EBF SUSTAINABLE FINANCE ROUNDUP ARTICLE 

ESG Ratings: A European approach?

By Marta Morellato, EBF Financing Sustainable Growth

z

BRUSSELS, 20 June 2022

x

ESG Ratings are meant to offer a snapshot evaluation of the impact of ESG (environmental, social and governance) factors on a company as well as the company’s impact on the outside world.

As ESG investing is becoming increasingly mainstream, these ratings are being widely used by a variety of stakeholders at a growing rate. In particular, there has been an increasing focus on ESG factors and their relationship with financial performance. In other words, an increasingly common question is whether and to which extent ESG factors impact an entity’s creditworthiness. On top of this, at a time when the financial industry is being called to closely assess the ESG impact of their portfolio, both on a voluntary basis and as a result of mandatory EU legislation, these ESG ratings can potentially serve as a useful tool.

While on the one side ESG ratings could contribute to filling current data gaps in the area of sustainability, the rapid development and increasing reliance on such ratings by market participants has led to the proliferation of agencies offering these products, which investors and other stakeholders rely on. What has, however, been observed is that there are significant divergences between the rankings produced by different agencies. This can be traced back to at least one underlying rationale: different rating providers use different methodological approaches when providing ESG ratings. The approaches vary across providers and different weights are attributed to the single components of the score (i.e., to the ‘E’, ‘S’, or ‘G’), leading to issues of comparability across ratings. It goes without saying that if the same methodological approach is not applied, comparing results can be quite arduous. In the process of making a portfolio selection or investment decision, increasing transparency about the underlying methodologies, data sources, and weightings ESG rating providers are using is therefore crucial.

Another relevant area of concern is ESG ratings providers’ accessibility to this expanding market. At the current state of things, ratings are mainly provided by large market players headquartered outside the EU. The combination of these two elements, raises a few issues. First, it limits access to the market by smaller providers, which face entry barriers linked to high data collection costs and brand recognition of larger providers.  The exponential growth in demand for ESG data should be matched by an equal, or at least similar, expansion of the relevant market. The EU ESG regulatory landscape is growing rapidly and facilitating access to the market also to smaller ESG rating providers may be particularly beneficial to cater to regional specificities. Moreover, few providers cannot cover the totality of demand for ESG ratings, especially in Europe, where the need for readily available ESG data reflects the rapid progress of sustainability-related disclosure requirements. Not matching the growing demand with a larger market will ultimately be detrimental in terms of the quality of the ratings provided. Second, over-reliance on few non-European providers and the resulting lack of competition may lead to higher costs for European companies. It is also important to ensure that ESG ratings are reflective of the fast-changing EU ESG legislative landscape.

So, how can we ensure the most is made of this essential tool?  The EU certainly needs a coordinated approach, and this could be achieved through a common methodological framework bringing transparency and greater harmonization amongst ESG ratings against a current reality of unregulated data providers operating in the EU market.

With the EU standing as a frontrunner in the field of sustainability, it is crucial that we ensure a well-functioning, reliable, and transparent system for ESG ratings, which should provide meaningful and high-quality assessments of the ESG performance of companies.

X