The challenges of the current ESG ratings market
The European Securities and Markets Authority (ESMA) issued a “call for evidence” on February 3 as it begins a formal review of the environmental, social, and governance (ESG) ratings market in the European Union (EU).
Additionally, the U.S. Securities and Exchange Commission (SEC) recently released a staff report detailing potential market risks arising from nationally recognized statistical rating organizations (NRSRO) that also provide ESG scores.
ESMA, the SEC, and the UK Financial Conduct Authority (FCA), as well as other global financial regulators, have increasingly been eyeing regulation of the ESG ratings market, highlighting the challenges and potential conflicts of interest involved with ESG scoring systems. In this report, KBRA details challenges with ESG ratings in their current form that have been cited by both regulators and investors.
In its analysis of ESG considerations, KBRA focuses on whether ESG factors influence the risk of default and, where relevant, how an issuer actively manages the ESG risks and opportunities its entity faces. KBRA does not offer ESG ratings, a decision that was heavily influenced by extensive investor feedback and discussions with relevant regulatory bodies. Investors desire access to better quality and more consistent ESG data; however, KBRA believes that ESG ratings in their current form are doing more harm to the market than good.
What Is an ESG Rating?
To start, ESG rating providers and credit rating agencies have different objectives for their ratings. A credit rating has a clear-cut, defined purpose: to measure the creditworthiness and risk of default of an issuer or transaction. When KBRA issues a credit rating, it incorporates an analysis of credit-relevant ESG factors. In this process, our credit analysts look at a subset of ESG considerations that investors may be interested in from a financial materiality perspective, which are factors that influence or have the potential to influence the risk of default.
An ESG rating, on the other hand, considers all different types of ESG factors, many of which are not tied to financial returns or creditworthiness, but instead measure wider impacts on society and the environment, which is often much more subjective. There is no commonly accepted definition of ESG impact and therefore of measurement for an ESG rating. As the International Organization of Securities Commissions noted in its November 2021 report on ESG rating providers, “There is little clarity and alignment on definitions, including on what [ESG] ratings or data products intend to measure.”
Challenges With ESG Ratings in Their Current Form
Bias Toward Larger Entities: KBRA understands there is frustration from investors and issuers alike that ESG ratings are often biased toward larger firms. ESG ratings are primarily based on public data scraping, but many ESG rating providers also submit lengthy ESG questionnaires to issuers for supplemental information. This dynamic leads to company size bias, as large entities often have significantly more time and resources to complete the multitude of ESG surveys and disclosure requests they receive. Small and midsized issuers, on the other hand, do not have the same ability, and they are often penalized for not having the same means to fill out the requested information. The FCA noted this issue in its June 2021 consultation paper, highlighting that “there is also often limited opportunity to correct misunderstandings or misinterpretation of [the issuer’s] responses by the rating provider,” all of which can lead to “market distortion.”
Low Correlation of ESG Ratings: Many studies have highlighted the low correlation found in ESG ratings between different ESG scoring providers versus the high correlation found in credit ratings.In a public consultation paper, ESMA highlighted a previous study that found credit ratings, on average, have a 99% correlation, while ESG ratings of the same entity are correlated about 60% of the time. From KBRA’s perspective, the discrepancy among ESG ratings for the same issuer is a natural outcome of the lack of clear objectives and the subjectivity involved in ESG scoring systems. The weighting of environmental factors against social and governance factors to provide an average score inherently leads to making judgments about which metrics to weigh and how to measure the performance of those metrics. The FCA also notes this issue creates the potential for conflicts of interest, as issuers may specifically seek out ESG rating providers that better align with their business model or ESG priorities.
Opacity and Simplification of ESG Scoring Systems: Investors and regulators have voiced frustration more broadly with the ESG ratings market because of the lack of transparency involved with ESG ratings, the opaque weighting systems used to derive scores, and the often nonpublic, proprietary methodologies of ESG rating providers. The lack of standardized criteria behind measuring ESG performance also leads to market confusion and distortion, feeding into the low correlation of ESG ratings. Unlike credit ratings, ESG ratings are not regulated and providers are not required to publish their methodologies or provide details of how each issuer score is derived.
Potential for Conflicts of Interest With ESG Ratings: Another challenge that is often cited, particularly by regulators, is that many providers of ESG ratings also provide additional services such as ESG-related consultancy services. These additional services create the potential for conflicts of interest in ESG ratings and may lead to misleading ratings.
Risk of Greenwashing: The above-listed challenges create overarching risk in the current ESG ratings market, which is furthering the potential for greenwashing, misrepresentative claims around ESG performance and impact, and false marketing. The ESG investing movement has noble goals of moving the world toward a low-carbon economy while facilitating better social inclusion and reducing global inequity. However, the current challenges associated with ESG ratings may be leading to market distortions and difficulty in distinguishing bad ESG actors from good.
There is no universally agreed upon standard by which E, S, and G factors are weighted, or, in many cases, even measured. Given the myriad risks and challenges, it is hard to imagine a single ESG score that encapsulates an issuer’s E, S, and G profile, because those things mean different things to different people.
KBRA’s mission is to deliver the highest-quality credit analysis and research. In doing so, KBRA seeks to capture and be clear and transparent about all relevant credit factors in its ratings, including credit-relevant ESG factors. We also acutely understand the challenges of accessing detailed and comparable data, especially ESG-related data. Data quality, consistency, and coverage, along with the potential subjectivity associated with ESG metrics, present challenges for all market participants. KBRA is heavily focused on facilitating better quality and more consistent ESG disclosure, which we believe will benefit investors as well as issuers.
For more information on KBRA’s approach to ESG in our credit rating analysis, please see our ESG Global Rating Methodology. Additional sector-specific ESG research pieces can be found at esg.kbra.com.