By Paul A. Davies, Nicola Higgs, and Anne Mainwaring
On 26 July 2021, the Board of the International Organization of Securities Commissions (IOSCO) published a consultation report (the Report) that proposes a set of recommendations to mitigate risks flowing from activities of ESG ratings and data products providers and to address some of the challenges faced by users of ESG ratings and data products as well as the companies that are the subject of these ratings or data products.
This blog post provides of an overview of the ESG ratings and data market and outlines IOSCO’s proposed set of 10 recommendations.
The market for ESG ratings and data has grown exponentially over the past few years. In particular, as investors have become increasingly focused on the potential financial risks posed by climate change and other environmental, social, and governance (ESG) considerations, such considerations have become increasingly significant in investment decision-making.
Investor demand, as well as regulatory developments, has encouraged the development of new ESG ratings and data products. However, these ratings and products are mostly outside the remit of regulators. In light of this, the Report notes that increasing reliance on these services raises concerns about the potential risks they pose to investor protection, the transparency and efficiency of markets, risk pricing, and capital allocation.
Prior to publishing the Report, IOSCO undertook a fact-finding exercise that revealed a lack of transparency about the methodologies behind the ratings or data products and an often uneven coverage of products offered across industries and countries. The Report therefore highlights that the lack of standards in this area may present a risk of greenwashing or misallocation of assets and could lead to a lack of trust in ESG ratings or in data products’ robustness or relevance.
Financial institutions and multinationals use ESG data in many different ways and for many reasons, including regulatory purposes. For example, they may be required to comply with the disclosure requirements under the EU Non-Financial Reporting Directive, the EU Taxonomy and the Sustainable Finance Disclosure Regulation. ESG data will become increasingly central as the global ESG disclosure landscape evolves with more and more global regulators introducing ESG disclosure standards that rely heavily on third party ESG data sources.
To address challenges in the ESG ratings and data products providers market, IOSCO has proposed the following set of 10 recommendations.
Recommendation for IOSCO and IOSCO members
- Regulators may wish to consider focusing more attention on the use of ESG ratings and data products and on those services’ providers.
Regulating ESG ratings and data products providers could contribute to a greater level of confidence in the use of these products and lead to a greater take-up, while at the same time protecting investors. Moreover, national regulators might consider the extent to which the processes for determining ESG ratings and data products overlap with the processes for determining credit ratings, and whether there is a potential conflict of interest.
Recommendations for ESG ratings and data products providers
IOSCO noted that there is scope for high-level guidance to improve the reliability, comparability, and interpretability of ESG ratings and data products, and that such guidance could be sufficiently flexible to accommodate the developing nature of the market. As such, ESG ratings and data products providers could consider:
- Issuing high quality products based on publicly disclosed data sources where possible, using transparent and defined methodologies
- Ensuring their decisions are, to the best of their knowledge, independent and free from political or economic pressures and from conflicts of interest arising due to the providers’ organizational structure, business or financial activities, or the financial interests of the providers’ employees
- On a best-efforts basis, avoiding activities, procedures, or relationships that may compromise or appear to compromise the independence and objectivity of the ESG rating and ESG data products provider’s operations or identifying, managing and mitigating the activities that may lead to those compromises
- Making high levels of public disclosure and transparency an objective in their products, including their methodologies and processes
- Maintaining in confidence all non-public information communicated to them by any company, or its agents, related to their ESG ratings and data products, in a manner appropriate in the circumstances
Recommendation 6 above is significant as market sentiment evolves to treat a change in an ESG rating as “price sensitive” information. See our previous blog post for further discussion on that topic.
Recommendation for ESG ratings and data products users
- Financial market participants could consider conducting due diligence on the ESG ratings and data products that they use in their internal processes. This due diligence could include an understanding of what is being rated or assessed by the product and how it is being rated or assessed, and limitations and the purposes for which the product is being used.
This recommendation is intended to ensure that a mechanistic reliance on ESG ratings and data products is avoided when possible.
Recommendations on how ESG ratings and data products providers may wish to consider interacting with entities subject to assessment
The following two recommendations are aimed at addressing some of the reported shortcomings in market conduct. ESG ratings and data products providers could consider:
- Improving information-gathering processes with entities covered by their products in a manner that is efficient and leads to more effective outcomes for both the providers and these entities
- Responding to and addressing issues flagged by entities covered by their ESG ratings and data products while maintaining the objectivity of these products
Recommendation on how covered entities could consider interacting with ESG ratings and data products providers
- Entities subject to assessment by ESG ratings and data products providers could consider streamlining their disclosure processes for sustainability-related information to the extent possible, bearing in mind regulatory and other legal requirements in their jurisdictions.
The intention behind this final recommendation is to address the full spectrum of issues relevant to the production of ESG ratings and data products, which could help with delivering up-to-date and accurate assessments and reducing the burden on covered entities to follow up with providers to discuss any errors or omissions.
The consultation is open until 6 September 2021. Given the wide international reach of IOSCO (it groups regulators across 130 jurisdictions), it will be interesting to see how national entities respond to the Report and potentially adopt the recommendations, bearing in mind the complexity of, and differences between, the local rules.
IOSCO is not the only actor looking at this topical issue — the new Sustainable Finance Strategy announced by the European Commission earlier this month plans to introduce measures that improve the reliability, comparability and transparency of ESG ratings, but this isn’t expected until at least 2023. In the UK, the FCA (which has been closely involved with this IOSCO workstream) recently issued a consultation to extend climate-related disclosures for listed companies, discussing a similar topic. This consultation, together with the FCA’s consultation on mandatory disclosures for asset managers in line with the Task Force on Climate-related Financial Disclosures guidelines, forms part of the drive to ensure that there is high-quality information on how climate-related risks and opportunities are being managed along the investment chain. Moreover, French and Dutch regulators have previously made the case for regulating ESG ratings — they published a joint paper outlining possible third-party data vendor standards last year, with a focus on transparency and conflict of interest.
Notably, the Report is part of IOSCO’s broader work with the International Financial Reporting Standards (IFRS) Foundation to establish global sustainability disclosure standards that national jurisdictions could incorporate or build upon as part of their mandatory reporting requirements. By improving the quality of disclosures, this could in turn become an essential part of any methodology underpinning the development of ESG ratings or data products, making them more reliable and transparent.
Latham & Watkins identified converging the alphabet soup of ESG terminology, standards, and initiatives as one of the top 10 ESG trends for 2021 and will continue to track developments in this space.
This post was written with the assistance of Aleksandra Dulska in the London office of Latham & Watkins.
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