Market participants are calling for stronger regulation of ESG ratings in Asia with growing concerns that the region is lagging the rest of the world, particularly Europe, where regulators are leading the way in providing oversight of the nascent sector.
The ESG Data and Ratings Code of Conduct Working Group will be co-chaired by M&G, Moody’s, the London Stock Exchange Group and Slaughter and May.
This comes only a few months after the European Commission published a report following its consultation on the ratings market in the EU with many expecting that this will lead to new regulations after a large majority of respondents backed legislative intervention.
In contrast, in Asia, the Securities and Exchange Board of India (SEBI) is the only regulator so far to propose regulating the ESG ratings sector and the region is viewed as being held back by its absence of a strong supranational regulator like the EU.
That has not stopped market participants clamouring for more oversight. In October, the Institute for Energy Economics and Financial Analysis (IEEFA) issued a new report on the sector. Its recommendations included regulatory oversight of the sector in addition to more standardised frameworks for rating methodology as well as mandatory reporting of each E, S and G pillar and its key sub-components.
“ESG rating providers need to be registered and supervised. Their methodologies need to be back-tested. I mentioned in the report that a study found several companies got upgraded because the methodology got changed and we don’t know why; these are things that only a regulator could come and examine,” said Hazel James Ilango, energy finance analyst, debt markets at the IEEFA.
State of play
Investors primarily rely on Sustainalytics and MSCI for their ESG ratings, although the industry is very fragmented. In 2020, KPMG estimated that there were around 150 major ESG data providers globally and in some jurisdictions the major rating agencies do not have much of a foothold.
In China, for example, local rating agencies such as SynTao Green Finance dominate, while in Korea, the Korea Corporate Governance Service, a trade body backed by the stock exchange and industry groups, provides its own ESG ratings for listed companies.
The result of this backdrop of different ESG rating agencies is that asset managers normally have to buy data from multiple different vendors, which increases costs and also disadvantages smaller investors. Most of them do not even rely on the ratings themselves and instead use the underlying data to build their own ESG scores.
“With the rating agencies, they’ve done a fantastic job with the resources they have. If you speak with MSCI or Sustainalytics, they have good teams, good analysts but because there’s so much demand and there’s so much work, the limited resources they have, they cannot respond to all companies all the time so the data tends to become a bit old after a certain time,” said Xuan Sheng Ou Yong, ESG and green bonds lead at BNP Paribas Asset Management.
Some market observers have gone further and criticised ESG rating agencies for their lack of comparability, reliance on company disclosures and opaque methodologies. An often-cited study from MIT Sloan and the University of Zurich showed that the correlation among several major rating agencies’ ESG ratings was on average 0.61, well below the 0.92 score for credit rating agencies.
“This is one of the biggest challenges. The standing, the methodologies and the philosophies behind ESG data vendors are very different and that’s also reflected in the scores and the ratings themselves. There are cases that comparisons between data vendors are very difficult” said Konstantina Founta, head of risk analytics for Asia Pacific at State Street.
Situation in Asia
So how do these shortcomings impact Asia in particular? Market observers noted that when it comes to ESG, the region is hampered by the fact that it is so fragmented with multiple regulators in different jurisdictions requiring different sets of data and different granularities of that data.
BNP Paribas Asset Management’s Xuan noted that there was very little coordination between the different regulators in the region when it comes to ESG disclosure requirements, although he put a lot of faith in some of the new global standards, particularly the International Sustainability Standards Board’s (ISSB) new baseline globally requirements on climate and sustainability.
“From speaking to regulators, I get the feeling they are waiting for the ISSB to finalise their regulations and that makes sense. They’re not going to spend their efforts harmonising reporting regimes, while there is a parallel effort to harmonise at the global level,” he said.
Unsurprisingly though, this fragmentation of disclosure requirements has also led to a fragmentation of data, which in turn impacts the viability of the ratings that rating agencies provide. Market observers noted that addressing this lack of harmonisation across the region was crucial in improving the standard of rating agencies, although they noted that it was only the first step.
“I firmly believe that these standards such as ISSB would definitely be a good step in improving harmonisation of disclosures to support effective ESG rating assessments. But I have to add that it is only one part of the solution. The bigger question is what are ESG ratings meant to measure because right now there is no clear definition. Even if data is harmonised, then how the data is applied and what it is meant to measure still remains debatable,” said the IEEFA’s James Ilango.
This issue has prompted some market observers to urge regulators in Asia to go further than those in the UK and elsewhere that have opted to adopt a voluntary code of conduct, which critics argue can be subjective and ineffective in improving transparency in the sector. This is a view James Ilango shares.
“If you think about credit rating agencies, they are faced with a much more comprehensive regulatory framework. SEBI was the first, if not one of the first few regulators in the region I am aware of, that has taken steps to improve oversight with things like mandating that each rating agency must have proper rating committees, although that is only the first step,” she said.
