Do the Old Rules Apply to ESG Ratings and Benchmarks?

The steady growth of sustainable finance in recent years poses difficult questions on how regulators should approach it. In the European Union (EU), for example, there has been an explosion of new rules aimed at addressing a broad array of concerns about investors’ reliance on the quality of sustainable financial products. In a new paper, we explore one aspect of those products, namely ESG ratings and benchmarks offered by information intermediaries. We address a simple research question: How much should the law on sustainable finance mirror traditional financial law? We also develop two sub-questions: (i) how “new” is sustainable finance compared with the “old” world, and (ii) to what extent can the regulatory strategies that were developed in traditional financial law to support confidence in ratings and benchmarks be exported to the new world of ESG finance?

Unsurprisingly, ESG ratings and benchmarks have gained traction among EU regulators. In 2018, two new labels were added to the Benchmark Regulation that identify indices for levels of reductions in greenhouse gas emissions, the EU Paris-aligned Benchmark and the EU Climate Transition Benchmark. But sustainability ratings have been on policymakers’ agenda for a long time and, more recently, the 2021 Action Plan anticipates that the European Commission will try to improve the reliability and comparability of ESG ratings.

In answering our research questions, we analyze the market failures that justify the regulation of traditional information intermediaries, and we explore the extent to which they also affect their correspondents in the world of sustainable finance. All markets are prone to asymmetric information or agency problems, and the markets for traditional and sustainable finance are no exceptions. In both worlds, information intermediaries play an essential role in addressing these market failures by gathering relevant data and disseminating synthetic information that is easier for investors to handle. However, the dynamics of market failures are not necessarily identical in the old and the new worlds, and that affects the role of ESG ratings and benchmarks.

One of the differences between traditional finance and ESG finance is the different nature of the information investors use for their investment decisions. In the traditional world, this is by and large information about risks and returns. When ESG factors come into play, things may change. In the EU, when assessing whether sustainability-related information is material, it is now consolidated practice to distinguish between two prongs (double materiality). In one scenario, investors may include ESG factors in their strategies just as they would one of the many elements to be considered when quantifying the risk and return of an asset. Here, the new world of sustainability is not entirely new. In another scenario, however, investors may want to look at the quality of their investments along with the impact on ESG targets, regardless of the potential ability of these consequences to backfire on the risks or the returns of their exposure. This approach, which is less profit-oriented and more focused on pure sustainability, is very different from the traditional one.

The first source of problems lies with determining whether indicators are referring to the first, more traditional, scenario (as is the case with ESG risk ratings) or to the second (ESG impact ratings), as confusion is reportedly high on this matter. But scholars and institutions have questioned the reliability of ESG-related indicators. Therefore, we explore whether the regulatory strategies that addressed methodological concerns for traditional information intermediaries can provide guidance for ESG indicators, and for ESG ratings in particular.

Through a comparison of sustainability ratings with two activities that are currently regulated and show material similarities with ESG ratings – credit ratings by credit rating agencies (CRAs) and investment recommendations by financial analysts – the paper shows that the new world displays many similarities with the original markets for ratings but also has some distinguishing features.

One element to consider is that market mechanisms may not work in the same way as in traditional finance when sustainability considerations are included in investment decisions and, hence, in the dynamics of price discovery. While in the traditional setting market participants will look at the discounted expected value of an asset’s future cash flow, attention to ESG factors introduces a set of preferences more prone to value judgment compared with information than can be more easily quantified, such as the probability of default in credit ratings. Therefore, it is not surprising that a growing literature has noticed low levels of correlation among ESG ratings addressing the same issuers.

These and other differences that our paper highlights suggest that policymakers should be cautious when transposing rules from the old world to the new. This is especially the case with ESG ratings. Here, credit ratings and their regulation are often the immediate references in the policymaking debate. The common label of “rating” can be misleading and risk an anchoring effect in the design of new rules. First, the assessments underlying ESG ratings are often more subjective than those supporting traditional indicators. Second, there seems to be a higher risk of regulatory failures connected to the authorisation and registration labels in the new world of sustainability. Rules incentivising the use of sustainability ratings may lead to an implicit license that directly or indirectly adopts ratings as a requirement to enter the market and encourage overinvestments in assets that turn out to be not as sustainable as expected.

The paper, therefore, suggests that the future European legal framework on ESG ratings should start with a light-touch approach, one that focuses more on disclosure and surveillance by market participants rather than registration and public supervision. In this regard, the European rules on financial analysts could be a suitable model to consider at this stage.

Another salient feature of the EU approach to financial analysts is the calibration of duties based on the nature of the analysts as either a generic market participant, an expert or an intermediary. Rules do not mandate any registration and focus on a few essential elements. These include the clear distinction between facts, interpretations and estimates, the duty to disclose the basis of valuations and the methodology adopted, together with their underlying assumptions.

Along this line, we suggest that the forthcoming European rules should address the methodological concerns on ESG ratings with a small number of targeted disclosure measures that focus on the very nature of the ESG ratings involved (in terms of ESG risk ratings or ESG impact ratings), on some methodological concerns and on the impact of conflicts of interest. Should market failures persist after a reasonable time, a higher bet can be made with a fully-fledged authorization and registration system along the line of credit ratings.

Luckily, EU law is more advanced on ESG-related indices. The main reason for this is that ESG indices qualify as a “benchmark” under the Benchmark Regulation and are therefore subject to all the measures provided therein. Remarkably, the regulation was first adopted to address the quality of input data, which was at the core of the Libor scandal. ESG-related data that support sustainability ratings are prone to the same kind of risk, so the Benchmark Regulation provided a turnkey regime that policymakers could easily rely upon, as they wisely did.

This post comes to us from professors Matteo Gargantini at the University of Genoa and Michele Siri at the University of Genoa and the Jean Monnet Centre of Excellence on European Union Sustainable Finance and Law (EUSFiL). It is based on their recent paper, “Information Intermediaries and Sustainability,” available here.

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