The EU Wants to Regulate ESG Rating Agencies

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Who watches the ESG watchmen?

They may be the newest kids on the block, but like most ratings agencies in the financial services world, the fresh crop of firms grading companies on their environment, social, and governance credentials are already being tagged with concerns over conflicts of interest. New EU rules set to be proposed by the European Commission next week aim to keep the ratings agencies in check — in a socially sound way with zero carbon footprint, we expect.

Underrated or Overrated?

The International Organization of Securities Commissions has been urging global regulators to keep a watchful eye on ESG data providers since 2021. And it’s easy to see why. Global ESG Investment could soar to as high as $50 trillion by 2025, according to a Bloomberg Intelligence estimate, roughly triple where it stood in 2014. And as investments continue to increase, just a small group of data firms came to virtually corner the ratings agency market, with groups like the Institutional Shareholder Services and S&P Global launching influential ESG ratings divisions.

Meanwhile, deciding what does and doesn’t count as effective ESG investing can often appear arbitrary — with critics accusing groups of claiming borderline investments to “greenwash” their books. And ratings groups aren’t doing themselves any favors to defend against those charges. For example: At the end of April, a wave of ESG ratings downgrades from MSCI Inc.’s prominent ESG division were set to knock down the percent of funds earning its highest rating from 20% to just 0.2%. MSCI said it aimed to address a discernible “upward drift” in scores. At the same time, MSCI’s criteria for such judgments are often completely different from its industry peers.

That’s a big red flag for big green. The EU’s new rules could clean things up:

  • The draft proposal cautions against the ratings agency industry’s “divergences, lack of transparency and absence of common rules,” according to the Financial Times. “Confidence in ratings is being undermined,” the legislation says, with language included that would push member states against introducing their own independent rules.
  • The legislation would also require the roughly 60 ratings agencies operating in the EU to show their ESG ratings are appropriately firewalled from other business interests, such as auditing and consulting.

“Quite a number of [agencies] today provide consultation services and ratings, so they are not going to like that, but frankly it is good practice,” Thierry Philipponnat, chief economist at the NGO Finance Watch, told the FT.

Count US Out: While the EU looks to regulate its ESG industry, the rest of the world may be blowing it off entirely. In the recently published Global Asset Management Survey, data firm Linedata found that the percentage of the 265 buy-side institutions who claimed ESG as a high-priority jumped from 37% in 2021 to 40% — but only thanks to our zealously green friends in Europe, where support lept from 41% to 63%. In North America, support fell from 33% in 2021 to 22%. Hopefully Kermit the Frog has a passport.