[Shouvik Kumar Guha is an Associate Professor of Law and Sourav Paul a fourth year undergraduate student, both at the West Bengal National University of Juridical Sciences, Kolkata]
On July 3, 2023, the Securities and Exchange Board of India (‘SEBI’), introduced the Securities and Exchange Board of India (Credit Rating Agencies) (Amendment) Regulations, 2023 (‘Regulation’) to amend the Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999. The primary objective of the Regulation is to establish a comprehensive regulatory framework that governs the operations of the ESG rating agencies in India. The Regulation, inter-alia, attempts to set out rules regarding the registration of ESG rating agencies, their code of conduct, the process of ESG rating, and imposes disclosure obligations. This article focuses on the ESG rating agencies as specified in the Regulation and analyse the SEBI’s approach in regulating the same.
SEBI’s Position in the Consultation Paper
Prior to the notification of the Regulation, SEBI released a consultation paper on ESG Rating Providers for Securities Markets to understand the concerns related to the unregulated ESG rating agencies in India. SEBI came up with this consultation paper after the International Organisation of Securities Commissions’ report on ‘ESG Ratings and Data Product Providers’. In the consultation paper, SEBI acknowledged the ambiguity and inconsistency in ESG products, such as ESG Impact Ratings, and ESG Corporate Risk Ratings. Furthermore, it noted that there is a potential risk of greenwashing since there is no uniformity in the rating methodologies. Greenwashing refers to deceptive practicesemployed by businesses to portray themselves as more environmentally sustainable.
In the consultation paper, SEBI proposed with regards to the ESG rating process that the rating methodology for a specific product should be consistent across all assigned ratings. Further, the ESG rating agencies are required to exercise due diligence and independent professional judgment to maintain objectivity and independence. However, it would have been prudent to provide more explicit standards for such diligence and judgment to enhance the reliability of the rating process.
SEBI also undertook an in-depth analysis of the business model of the ESG rating agencies and compared it with the business models of the credit rating agencies. It noted that credit rating agencies follow an ‘issuer-pay’ model primarily because a credit rating is a mandatory requirement for the issuance of securities or listing in the markets. On the other hand, globally, ESG rating agencies follow a ‘subscriber-pay’ model where investors can subscribe to the rating services as there is no requirement for an ESG rating before the issuance of securities or listing in the markets. SEBI noted that a ‘subscriber-pay’ model may give rise to potential conflict of interest concerns. For instance, an investor subscribing to a specific rating offered by an ESG rating agency could demand a customised analysis based on the company’s goals.
SEBI also recommended the ESG rating agencies to form specialised committees to execute the rating process. However, it refrained from proposing any standard rating scale to be followed by all the registered ESG rating agencies in India. This cautious approach may be based on the understanding that with the ESG landscape in India still being at a nascent stage and the markets constantly evolving, a premature imposition of such standard may hinder the natural growth of the industry. Further, this business model puts smaller investors in terms of monetary capacity at a disadvantageous position.
Upon reviewing the proposed framework relating to ESG rating agencies, it is evident that SEBI has followed an approach similar to the consultation paper. In the subsequent section, we analyse and comment on the SEBI’s framework related to ESG rating agencies under the Regulation.
Analysing the Regulatory Framework for the ESG Rating Agencies
The Regulation has laid down stringent eligibility criteria for ESG rating agencies seeking registration from SEBI. Regulation 28E, inter-alia, mandates that they are required to submit a detailed business plan regarding ESG rating activity in India. Further, the targets mentioned in the business plan must be strictly related to their proposed operation in the Indian securities market and must be reasonable.
SEBI, while framing the Regulation, has placed enhanced emphasis on the transparency and governance aspects of ESG rating agencies. As per the Regulation, they are required to maintain a website and disclose material information related to the ESG rating process. They also need to disclose their rating methodologies keeping in mind the confidential aspects of such methodologies. If there are any changes in the rating methodology, the ESG rating agencies are also required to explain the consequential changes on their website. The Regulation has made it mandatory to frame policies related to conflicts of interest, which needs to be published on the website. There is a blanket restriction on rating entities connected with the promoter of the ESG rating agency. The ESG rating agencies are also required to appoint a compliance officer to ensure compliance with the applicable laws. In case of any non-compliance, the compliance officer must report independently to SEBI on an immediate basis. Such measures would ensure information symmetry among the various classes of investors related to the functioning of ESG rating agencies.
To prevent shareholding interlocks in the ESG rating sector, SEBI has introduced shareholding restrictions in the Regulation. An ESG rating agency cannot hold more than 10% of shareholding either directly or indirectly in any other ESG rating agency. SEBI’s approval is required if any ESG rating agency intends to acquire shares or voting rights exceeding 10% in any other ESG rating agency. Further, to prevent director interlocks, an ESG rating agency cannot have a representation on the board of directors of any other ESG rating agency. The global market for ESG rating agencies is heavily dominated by a few entities–MSCI ESG, Sustainalytics, RepRisk, and ISS Environmental & Social QualityScore. The shareholding restrictions would prevent such consolidation in this nascent industry. Further, restrictions related to board interlocks would prevent collusion among the ESG rating agencies.
The Regulation has laid down broad guidelines pertaining to the ESG rating process and monitoring of the ratings. SEBI has mandated that the ESG rating agencies should have written policies, procedures, and internal controls to ensure consistency in the application of the rating methodologies. Notably, SEBI has mandated the ESG rating agencies to consider the unique features of the Indian securities market while assigning ESG ratings. Additionally, they are required to periodically update and review their rating methodologies. The ratings of their client need to be continuously monitored unless the rating is withdrawn by SEBI. The Regulation mandates the ESG rating agencies to review their published ESG ratings either annually or more frequently as needed. Further, the agencies should have advanced technological tools to track the material developments related to ESG to update the ratings in a timely manner.
Under the Regulation, SEBI has imposed specific disclosure obligations on the ESG rating agencies. The Regulation stipulates that such an agency is required to disclose the definitions and symbols of their ratings. Further, the agencies must explicitly mention that their ESG ratings should not be considered as recommendations to buy, hold, or sell any securities.
In sum, SEBI has imposed stringent compliance requirements and introduced corporate governance norms in the regulatory framework governing ESG rating agencies in India. Transparency and accountability on the part of the ESG rating agencies are the key underlying principles contained in the Regulation. However, the Regulation is silent on the potential risk of greenwashing since ESG disclosures are unaudited. Further, with the mandatory filing of Business Responsibility and Sustainability Reports from the financial year 2022-2023 for the top 1000 listed entities, the lack of uniformity in the ESG rating methodologies may facilitate false reporting.
Conclusion
The rise of ESG investing has significantly influenced the importance of ESG rating agencies within the capital markets ecosystem. These agencies play a pivotal role, since the investment community relies on ESG scores to identify sustainable investment portfolios. The purpose of ESG ratings is to provide stakeholders with information regarding the quality of a company’s ESG practice. SEBI’s efforts to regulate ESG rating agencies in India is a step in the right direction. Future research in this domain should focus on the concerns related to heterogeneity in the ESG rating methodologies. Additionally, empirical research may focus on the impact of ESG ratings on investor preferences in the Indian context.
– Shouvik Kumar Guha & Sourav Paul
