ESG rating: what's the future?

In the last decade we have been witnessing an acceleration in the transition to a "greener" finance. Since the issue of the Directive 2014/95/EU regarding the disclosure of non-financial and diversity information, European lawmakers have outlined a regulatory framework of growing transparency on sustainability and non-financial information. Major investors and investment funds at global level have started to base investment decision on companies' ESG performance. Larry Fink, Chairman and CEO of BlackRock, in his annual letter to CEOs, has expressed his strong conviction that the climate transition represents an unparalleled investment opportunity.

This trend is beginning to be felt in Italy as well: Intesa Sanpaolo (after Assicurazioni Generali and UniCredit) has announced the adoption of a specific policy, aiming to limit the financing to the coal mining sector. Moreover, one of the first private equity impact fund, compliant with article 9 of the Sustainable Finance Disclosure Regulation (SFDR), is bound to be launched in Italy this year, focusing on decarbonization and the transition to the circular economy.

However, despite the increasing awareness of financial operators of the importance of sustainability topics, it remains still particularly difficult for economic operators to access unambiguous information.

1. The role of ESG Rating Agencies

The ESG rating (or sustainability rating) is a synthetic evaluation made to assess the financial strength of an issuer, a security or a fund focussing on environmental, social and governance aspects. The ESG rating is the result of the ESG analysis of a company. It is based on the (i) collection of information (financial statements, CSR reporting, interviews, questionnaires), (ii) information assessment, and (iii) output data verification. Sustainability rating is generally entrusted to research centres specialized in the collection and processing of information and data on the ESG behaviour of companies.

However, it is questionable whether the evaluation criteria developed by ESG rating agencies are able to offer adequate responses to investors.

The ESG criteria are evaluated through a variety of approaches:
a. quantitative approaches, which assess sustainability of the company's performance on the basis of publicly available data prepared according to international standards (for example, ISO 14001 certification on the management of environmental issues in business processes);
b. qualitative approaches, which involve the collection of data and information from companies through questionnaires regarding the three ESG dimensions, which are then evaluated following a variety of methodological approaches;
c. mixed approaches, which combine the two above-mentioned methodologies.

The evaluation outputs are also expressed according to different indicators. Some of the ESG assessment providers use an overall numerical scale (e.g. 0-100), others go through rating scales represented by a letter or a series of letters (e.g. A, A +, AAA etc.).

2. Problematic aspects in the evaluation

Although investors require an effective valuation of ESG criteria it is currently not possible to compare the various ESG ratings. There is an absence of standardized methodologies, as each ESG rating company follows individual approaches. Furthermore, rating companies seem to be inclined to provide favourable ratings to large economic operators. As a result, the evaluation of the same company by different rating agencies might lead to different results, leading to confusion among investors.

The differences may arise from:

1. scope divergences. For example, environmental risk management is considered for the E factor assessment only by a limited number of agencies. Depending on the agency, this may lead to the inclusion or exclusion of a given element for the purposes of a final rating;

1. weights divergences. Various agencies might weight the same indictor in a different manner. For example, taking the factor E into consideration, management of water resources is evaluated heterogeneously by different rating agencies, leading to a lack of rating uniformity;

1. measurement divergences. These divergences occur when the same element is measured based on different sets of indicators, influencing the final rate. A typical example relates to the treatment of workforce, which can be assessed on the basis of the workforce turnover or by the number of lawsuits initiated by workers against the company. Measurement divergences seem to generate the greatest degrees of divergence, especially in the areas of human rights and product safety.

Therefore, a degree of convergence between the different ESG rating models of 38% to 71% was observed. Credit ratings (which have a long history which clearly influences the data) achieve a convergence of 99%.

From ESG ratings to ESG disclosure

This is why the European lawmakers have outlined in the last years a clear path towards the standardization of sustainability reporting, thus increasing the disclosure of ESG performance and the quality and quantity of available information on sustainability.

In particular, at international level, there have been a few key steps in the recent past:

• On 25th September 2015, 193 UN member countries signed the 2030 Agenda for Sustainable Development;

• In 2018, the European Commission issued a Communication outlining the Action Plan to finance sustainable growth;

• EU Regulation 2020/852 or Taxonomy Regulation, which contains a classification of economic activities that can be considered sustainable in environmental matters;

• In 2021, the European Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would amend the existing reporting requirements of the NFRD;

• Proposal for a Directive on corporate due diligence on sustainability of 23 February 2022;

• Proposal for the structure of the Social Taxonomy of 28 February 2022;

• The proposed regulation "Substantiating Greens Claims" or "Environmental performance of products and companies - prove the truthfulness of the claims".

A major push to sustainable investment was also the publication by the United Nations of the Principles for Responsible Investments (PRI), aimed at encouraging the growth of responsible and sustainable investments among institutional investors. Membership of the PRI is voluntary and requires compliance with six key principles, revolving around the key concept of incorporating environmental, social and governance (ESG) parameters into financial analysis and investment decision-making processes. Despite the pandemic, the 2021 PRI annual report showed a 20% increase the value of managed or held assets (US $ 103.4 billion) and an increase of 29% of signatory investors (2,701).

4. EU: Action Plan Financing Sustainable Growth

With the Action Plan on sustainable finance, the European Commission has evaluated initiatives closely related to the need of convergence in sustainability ratings. In particular:

• Establishing a EU classification system for sustainable activities and developing sustainability benchmarks (Actions 1 and 5);

• Improved integration of sustainability in ratings and market research (Action 6).

On June 18th, 2020, by implementing the first point, the European Union adopted Regulation (EU) no. 852/2020, regarding the establishment of a framework to facilitate sustainable investments, and amended Regulation (EU) 2019/2088. In recital no. 13, it is expressly considered that:

"If financial market participants do not provide any explanation to investors about how the activities in which they invest contribute to environmental objectives, or if financial market participants use different concepts in their explanations of what an environmentally sustainable economic activity is, investors will find it disproportionately burdensome to check and compare different financial products. It has been determined that such practices discourage investors from investing in environmentally sustainable financial products. Furthermore, a lack of investor confidence has a major detrimental impact on the market for sustainable investment. It has also been determined that national rules and market-based initiatives launched to tackle this issue within national borders lead to a fragmentation of the internal market. If financial market participants were to disclose how and to what extent the financial products that are made available as environmentally-friendly invest in activities that meet the criteria for environmentally sustainable economic activities under this Regulation, and if financial market participants were to use common criteria for such disclosures across the Union, it would help investors compare investment opportunities across borders and would incentivise investee companies to make their business models more environmentally sustainable. Additionally, investors would invest in environmentally sustainable financial products across the Union with higher confidence, thereby improving the functioning of the internal market".

The Regulation, referring to the "Environmental" profile, aims to define which investments shall be considered environmentally sustainable, providing a framework that will be integrated through delegated acts, including a technical content, specifying the various environmental objectives (Article 9):

1. climate change mitigation (art. 10);

1. adaptation of climate change (Article 11);

1. the sustainable use and protection of water and marine resources (Article 12);

1. the transition to a circular economy (Article 13);

1. prevention and control of pollution (Article 14);

1. the protection and restoration of biodiversity and ecosystems (Article 15).

This framework may reduce discretionary approaches in the assessments of ESG by rating agencies, which would however continue to have a certain importance in procuring ESG information on companies catalogued with the standards imposed by the EU.

On 6th January 2021, the EU Commission published the Study on Sustainability Related Ratings, Data and Research to tackle the second point (Action 6 of the Plan). Acknowledging the current context, the Commission issued the following recommendations, aiming to implement transparency, reliability and accuracy of data and information, conflict of interest management, materiality principles and mutual understanding between the relevant parties (issuers, rating agency etc.):

1. disclose rating methodologies implemented by ESG rating agencies;

1. develop and apply industry standards for sustainability-related rating and data product providers (establishing general classifications, appropriate governance structures, codes of conduct, means of engagement with companies, the process for correcting errors and updating assessments, the transparency of methodologies, the consideration of materiality and risk of bias);

1. implement ways of communication with target companies;

1. implement disclosure of rating objectives and limitations and of data and research papers published;

1. public disclosure of provider's policies on conflicts of interest;

1. implement disclosure through declarations related to the sustainability assessment of asset managers;

1. enhance company sustainability disclosures with the aim of improving the comparability, completeness, consistency and quality of the data disclosed;

1. provide clarity of terminology and support capacity building on sustainable finance and sustainability-related products and services for all market participants and stakeholders.

The intervention of the EU lawmakers offers an interesting future perspective, to the extent that it may allow a better data evaluation in relation to the higher levels of disclosure required.

5. The EU Sustainability Reporting Standards

Key in the convergence of ESG ratings is also the adoption of the proposal for a Corporate Sustainability Reporting Directive (CSRD). The CSRD would extend the scope of non-financial reporting to all large companies and all companies listed on regulated markets, require the audit of reported information, introduce more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards. This last point is probably the most important, with the European Commission giving mandate to the European Financial Reporting Advisory Group (EFRAG) to develop a first set of harmonized EU Sustainability Reporting Standards (ESRS). Recently, EFRAG has published for public consultation its Draft ESRS with deadline 8 August 2022.

What is pivotal in these EU Sustainability Reporting Standards is their structure. In fact, these first draft of ESRS is organized as a set of cross-cutting and sector-agnostic standards, ensuring comparability among different firms and industries, a point that has been missing in sustainability reporting so far. Also, a key goal has been the harmonization of the reporting structure. In recent years, the sheer number of different formats and structures of sustainability reporting have hindered the ability to compare ESG performance of different firms, something that is key for benchmarking purposes across peers. In our book "La Misurazione della Sostenibilità", presenting the findings of our study as ESG European Institute, we have underlined the importance of a layered structure for sustainability disclosure, that would entail a first layer of sector-agnostic standards.

Moreover, we have highlighted the need for a uniform reporting format that would on one side foster the transition towards integrated reporting, in order to disclose financial and non-financial information in the same document, and on the other side revolve around clear quantitative data. Looking at the non-financial reporting of the 15 major companies listed in Italy, we have experienced the confusion that can arise from different reporting formats, each relying heavily on qualitative data. While it is important to describe each company's approach to sustainability, a factor correctly covered by the cross-cutting standards, the best way to reduce the risks of greenwashing is requiring from the reporting entities clear and comparable quantitative data. This kind of data will also help the convergence of sustainability ratings, which, as already mentioned, have so far suffered from a heterogeneity in terms of guiding principles, methodologies and a lack of transparency.

This article is also published on Corporate Disclosures. Illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.