27 July 2021 / Regulation

IOSCO recommends regulatory oversight of ESG ratings

By Natalie Kenway

10 recommendations after finding lack of transparency and inconsistencies in data in ESG ratings research

IOSCO recommends regulatory oversight of ESG ratings

ESG ratings and data product providers could see an increasing focus from regulators, after research from the board of the International Organization of Securities Commissions (IOSCO) found inconsistent data, and a “lack of transparency”, were underpinning ratings across the market.

The IOSCO Consultation Report on Environmental, Social and Governance (ESG) Ratings and Data Product Providers listed 10 recommendations to establish frameworks and mitigate risks it found within ESG ratings and data, and added as ESG ratings currently do not fall within the typical remit of securities regulators there are some “key considerations” for securities regulators to be aware of.

“Where regulators have supervisory authority over ESG ratings and data products providers, they may wish to consider whether the reliability, comparability and interpretability of ESG ratings and data products could be enhanced by taking steps to improve the governance and transparency of the assessment process and the management of conflicts of interest,” the report’s proposals said.

By taking steps, regulators could improve the “governance, transparency and management of conflicts of interest surrounding these products” improving confidence and supporting a greater up-take in usage while also protecting investors.

See also: – Baillie Gifford’s Stuart Dunbar: The shortcomings in data approaches to ESG

Key findings

IOSCO said it undertook a fact-finding exercise, through conversations with ESG ratings providers and those who interact with ESG data products providers, that revealed there was a “lack of transparency about the methodologies underpinning ratings or data products” and “uneven coverage of products” across industries and regions.

This has led to “gaps and inconsistencies” and raised concerns around the potential conflicts of interest, including fee structures and separation of business lines where groups provide ratings and advisory services.

It noted ESG ratings and data had been in a phase of rapid growth in recent years, in line with investor demand for more information on ESG credentials and increasing legislative requirements, but a lack of information disclosures at the entity level is causing confusion.

Nonetheless, it said ratings had been evolving to meet investor needs and respond to new topics of interest, such as alignment with the UN’s Sustainable Development Goals and emerging areas of attention including biodiversity and corporate culture.

See also: – Global ESG Summit: The pitfalls and opportunities in ESG data

Methodological approaches

IOSCO found methodological approaches to underlying ESG ratings and data products are extremely varied resulting in “low correlation and high divergence in ESG ratings and data products between providers even where products are aiming to address the same objective”.

As well as various methods of data collection, the weight given to quantitative and qualitative analysis varies from one ESG ratings and data products provider to another and ratings also differ in their finality with some focusing on performance, others on risk etc.

Importantly, those in discussions with IOSCO for the research highlighted the lack of engagement and transparency from ESG ratings and data products providers, with one respondent describing the evaluation phase as a “black-box” with limited explanation of the outcome, ranking and assessment criteria.

Recommendations

IOSCO found the quality of raw ESG data needs to be improved, to enhance the consistency of ESG ratings, opaque methodologies need to be exposed, and explicit measures need to be implemented to ensure independence and separation of ESG ratings from consulting services, and address governance concerns.  

Improved transparency around timings of questionnaires companies need to complete for ratings providers would also benefit communication across the industry.

The board categorised its recommendations as follows:

  1. Regulators may wish to consider focusing more attention on the use of ESG ratings and data products and ESG ratings and data products providers in their jurisdictions.
  2. ESG ratings and data products providers could consider issuing high-quality ESG ratings and data products based on publicly disclosed data sources where possible and other information sources where necessary, using transparent and defined methodologies.
  3. ESG ratings and data products providers could consider ensuring their decisions are, to the best of their knowledge, independent and free from political or economic pressures and from conflicts of interest arising due to the ESG ratings and data products providers’ organisational structure, business or financial activities, or the financial interests of the ESG ratings and ESG data products providers’ employees.
  4. ESG ratings and data products providers could consider, on a best-efforts basis, avoiding activities, procedures or relationships that may compromise or appear to compromise the independence and objectivity of the ESG rating and ESG data products provider’s operations or identifying, managing and mitigating the activities that may lead to those compromises.
  5. ESG ratings and data products providers could consider making high levels of public disclosure and transparency an objective in their ESG ratings and data products, including their methodologies and processes.
  6. ESG ratings and data products providers could consider maintaining in confidence all non-public information communicated to them by any company, or its agents, related to their ESG ratings and data products, in a manner appropriate in the circumstances.
  7. Financial market participants could consider conducting due diligence on the ESG ratings and data products that they use in their internal processes. This due diligence could include an understanding of what is being rated or assessed by the product, how it is being rated or assessed and, limitations and the purposes for which the product is being used.
  8. ESG ratings and data products providers could consider improving information gathering processes with entities covered by their products in a manner that is efficient and leads to more effective outcomes for both the providers and these entities.
  9. ESG ratings and data products providers could consider responding to and addressing issues flagged by entities covered by their ESG ratings and data products while maintaining the objectivity of these products.
  10. Entities subject to assessment by ESG ratings and data products providers could consider streamlining their disclosure processes for sustainability related information to the extent possible, bearing in mind regulatory and other legal requirements in their jurisdictions.

IOSCO is inviting feedback on the recommendations up until 6 September 2021 by emailing consultation-02-2021@iosco.org with ‘Public Comment on ESG Ratings and Data Products Providers’ as the subject line.

Part of the Bonhill Group.