The ever-changing role of ESG Ratings

The OECD wants more done to empower firms to correct their scores, and there are signs of improvement. But are ESG ratings still relevant?

The OECD says there should be tougher rules about how ESG ratings providers communicate with the companies they rate. 

In a report published this week, the global body noted that only India and the EU currently require providers to engage with issuers before publishing their scores. 

It suggests that policymakers could, among other things, introduce more explicit expectations around correction mechanisms so firms can “contest factual inaccuracies through a dedicated and clear process”. 

Mathieu Joubrel says frustration about this kind of engagement is a “recurring theme”.  

“Companies struggle to ensure their own ESG ratings are accurate,” explains the co-founder of ValueCo, a start-up that provides analysis of third-party ratings to firms and investors. 

“Some of our listed-company clients tell us they’ve tried to contact ratings providers, and been asked to pay to just discuss their rating with them.”

Catherine Osborn, an associate partner at environmental consultancy ERM, agrees, saying “engaging with ratings providers to make sure reports and data are up to date has famously been a headache”. 

But, she adds, “there’s been a lot of improvement”, partly in response to looming regulation. 

Just this week, the UK’s Financial Conduct Authority closed applications for a pilot scheme for ESG ratings providers, the results of which will help shape a policy statement slated for the fourth quarter. 

A regulatory regime is expected to be introduced in 2028.   

Meanwhile, the European Securities and Markets Authority is currently consulting on a proposal for how EU-regulated providers should endorse non-EU ESG ratings under regulation coming in in July. 

Are ESG ratings still relevant? 

In a way, it’s a strange time to start regulating ESG ratings: while they were hugely influential among banks and investors at the start of the 2020s, their power has waned more recently.   

“Fewer investors are relying on them, because they’re developing their own internal assessments,” points out Joubrel – a trend accelerated by developments in artificial intelligence and the boom in mandatory sustainability disclosures. 

Earlier this year, for example, one of Europe’s biggest asset managers announced it had developed its own scores. 

Allianz Global Investors claimed “exclusive dependence on third-party providers has its limits” and “investors are increasingly evaluating customisable ESG ratings/scores to better align portfolio strategies with their ambitious sustainability objectives”. 

This is reflected in the results of a major study conducted by ERM last year, which found that nearly half of companies believe third-party ESG ratings will become less relevant over time.  

Role in supply chains

Overall, though, says Osborn, “the company responses indicated that ESG ratings will remain an important part of the sustainability ecosystem in the future”. 

In part, that’s because of their role beyond the finance industry. 

Accenture published a report on procurement practices last week, in which it found that a quarter of companies now use third-party sustainability ratings for more than half their spend.

Osborn says it’s tricky to work out exactly how much a good ESG rating is worth to a business, they’re definitely valuable for many.  

“ERM worked with one large company that was missing out on nearly a billion dollars of sales because it wasn’t meeting customer Ecovadis’ thresholds,” she says.

Other firms find ESG ratings helpful as a management tool, or to benchmark themselves against peers. 

But there is a “disclosure bias” for some businesses, Osborn notes.  

“One complaint about ratings is that companies in emerging markets can be disadvantaged because they aren’t subject to regulation that requires, for example, the disclosure of information on workforce gender composition,” she says.  

That can mean they’re penalised under many methodologies simply because they’re not automatically transparent on topics that their developed-markets counterparts are.  

Will the regulation make things better? 

It’s not the only methodological frustration: a new paper from researchers at the Massachusetts Institute of Technology and Harvard suggests some ratings decisions are influenced by a desire to offer stability to investors by, for instance, keeping scores just above or below the point at which an investor would need to formally react. 

Another recent study highlighted how few ESG scores capture a company’s actual contribution to environmental and social objectives.  

The current moves to regulate ratings won’t address the credibility of methodologies, or take a position on whether they should measure impact, risk or something else; but they may provide more clarity.  

“The regulation is aimed at making the scores more transparent and avoiding conflicts of interests,” says Joubrel.  

“It’s not about creating a single score or questionnaire, because users are all looking for something different, so they don’t want the same ESG rating – that’s the whole point.”