Regulation and transparency in ESG Ratings

Environmental, Social, and Governance (ESG) ratings are increasingly influencing global investment decisions and can be used to distribute billions of dollars every year. However, in many angles these evaluations seen as not transparent and are inconsistent, which is an issue even though they have gained momentum. With such inconsistent ratings, unclear processes and absence of government regulation, investors are facing challenges in maintaining their reliance. The involvement in the ESG ratings landscape will be characterized by transparency and honesty as the governments make new disclosure requirements. This is where age of accountability in the ratings starts.

Due to the lack of similarity in the criteria used by all rating organizations, there has been questioning of the reliability of ESG ratings. In comparison to the 0.92 correlation between conventional credit ratings, ESG ratings of the various agencies are only correlated at 0.54 based on a study of the MIT Sloan Sustainability Initiative. Here the difference between the providers about the concept of good ESG performance is seen.

The inconsistency of the ESG technique is demonstrated, for instance., by the fact that Tesla, Inc. has gotten outstanding environmental ratings in some agencies and awful ratings in others. Research shows that depending on the data and weighting method applied, the degree of agreement between the suppliers of ESG can be between 38 and 71%.  The same business might appear to be a market leader or a market laggard with different rating agencies, and this would hurt investor confidence and bring the financial markets to their knees.

EU has reacted to such disparities by acting to regulate the practice of ESG grading. The European Parliament passed the ESG Rating Activities Transparency and Integrity Regulation in April 2024. The methodologies, data sources, weighting systems, and conflict of interest management measures of ESG rating businesses must be publicly acknowledged.

The policy further adds accountability and standards by subordinating the providers of ESG ratings to the European Securities and Markets Authority (ESMA). Rating agencies which deal with EU based organizations or goods sold in EU, even though they may have their headquarters out of the EU, also require being licensed. These reforms are aimed at achieving the objective of ensuring that ESG scoring ceases to be a black box by aligning it with the transparency framework governing financial credit ratings.

Greater transparency can increase investor confidence and bring ESG ratings closer to each other. Rating agencies ought to publish their models and assumptions to enable investors understand, and make sense of differences and results. This clarity may be in a better position to distribute funds more effectively to businesses that have long term viability.

With the enhancement of monitoring and hence increased trust, the ESG marketplace has a good balance between the transparency and innovativeness.

Majed Al-Qatari

Still, standardization also brings some problems. When approaches meet, there might be a lack of variety and creativity in ratings. Other research assert that smaller agencies can incur higher compliance costs that can result in less competition and the potential monopoly of market control by a small group of large businesses. Moreover, compliance would be prohibitively expensive, which tends to discourage methodological innovation and consequently results in too generic ESG approaches that lack sector-specific information.

With the enhancement of monitoring and hence increased trust, the ESG marketplace has a good balance between the transparency and innovativeness.

Due to the shift in the regulatory needs, it is observed that most corporations are reassessing their sustainability programs. In order to ensure consistency in internal reporting and external ESG reporting, a significant number of them are adopting the frameworks such as the Global Reporting Initiative (GRI), the International Sustainability Standards Board (ISSB) and the EU Corporate Sustainability Reporting Directive (CSRD).

Businesses must align their internal data systems with these standards to decrease rating volatility and provide information in advance to address gaps in the information. As more and more investors increasingly hinge on standard disclosures of ESG as a means of evaluating risk and performance, access to funding is also enhanced by transparent reporting. The shift is indicative of a broader trend in strategy whereby the application of ESG ratings to serve the purpose of PR is being replaced by sustainability aspects being integrated into the fundamental governance and investment strategies of a company.

The positive side of supervision is that it will assist in the establishment of confidence, reduce greenwashing, and use investment in companies that actually meet their sustainability objectives. There is an improvement in the disclosure of ESG risks and opportunities, and the market becomes more transparent.

But dangers still exist. Excessively harsh regulations can restrict the diversity of methods and discourage the creation of new systems of grading. Equity imbalance in access to capital might also be increased by the situation where compliance costs too much to smaller businesses and issuers based in developing markets. Moreover, methodological convergence may also result in investors beginning to crowd together around assets of similar ratings, leading to valuation bubbles.

Policymakers should ensure flexibility in order to remain innovative and inclusive in the ESG ecosystem, although the transparency leads to more confidence.

The ESG rating market has a turning point.  Imbalanced and uncontrollable processes as a consequence of decades of uncontrolled development undermined investor confidence.  The key elements of a credible sustainable finance include transparency, accountability, and comparability, and the legislative conceit of the European Union to the year 2024 points to a shift in this direction.

The reforms will ensure that ESG assessment is more credible, and this is good news to investors. Businesses are compelled to report better on their disclosure and bring them nearer to the requirements of reporting as it is set out. This is because credibility will make ESG leadership in this new responsibility age, rather than marketing.

• Majed Al-Qatari is a sustainability leader, ecological engineer, and UN youth ambassador.