The ESG market places “too much reliance on ratings”, although this problem will potentially work itself out as the industry matures and regulators and professionals find the right balance between supervision and autonomy, according to Martin Maloney, secretary general of Madrid-based IOSCO.
Government regulators and multinational groups, including the International Organization of Securities Commissions, have been closely vetting the market for ESG finance amid a surge of interest and deal volume. Among the challenges in this nascent industry has been the confusing sets of standards and methodologies that go into evaluating an issuer’s environmental credentials and earn them green labels, second-party opinions and ESG ratings – as well as investor confidence.
Absent more substantive, dependable data on vital things like carbon and methane emissions, money managers often rely too heavily on these evaluations, Maloney argues.
“In a mature, well-serviced market, ratings are part of a broader market analysis and assessment process where information is combined and digested according to the investment appetites of customers,” Maloney said in a written response to IFR questions. “We have too much reliance on ratings when it comes to ESG matters at the moment because that ecosystem of information, market analysts and ESG investment managers is only in its infancy.”
At present, ratings providers bear a “huge burden of responsibility”, he said.
At the end of last year IOSCO, whose members include the US Securities and Exchange Commission, called for greater oversight of ESG ratings and data providers in a 53-page report detailing its concerns. The report found, among other things, that there was a lack of clarity about what ratings or data products intend to measure and a lack of transparency about the methods used to produce the ratings.
“They have to build trust through good management of conflicts of interest, strong transparency about their methodologies and openness about the limitations of their ratings,” said Maloney, who joined IOSCO as secretary general in September.
The oversight of ESG financing as a whole has become more important as the amount of money backing these apparently benevolent concepts has grown quickly. The global market for ESG bonds, for example, hit a record US$985.6bn in 2021, with 44% year-on-year growth, according to Refinitiv data. As volumes continue to surge, the SEC and other agencies are expected to provide guidance on crucial practices like corporate disclosures that are intended to improve the quality of data that investors and ESG ratings providers use to gauge assets.
“I am very confident that as we improve the quality of issuer information there will be a trickle-down effect into ratings,” Maloney said.
The ESG ratings industry has already been affected by the regulatory changes made to the credit ratings industry in the wake of the 2008 credit crisis. Many of the newer rules related to credit spelled out in the 2010 Dodd-Frank Act are being used to at least help guide the ESG industry.
Among other things, credit ratings regulations have helped set standards for the “precision of methodology and responsiveness to market developments” and imposition of fines, Maloney said. They have also “encouraged investors not to rely mechanistically on these ratings” and helped establish working relationships between regulators and agencies.
In both industries – as in the financial markets as a whole – it is also possible to manage any inherent conflicts of interest that may arise from practices like an issuer-pays model for ratings. Eliminating the conflicts is not the only way to manage them, he said.
“It is quite feasible to manage conflicts of interest,” he said. “Indeed, managing conflicts of interest is essential to developing viable business models in many aspects of financial services.”
Yet the data, methodologies and risks related to ESG are quite different than those of credit; there are limits to applying the solutions to one industry's problems to another.
“There is much to build on – such as the experience in terms of internal processes, due diligence and transparency – but there is much left to do,” he said.
Maloney said he is “quite hopeful” that the problems IOSCO “so forcefully called out” in its November report will be eventually addressed, in part because many of submissions it received in the consultation process showed “an industry grappling with change rather than in denial".
“Regulators and the industry should press the ESG ratings sector to work towards consistency of practices across all their ratings work,” he said. “In a sense, we are knocking on an open door with the industry on this one.”
Of course, this does not mean the every market for ESG ratings will be exactly the same. IOSCO, as an international organisation, naturally acknowledges that regulation is done in different ways in different jurisdictions.
“We in IOSCO have learnt to be comfortable with that fact,” Maloney said. “We see the merits of many different approaches; we recognise again and again on different issues that there is not just one way to regulate markets.”