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July 10, 2023

What impact will the upcoming ESG rating regulations have on the business world?

4 Min. Read
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The upcoming ESG rating regulations bring significant changes that will impact not only the business community, but also the sustainable investment environment. These regulations aim for greater credibility in ESG ratings by encouraging rating agencies to provide greater transparency about data collection, methodologies and the weighting of specific metrics. Data collection and management A more transparent and consistent data management process will help businesses to accurately measure and improve their sustainability performance.

The field of Environmental Social Governance (ESG) assessment is in a rapid development phase. Today, there are approximately 140 different ESG data providers in the market, including ESG branches of well-known organizations such as Refinitiv, Moody's, S&P, Morgan Stanley Capital International (MSCI), and this number is expected to continue to grow with increasing investor interest. The estimated scale of ESG assets under management is estimated to reach $53 trillion by 2025, equivalent to one-third of all global investments.

With the EU Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR), increased investor demand for energy technology products that move society toward a greener economy and help mitigate climate change, along with regulatory focus on ESG, is driving increased interest in ESG in potential investments. These drivers are expected to intensify further in the coming years, leading ESG ratings to serve as a key switch in the sustainable finance ecosystem.

This rapid development of the sector has also led to some vocal criticism. Leading investor rating agencies do not rate companies on their environmental or social responsibility ratings. Instead, they measure how much damage EMS values can potentially do to companies' financial balance sheets. For example, they are interested in the impact of factors such as carbon emissions on companies' profit performance. However, corporate responsibility and financial risk are not the same thing. These criticisms stem from the lack of a common definition of the data that ESG should measure and the lack of standards to talk about. Therefore, different ESG rating providers provide indicators for different aspects of sustainability and the methodologies applied vary.

While ESG rating providers often have the same information, they tend to reach different conclusions, and the correlation between the leading providers' ratings of the same company averages 0.54. This is considerably lower than the 0.99 correlation observed in the regulated credit rating space. As a result, the market is receiving mixed signals, while businesses are receiving conflicting messages on what steps to take to improve their ESG performance. Moreover, transparency on key methodologies is often restricted, particularly due to confidentiality issues, making it difficult for businesses to adopt the criteria used to assess them.

All these factors call into question the reliability of ESG ratings and how accurately they reflect an organization's commitment to sustainability, justifying concerns about greenwashing.

The Japan Financial Services Agency published a Code of Conduct for ESG rating and data providers in 2022. This is the first such example published by a national regulator. The Code includes six principles covering transparency on methodologies and data sources, and adopts a "comply or explain" approach. This trend is spreading to other parts of the world.  For example, the UK has established a code of best practice working group for ESG raters, which it is seeking to bring under the Financial Conduct Authority. In addition, the European Commission aims to publish a regulation to monitor the credibility and transparency of ESG ratings in 2023 as a pillar of the European Green Deal.

It seems that regulations will soon become a new reality for ESG rating businesses. However, it remains to be seen what the implications of these regulations will be for business and whether this is good news.

Regulatory frameworks for the global implementation of ESG ratings are making efforts to harmonize terms used in different jurisdictions. This common terminology will be adopted by decision makers and regulators, providing consistency for businesses and supporting sustainability efforts. It will also benefit public disclosure.

There is an increasing demand for transparency for ESG rating and upcoming regulations encourage greater transparency to more clearly set out methodologies, data collection methods and the weighting of specific criteria. A better understanding of the rating criteria will help businesses understand what it takes to improve their ESMS scores, focus on specific areas and perform better in the next assessment.

One of the main objectives of regulating ESG ratings is to prevent greenwashing and to prevent (sometimes unintentional) misleading practices regarding ESG performance. Greater transparency of rating targets and methodologies will prevent businesses from inflating their sustainability values, especially when overseen by a regulator. Thus, there will be increased pressure on companies to avoid exaggerated claims and, more importantly, to back up their ESG activities with concrete evidence.

As ESG ratings play an important role in supporting a sustainable investment climate, these regulations will ultimately be good news for everyone. The transformation of ESG ratings into a more harmonized and transparent system and the elimination of greenwashing claims will support increased trust in this sector. This will create a win-win situation not only for rated companies and investors, but also for ESG raters.‍ ‍