ESG Rating Providers: Analyzing India’s Proposed Regulatory Framework

[Paridhi Jain is a 5^th year B.B.A., LL.B. (Hons.) student at Symbiosis Law School, Noida]

Once a niche market for investors, environmental, social, governance (“ESG”) investing has grown over the past few years. The pandemic is being referred to as a “sustainability” crisis and one that has re-invigorated focus on climate change, acting as a wake-up call for investors to prioritize a more ‘sustainable’ approach to investment. The pandemic has also alerted investors to unforeseen risks, and shocked many of them into action. Bloomberg reports that by the end of 2025, the global AUM (assets under management) of ESG assets is expected to surpass the USD 50 trillion mark, thereby representing over one-third of global AUM. The amount invested in ESG funds has increased tenfold from 2018 to 2020. India has also been hit by the wave of ESG with a whooping 76% increase in the amount invested in ESG funds and a slew of new ESG funds being launched. The Nifty 100 ESG index has constantly outperformed the benchmark Nifty 50 and 100.

With ESG investing becoming mainstream, the demand for ESG data and indices has also increased globally. Investors are increasingly relying on ESG ratings to gauge a company’s performance on ESG issues and exposure to ESG related risks. The lack of a common definition and framework of what ESG encapsulates complicates the analysis of companies reporting on ESG performance. ESG ratings help to bridge this gap by collecting the myriad ESG data, analyzing and diluting it to a single score/rating. ESG rating providers (“ERPs”) collect ESG data for a given company mainly from a company’s own disclosures, news items, third party reports and questionnaires. ERPs thereafter employ their distinct methodology to aggregate and process this data into a single score/rating.

However, concerns have arisen as to the mechanism of ERPs in assessing/rating companies, more so after the issues that arose with Volkswagen, Facebook and Boohoo. These companies had “above average” ESG ratings – more than their peers – but their environmentally pernicious activities were subsequently uncovered. Thus, entities’ ‘greenwashing’ results in them securing high ESG ratings and thus misleading investors into believing that they follow environmentally conscious business practices before their negative ESG incidents get uncovered. Moreover, studies find that this voluntary reporting allows for “near complete customization of style, format and content of disclosures” and “provides ample room for companies to manipulate the disclosure process”. Remy Briand, the head of the leading ESG rating provider MSCI has also commented that “one of the biggest challenges in ESG ratings comes from self-reported data”. As a result, there is dire need for the data to be subjected to due diligence, audit and internal controls. There is also significant research which suggests that there exists serious rating bias. A study shows that raters tend to give higher scores in multiple categories and other shows that large companies are typically rated better than small companies.

These issues demand a closer examination of the working of ERPs. Firstly, there is minimal or complete non-disclosure by ERPs about their methods and sources while assigning a rating, which undermines ESG ratings’ transparency, usefulness, and reliability. Secondly, the ‘methodology’ adopted by ERPs, vary substantially. There is notable divergence between ERPs in the factors considered and also in the weightage assigned to variables in assessing a particular entity’s ESG performance. This, in addition to the lack of an industry standards/benchmarks, has further convoluted the comparability and interpretability of ESG ratings by different ERPs. A study suggests that the correlation between ESG ratings across different providers is only around 0.3. This is in contrast to ‘credit ratings’, where the correlation stands at around 0.99.

These concerns coupled with investors’ growing reliance on ESG disclosures, ratings, and various types of ESG related funds has invited greater scrutiny from market regulators globally. They are concerned about the risk of greenwashing and misallocation of assets surfacing due to lack of regulatory oversight. Securities regulators globally have been ramping up their efforts to contribute to this transition towards ‘sustainable investments’ and a ‘sustainable economy’. International Organization for Securities Commissions (IOSCO)  published its report  last year on ‘ESG Ratings and ESG Data Providers’, where it called for regulation of such providers. Regulators were encouraged to pay greater attention to the use of ESG ratings and activities of  ESG rating providers in their respective jurisdictions. The European Union’s securities watchdog European Securities and Market Authority (ESMA) also recommended  regulating ‘sustainability service providers’ in capital markets.

India – SEBI’s Proposed Regulatory Framework

India’s market regulator, Securities and Exchange Board of India (“SEBI”) has been at the forefront in regulating sustainable investment and aligning itself with the prevailing international norms and standards. Over the last year, it has introduced a host of regulations, including the shift from ‘Business Responsibility Report’ (BRR) to ‘Business Responsibility and Sustainability Report’ (BRSR), thereby requiring listed companies to disclose the financial implications as well as plans to mitigate or adapt to ESG risks. It also proposed to introduce new norms for mutual funds that invest as per the ESG criteria. Lastly, and most recently, it released a consultation paper on ‘ESG Rating Providers for Securities Markets’ wherein a regulatory framework for ERPs is proposed to be introduced. The consultation paper underlines the key issues faced by investors when using ERPs, including lack of transparency, consistency, and potential risk of conflict of interest and attempts to achieve through regulation better interpretability, comparability, and reliability.  

Eligibility Criteria

Under the proposed regulatory framework, the SEBI has suggested that ERPs need to be accredited to ensure that it has adequate capital, infrastructure, and skilled manpower to conduct its activities. Therefore, if any listed entity, mutual fund, alternative investment fund or index provider chose to avail an ESG rating, they would have to do it from a SEBI accredited ERP. The SEBI has further proposed that only registered credit rating agencies (CRA) and research analysts (RA) would be eligible to be accredited as ERPs with SEBI. Besides fulfilling the criteria of CRA/RA, they will need to have a minimum net worth of Rs. 10 crores. Additionally, due to ESG being a “knowledge and technical know-how driven exercise”, the SEBI has recommended that the ERPs would need to have a specialist in each of the following areas at all times: (i) data analytics, (ii) sustainability, (iii) finance, (iv) information technology, and (v) law.

The SEBI stipulates that the parallels between CRAs and ERPs makes them appropriate entities to be accredited as ERPs. While it is true that there is some overlap in the functions performed by CRAs and ERPs as both the entities assign ‘ratings’, it is my view that there exist fundamental differences between the purpose, method, and process of assigning each of these ratings. It has to be noted that while credit ratings deal with the sole issue of ‘corporate default risk’, rating ESG requires an objective assessment of subjective issues such as board diversity, labour issues, carbon footprint, etc. The resources and skills needed to arrive at an ESG rating are markedly distinct from those needed to assign a credit rating. There also arises potential conflict of interest concerns since CRAs could hesitate to downgrade companies that pay a huge sum availing credit ratings. Further, restricting the accreditation to only CRAs/RAs would prevent the entry of new players who specialize in sustainability related services and are neither CRAs/RAs, and would give monopoly to the already established players. Therefore, while CRAs/RAs could offer ESG related services, the market should not be solely restricted to them.

Scope of Regulation

The SEBI acknowledges that the space of ESG is constantly evolving and there exists a wide variety of ESG rating and data products which may vary significantly. It, thus, proposes to regulate only the ESG rating service offered by the entities, and not the other associated services. It classifies ratings under two broad heads – (i) impact rating, which deals with the effect corporations have on ESG related issues, and (ii) risk rating, which deals with the ESG risks that the corporates are exposed to. Consequently, it states that entities wishing to accredit themselves as ERPs must provide either of the two ratings or any other ESG related rating products, provided they are properly labelled. It further expressly cautions that it would not regulate specific ratings like ‘carbon-risk’ rating as that only assesses the ‘environmental’ aspect, and does not cover the whole ambit of ‘ESG’. In doing so, the SEBI departs from the recommendation in IOSCO’s report to regulate the entire range of ESG data and rating providers. This is a welcome move since it will admittedly help in defining and narrowing down the ambit of ESG products and services and help investors discern what they are receiving when choosing to avail ERP services.

ERPs Transparency and Governance 

Given the differences between ESG ratings, transparency of the underlying methodology and process followed would be key. Thus, the SEBI has proposed that ERPs mandatorily disclose the type of rating they offer (whether risk based, or impact based) and define each component i.e. E, S and G. They have to further reveal the methodology followed and the resources relied on while assigning a rating. This will certainly aid the investors to better understand and choose the rating which matches their own interpretation of ESG. However, issues could arise where ERPs who have developed a “proprietary rating methodology” refrain from disclosing it publicly.

In order to make the ESG rating process more uniform and proper, the SEBI has also recommended that the ERPs conduct in-depth analysis before assigning a rating and maintain records to support their decisions. It is proposed that ERPs have a professional rating committee comprising of personnel skilled to assign a rating. The committee would be responsible for developing the methodology and making any changes in it if required. ERPs would also be required to maintain an operations manual/internal governing document which would inter alia inform the users on the ESG rating method followed, minimum information required, key performance indicators and the method of reviewing and reporting ESG rating. This would allow investors to assess the quality and robustness of ESG ratings and make informed investment decisions.

Prevention of Conflict of Interest

In many cases, ERPs which rate entities on the ESG criteria, also provide consultancy services to help them address these issues. Thus, there exists serious conflict of interest between the ERPs and the entities they rate. To manage this, the SEBI has proposed that ERPs maintain a strong policy to identify, disclose, and mitigate potential conflict of interest issues. They must not give ratings to their related entities and securities issued by them. Further, the personnel responsible for assigning the rating should be separated from other services of the rating provider like ESG consultancy services. Their reporting lines as well as compensation structure ought to be structured so as to avoid any potential risk of conflict of interest. 

Conclusion

While the proposed framework addresses existing concerns and provides a comprehensive regulatory framework, much work still needs to be done. It would still be difficult to detect fraud and tackle the risk of greenwashing as an ESG rating is mainly based on self-reported and unaudited disclosures made by the company being rated.

Despite the existence of ratings such as ESG or any other combination of factors, there would be no substitute for investor due diligence to assess a particular entity’s performance. From the entity’s point-of-view, the way forward would be to set achievable ESG goals and ensure accountability for the same. Nevertheless, to achieve the larger goal of sustainability, it would not just involve entities aligning themselves with ESG practices, but would require collaborative efforts between various institutions, including the government and regulators, to create actual impact.

– Paridhi Jain