered down somewhat. The EU Council said: “Regarding the separation of business and activities, the Council introduced the possibility for ESG ratings providers to not have a separate legal entity for certain activities, provided that there is a clear distinction between activities and that they put in place measures to avoid conflicts of interests. This derogation would not be applicable to consulting or audit activities when they are provided to rated entities.”

In the UK, the ESG Data and Ratings Working Group (DRWG), an industry working group mandated by the FCA, has developed a voluntary Code of Conduct for ESG data and rating providers, published in December last year. DRWG said: “The Code is grounded in IOSCO’s recommendations for ESG data and ratings, with a focus on promoting transparency, good governance, management of conflicts of interest, and robust systems and controls.”

Do ESG ratings matter?

If ESG ratings can be trusted and benchmarked, then they undoubtedly have an important role to play. According to the European Commission: “ESG ratings play an important role in the EU sustainable finance market as they provide information to investors and financial institutions regarding, for example, investment strategies and risk management on ESG factors.”

Allister Furey, CEO at carbon data provider Sylvera, said: “The UK government’s plans for a regulatory regime for the ESG ratings industry are a welcome step toward standardising metrics and more uniform definitions of what best practice looks like to enable greater transparency and, in turn, drive net-zero progress in the long term. With more reliable data about the actions companies are taking on their net-zero journeys, investors can then have the confidence to back firms who are taking their role in mitigating climate change seriously. In time, with standardised and independent data, companies will see financial incentives emerge, such as higher share prices and cheaper borrowing.”

Insurance and ESG ratings

As for insurance, a study last year by broker Howden and insurer Fidelis found that higher ESG ratings lead to better underwriting performance. The study analysed loss ratios across 30,000 policies from Howden and Fidelis’ datasets, comprising a premium value of around $9bn, against third-party ESG ratings. It found environmental ratings have the strongest correlation with loss ratios.

In the light of the findings, David Howden, CEO, Howden Group Holdings, said: “The data backs up our long-held belief that clients should be rewarded for high ESG credentials. This is an obvious way in which the insurance industry can support the transition. I hope to see, in the near future, ESG factors built in to underwriting processes and pricing decisions to a much greater degree.”

AXA XL recently carried out a study that examined the extent to which a section of clients’ loss ratios correlated with their ESG scores, obtained from a range of ESG ratings providers, since 2015. “Overall, the ESG study showed statistically significant results for some professional and casualty lines of business, and mixed results for property,” said AXA XL.

The insurer concluded: “There’s huge potential to use ESG data in positive ways, not only to better model and price risks to help our clients be more resilient to ESG threats but also to help them become more net-positive to the world – and this is where we hope to get to with our aim of enabling impact underwriting.”

From a risk manager’s point of view, ESG ratings are not just about investor requirements, or insurance requirements, but as a potential way of identifying ESG risks and developing strategies to manage/mitigate those risks.