ESG ratings and data products have rapidly evolved to become essential tools for FIs in the evaluation of portfolio performance and the computation of environmental consequences. Fully 85% of FIs responded that they had climate-related opportunities that could have material financial or strategic impacts in 2023; meanwhile, US$4 trillion in combined assets reported that improved ESG ratings were major contributors to financial success. However, the more imbued these tools become within financial decision-making, the more they are under intensifying scrutiny-recent waves of new regulatory measures to ensure reliability and transparency.
ESG Ratings of Growing Importance
Interest in ESG ratings has been driven by the growing awareness of the financial risk and opportunities presented by climate change and other environmental factors. The demands put on corporations by investors and regulators to be more accountable have raised demands for substantial ESG data. This, in turn, is feeding concerns about the accuracy and transparency of the ratings and the methodologies through which they are produced.
CDP Director of Policy & External Affairs Pietro Bertazzi underscores the importance of that scrutiny. “It’s absolutely pivotal that the right checks and balances are in place to address this risk wherever possible and ensure capital allocation is efficient and impactful to achieve the goals of global environmental agendas,” he says.
Regulatory Responses and Global Alignment
As ESG ratings begin to be part and parcel of the financial market, today regulators all over the world step in to ensure that the ratings are credible and helpful. IOSCO has been at the forefront of this through a framework that recommended oversight, management of conflicts of interest, transparency regarding ESG data products.
For many of the key jurisdictions, such as Japan, Hong Kong, Singapore, the UK, India, and the EU, new regulatory regimes or best-practice codes to regulate providers of ESG ratings have either been issued since its 2021 report or are proposed. Not unexpectedly, many of these regulations show a common orientation to the IOSCO guidance, but there is variation in form, considering how different markets articulate these regulations, especially with respect to what constitutes ESG ratings and ESG data products.
Key Regulatory Initiatives and Global Divergence
These recommendations have largely been enacted in one form or another in most of the major jurisdictions. For example, both Japan and the EU have introduced their bespoke requirements, which include rating activity segregation from other consulting services in order to remove any potential conflict of interest situations. These are all part of a broader effort to not only make sure ESG ratings are correct, but also unbiased by the potential biases that might come up from conflicts within the rating agencies themselves.
One such issue, which has remained an ongoing concern, is that even among different jurisdictions, there are no agreed definitions regarding ESG ratings and data products. The resulting divergence causes market confusion and obstructs the work of international policy alignment. As IOSCO underlines, developing agreed definitions would allow the avoidance of market confusion and, in turn, facilitate policy alignment to help investors and companies.
Need for Interoperability of ESG Regulations
In this sense, if ESG ratings and data products are to support effective sustainable finance globally, regulations must be interoperable across borders. As Bertazzi adds, interoperable policies are central to this market, given that ESG ratings and data products are cross-border assessments often conducted by providers operating in multiple locations and consumed by users worldwide.
There are various benefits to global policy alignment; this would serve to reduce compliance costs, but it would also provide greater levels of transparency and help investors and corporate companies better conduct due diligence. As the regulations surrounding ESG ratings remain in place in many countries, consistency with the IOSCO baseline will be crucial to building a robust and coherent ESG regulatory framework.
Conclusion of the CDP Report
The evolving landscape of ESG ratings regulation is further put into perspective in the CDP report. It is underlined that at present, globally, regulators are elaborating on both voluntary and binding policies that prevent greenwashing and make more practical use of ESG data for sustainable investment. In turn, 94% of investors were using ESG ratings at least monthly to inform portfolio decisions with less portfolio-related risk.
What comes out powerfully from the readings in this report is the divergent degree of ambition of regulatory frameworks. For example, EU requirements on transparency go higher than those advanced by IOSCO regarding topics like the disclosure of scientific evidence and the use of AI during the decision-making process and its alignment with international agreements such as the Paris Agreement.
The Road Ahead of ESG Ratings
Consequentially, it would follow that with the increasing importance of ESG ratings in the financial sector, solid and transparent regulatory frameworks would have to be created. Such steps on the part of IOSCO and many national regulators are thus very crucial in order to make these ratings reliable and effective tools for driving sustainable investment. Yet, how such regulations can be harmonized across borders will always be the growing polarity that ESG ratings and data products support a globally transitioning economy toward sustainability.
In the future, ESG ratings are likely to be even more demanding, with increased scrutiny by investors and regulators alike as all work together to align financial markets with global sustainability objectives. What this shows is ample evidence that ESG considerations are no longer a niche concern, but an integral part of financial decision-making in the 21st century.
Source: CDP Report, International Organization of Securities Commissions (IOSCO)
Credits: This is a section extracted from the material prepared by CDP Report and IOSCO’s thematic review on ESG ratings and data products.