OPINION
2021 Jun/01
Directions for Improvement in ESG Rating Schemes
Jun. 01, 2021
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- Summary
- ESG ratings centering on non-financial data such as environmental, social, and governance factors are differentiated from credit ratings based on standardized corporate disclosure and accounting information under the global accounting standards. ESG ratings need improving in terms of transparency in methodology and consistency across raters because there is not a single set of standards on how to classify and measure corporate sustainability and report it to stakeholders. Under the rapid flow of investments pursuing ESG factors, the absence of standards could give rise to a distortion in asset allocation, and mis-selling issues. This is why financial authorities in developed nations have been seeking for improvement in this area. For example, global discussions mainly led by the EU include: establishing Sustainability disclosure standards in the ongoing non-financial disclosure directive revision; mandating financial institutions to disclose sustainability risks; and formulating a regulatory framework on ESG rating providers. It is worth referring to those discussions from the perspective of international compatibility when Korea seeks to improve its domestic ESG rating scheme.
Growth of sustainable investing and expansion of relevant rating services
Sustainable investing has shown a rapid increase in size globally. One of the recent data reported that the size reached EUR 45 trillion at the end of 2020, of which EUR 2.5 trillion were invested by institutional investors who track ESG ratings provided by raters.1) Over the past year in Korea, the sales of ESG equity funds that said they make investment decisions based on ESG ratings on top of financial results increased 3.8-fold to reach KRW 1.22 trillion as of May 6, 2021.
It takes tremendous endeavor to identify and categorize ESG factors in business activities, compute them based on a predetermined set of criteria, and actually reflect those in investment. Also, data granularity is required for selecting stocks that outperform others in environmental, social, and governance factors from the financial investment perspective. With sustainable investing attracting public attention and investment for the past few years, there has been a rapid rise in the services that provide relevant data. Providers of those services have been expanding their business scope that includes not only collecting raw data on ESG-related firms via disclosure or other sources, but also using their own classification and rating methodology to provide relevant data, ratings, and indexes.
However, ESG ratings are often said to lack two elements—transparency in methodology and comparability between raters, which is starkly different from credit ratings that are systematically computed based on standardized corporate disclosure materials and accounting information documented under well-established global standards. As sustainable investing is growing in size in Korea and abroad, there cannot be a more opportune moment for a reexamination on ESG rating schemes.
Differences in rating schemes and their orientation
Before trying to understand why ESG ratings lack consistency across raters, it is worth looking at the chronology of the current rating scheme. A systematic evaluation on corporate social responsibility dates back to 1988 when Kinder Lydenberg Domini & Co. (KLD) in the US first began building the KLD social rating data that played a key role in researching how to categorize corporate activities related to social responsibility and what methodology to choose for measuring the performance. How KLD classified social responsibility is a value-driven system, rather than a theory-driven, deductive categorization.2) Simply put, the evaluation is based on social values such as gender equality and human rights. By contrast, Innovest, founded in 1995, sought to evaluate firms based on their capability to cope with environmental degradation and the issue’s relevance to finance. This is an evaluation based on financial values from the perspective of materiality. The current rating schemes reflect both perspectives. For example, if a scheme uses the ratio of female workforce when it evaluates a financial institution’s social performance in ESG rating, it is close to the perspective of social values. If an evaluation is based on the number of mis-selling of financial products, such a scheme may prioritize the possibility of financial losses from legal actions. What constitutes social values here could vary depending on the ideology pursued by each social community. Because those values are non-financial elements, the evaluation results could also vary depending on the perspectives and methodology involved.
Three directions for improvement
Thus far, there is not a single set of standards based on which to classify and measure corporate sustainability and report the result to stakeholders. Under the rapid pace of ESG investment flows, the absence of the standards could possibly lead to a distortion in asset allocation or mis-selling, which calls for relevant authorities in developed economies to take action. Their response to this issue consists of three paths.
The first path is to come up with a credible set of standards and an institutional framework for helping firms to systematically disclose material information linked to their sustainability activities. The International Organization of Securities Commissions (IOSCO) recommends the International Financial Reporting Standards (IFRS) Foundation and the five bodies3) that set global standards for sustainability reporting to cooperate with each other in formulating a draft for ESG disclosure standards. IOSCO declared its commitment to draft environment-related disclosure standards first given that climate change among three ESG factors is of the most critical concern and its high proportion of quantitative data makes it easier to set objective standards. Accordingly, the five bodies mentioned above unveiled the prototype climate-related disclosure standard.4) The IFRS Foundation is reviewing its plan to establish an International Sustainability Standards Board (ISSB), an equivalent to the International Accounting Standards Board (IASB) that independently sets out international accounting standards. IOSCO is now seeking consultation from its own Technical Expert Group for mulling over the decision to support the ISSB as a global standard setting committee such as the IASB. The overall process is managed by the US Securities and Exchange Commission and the Monetary Authority of Singapore.
The second path is a move to try to resolve potential investor protection issues that could arise from discrepancies across rating schemes amid the lack of standardization. In the Sustainable Finance Disclosure Regulation (SFDR), the European Commission requires financial firms to disclose the impact of sustainability agenda arising from environmental and social areas at the firm level as well as the product level which refers to the impact on investment returns. Currently, the EC is working on the Regulatory Technical Standards (RTS) that seek to finalize the types of data to be disclosed, which is scheduled to go into effect in January 2022. More concretely, the RTS set out the specific content and template of disclosure, for example, a specific set of variables and equations for calculating the total concentration of all greenhouse gases emitted by an investee firm, and a concrete computation method for the gender pay gap. This can be viewed as part of attempt to apply a single set of standards to financial products for enhanced comparability from the perspective of sustainability.
The last path is to review the need for regulating ESG raters. In a letter to the EC sent in January 2021, the European Securities and Markets Authority (ESMA) admitted the need to consider plans to regulate ESG rating providers in the authority’s dealing with mis-selling related to ESG data and conflicts of interest that could arise when a single rater provides both ESG ratings and indexes. Towards that end, ESMA called for reviewing the need to develop regulations in reference to the existing rules governing credit rating agencies, but not at the expense of innovation in the ESG rating methodology that is currently evolving.
Need to be a stakeholder in international compatibility discussion
Korean firms will soon be obligated to disclose their sustainability activities. Importantly, mandated disclosure on ESG activities—if not properly supported by an objective and consistent set of standards—could still give rise to conflicting perspectives in interpreting the disclosure and end up with widely different ratings across raters. Such a possibility calls for Korea to review its current classification systems for environmental, social, and governance factors based on each factor’s significance. Also necessary is a more concrete set of disclosure standards with regard to sustainability risk—in particular, climate change risk—in investments at the levels of firms, financial institutions, and financial products. Although it is important to set Korea’s own standards, equally important is for Korea to participate in international discussions in this area as a key stakeholder, which will help Korea better represent its interest and closely examine the regulatory compatibility.
1) ESMA, 2021, ESG ratings: Status and key issues ahead, Report on Trends, Risks and Vulnerabilities No. 1.
2) The assessment categories initially included community relations, employee relations, the environment, the product, treatment of women and minorities, military contracts, nuclear power, and South Africa. They later were changed to climate change, the community, corporate governance, diversity, employee relations, human rights, product quality and safety.
3) CDP (Carbon Disclosure Project), CDSB (Climate Disclosure Standard Board), GRI (Global Reporting Initiative), IIRC (International Integrated Reporting Council), SASB (Sustainability Accounting Standard Board).
4) Reporting on enterprise value: Illustrated with a prototype climate-related financial disclosure standard, December 2020.
Sustainable investing has shown a rapid increase in size globally. One of the recent data reported that the size reached EUR 45 trillion at the end of 2020, of which EUR 2.5 trillion were invested by institutional investors who track ESG ratings provided by raters.1) Over the past year in Korea, the sales of ESG equity funds that said they make investment decisions based on ESG ratings on top of financial results increased 3.8-fold to reach KRW 1.22 trillion as of May 6, 2021.
It takes tremendous endeavor to identify and categorize ESG factors in business activities, compute them based on a predetermined set of criteria, and actually reflect those in investment. Also, data granularity is required for selecting stocks that outperform others in environmental, social, and governance factors from the financial investment perspective. With sustainable investing attracting public attention and investment for the past few years, there has been a rapid rise in the services that provide relevant data. Providers of those services have been expanding their business scope that includes not only collecting raw data on ESG-related firms via disclosure or other sources, but also using their own classification and rating methodology to provide relevant data, ratings, and indexes.
However, ESG ratings are often said to lack two elements—transparency in methodology and comparability between raters, which is starkly different from credit ratings that are systematically computed based on standardized corporate disclosure materials and accounting information documented under well-established global standards. As sustainable investing is growing in size in Korea and abroad, there cannot be a more opportune moment for a reexamination on ESG rating schemes.
Differences in rating schemes and their orientation
Before trying to understand why ESG ratings lack consistency across raters, it is worth looking at the chronology of the current rating scheme. A systematic evaluation on corporate social responsibility dates back to 1988 when Kinder Lydenberg Domini & Co. (KLD) in the US first began building the KLD social rating data that played a key role in researching how to categorize corporate activities related to social responsibility and what methodology to choose for measuring the performance. How KLD classified social responsibility is a value-driven system, rather than a theory-driven, deductive categorization.2) Simply put, the evaluation is based on social values such as gender equality and human rights. By contrast, Innovest, founded in 1995, sought to evaluate firms based on their capability to cope with environmental degradation and the issue’s relevance to finance. This is an evaluation based on financial values from the perspective of materiality. The current rating schemes reflect both perspectives. For example, if a scheme uses the ratio of female workforce when it evaluates a financial institution’s social performance in ESG rating, it is close to the perspective of social values. If an evaluation is based on the number of mis-selling of financial products, such a scheme may prioritize the possibility of financial losses from legal actions. What constitutes social values here could vary depending on the ideology pursued by each social community. Because those values are non-financial elements, the evaluation results could also vary depending on the perspectives and methodology involved.
Three directions for improvement
Thus far, there is not a single set of standards based on which to classify and measure corporate sustainability and report the result to stakeholders. Under the rapid pace of ESG investment flows, the absence of the standards could possibly lead to a distortion in asset allocation or mis-selling, which calls for relevant authorities in developed economies to take action. Their response to this issue consists of three paths.
The first path is to come up with a credible set of standards and an institutional framework for helping firms to systematically disclose material information linked to their sustainability activities. The International Organization of Securities Commissions (IOSCO) recommends the International Financial Reporting Standards (IFRS) Foundation and the five bodies3) that set global standards for sustainability reporting to cooperate with each other in formulating a draft for ESG disclosure standards. IOSCO declared its commitment to draft environment-related disclosure standards first given that climate change among three ESG factors is of the most critical concern and its high proportion of quantitative data makes it easier to set objective standards. Accordingly, the five bodies mentioned above unveiled the prototype climate-related disclosure standard.4) The IFRS Foundation is reviewing its plan to establish an International Sustainability Standards Board (ISSB), an equivalent to the International Accounting Standards Board (IASB) that independently sets out international accounting standards. IOSCO is now seeking consultation from its own Technical Expert Group for mulling over the decision to support the ISSB as a global standard setting committee such as the IASB. The overall process is managed by the US Securities and Exchange Commission and the Monetary Authority of Singapore.
The second path is a move to try to resolve potential investor protection issues that could arise from discrepancies across rating schemes amid the lack of standardization. In the Sustainable Finance Disclosure Regulation (SFDR), the European Commission requires financial firms to disclose the impact of sustainability agenda arising from environmental and social areas at the firm level as well as the product level which refers to the impact on investment returns. Currently, the EC is working on the Regulatory Technical Standards (RTS) that seek to finalize the types of data to be disclosed, which is scheduled to go into effect in January 2022. More concretely, the RTS set out the specific content and template of disclosure, for example, a specific set of variables and equations for calculating the total concentration of all greenhouse gases emitted by an investee firm, and a concrete computation method for the gender pay gap. This can be viewed as part of attempt to apply a single set of standards to financial products for enhanced comparability from the perspective of sustainability.
The last path is to review the need for regulating ESG raters. In a letter to the EC sent in January 2021, the European Securities and Markets Authority (ESMA) admitted the need to consider plans to regulate ESG rating providers in the authority’s dealing with mis-selling related to ESG data and conflicts of interest that could arise when a single rater provides both ESG ratings and indexes. Towards that end, ESMA called for reviewing the need to develop regulations in reference to the existing rules governing credit rating agencies, but not at the expense of innovation in the ESG rating methodology that is currently evolving.
Need to be a stakeholder in international compatibility discussion
Korean firms will soon be obligated to disclose their sustainability activities. Importantly, mandated disclosure on ESG activities—if not properly supported by an objective and consistent set of standards—could still give rise to conflicting perspectives in interpreting the disclosure and end up with widely different ratings across raters. Such a possibility calls for Korea to review its current classification systems for environmental, social, and governance factors based on each factor’s significance. Also necessary is a more concrete set of disclosure standards with regard to sustainability risk—in particular, climate change risk—in investments at the levels of firms, financial institutions, and financial products. Although it is important to set Korea’s own standards, equally important is for Korea to participate in international discussions in this area as a key stakeholder, which will help Korea better represent its interest and closely examine the regulatory compatibility.
1) ESMA, 2021, ESG ratings: Status and key issues ahead, Report on Trends, Risks and Vulnerabilities No. 1.
2) The assessment categories initially included community relations, employee relations, the environment, the product, treatment of women and minorities, military contracts, nuclear power, and South Africa. They later were changed to climate change, the community, corporate governance, diversity, employee relations, human rights, product quality and safety.
3) CDP (Carbon Disclosure Project), CDSB (Climate Disclosure Standard Board), GRI (Global Reporting Initiative), IIRC (International Integrated Reporting Council), SASB (Sustainability Accounting Standard Board).
4) Reporting on enterprise value: Illustrated with a prototype climate-related financial disclosure standard, December 2020.