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The ESG rating market: development and regulation

Sabrina Miehs

Sabrina Miehs

Landesbank Hessen-Thüringen

The market for ESG ratings and rankings, data or indices has grown enormously in recent years and is expected to continue to grow. One reason for this is that legislators and regulators are paying increasing attention to how financial market participants consider ESG characteristics in their investments. Another is that investor demand is growing for products that promote the development of a greener and more social society.

Numerous providers and heterogeneous rating methodologies

As a result, numerous providers have emerged in the global market for ESG ratings and data products. These range from a few large ESG information firms with a global presence to a large number of smaller providers with regionally focused or more specialized services. In total, the number of these companies globally is likely to be well over 100. However, in recent years, some of the larger, more established market players have begun to acquire smaller ESG providers or have invested significant resources to expand their own resources.

A wide range of ESG ratings is also available to investors for German banks. Among the 31 German Pfandbrief issuers of benchmark and sub-benchmark bonds, the three major ESG rating providers ISS ESG, Sustainalytics and MSCI, which base their ratings on public data, dominate. However, ESG ratings from the well-known credit rating agencies also play an important role, with as many as 13 banks opting for an ESG rating from this group of providers.

A major reason for this high number of ESG ratings compared to credit ratings is probably the heterogeneity of the rating methods used in practice. For example, ESG ratings lack a uniform orientation: the views on what constitutes the long-term sustainability of a company and which factors contribute to this and how, are too different here. In addition, rating providers place different emphases on capturing environmental, social and governance risks.

Overview of four selected ESG rating providers

The EU Regulatory Proposal: Few Surprises and Broad Endorsement

As a result, these differences significantly complicate the comparability of ESG ratings. The correlation of a company’s various ESG ratings is not infrequently low – even if the ratings have a similar objective, such as assessing ESG risks and opportunities.

That the EU has now responded with a regulatory proposal in June therefore comes as no surprise. For years, investors and companies have pointed to the lack of reliability of ratings and the limited transparency of the methodologies. Too often, the scope of the underlying data, the timing of data collection, the frequency of review and updates of the ratings remains opaque. In addition, reference is made to the large number of unsolicited ratings and the varying degree of involvement of the rated company by the rating provider. This makes it difficult to compare and interpret ratings and undermines the confidence in the ESG rating market.
One thing right from the start: the regulatory proposal does not take any steps toward standardizing ratings.

Rather, the aim is to increase transparency about how providers arrive at their results. Thus, the EU’s regulatory proposal seeks to improve the quality of information on ESG ratings and thus promote confidence in the activities of ESG rating providers.

Some of the proposed rules are likely to profoundly change the market for ESG ratings and the existing business models of rating providers.

First, ESG rating providers will be prohibited from offering other services, such as consulting or credit ratings. These restrictions are intended to ensure the independence, neutrality and integrity of ESG rating providers so that their ratings are based solely on the ESG information of the rated companies and are not influenced by other interests. Second, the regulation will lead to a significant expansion of transparency, reporting and record-keeping requirements, and quality controls to track rating decisions and the application of disclosed methodologies or deviations. These will entail significantly more resources and rising costs.

The majority of stakeholders welcome the EU’s decision to regulate ESG rating providers more strictly. However, pointing to numerous issues unresolved (such as a requirement to disclose the proportion of externally validated data as a percentage of the total data input), they also show that the desired level of transparency, clarity and rigor has not yet been fully achieved. The draft now presented is therefore likely to keep the markets busy for a while yet. However, the goal of improving the transparency and quality of ESG ratings and fostering trust in the ESG ratings market is undoubtedly worth the effort.