ESG ratings play a major role in how investors choose companies for ESG-aligned portfolios. However, as we have pointed out on numerous occasions (here, here, and here foe instance), there are significant flaws in the current ratings market. Financial Times ran a piece recently that broke down many themes behind distrust of rating agencies. The article compares ESG ratings to financial ratings pointing out two key differences:
“Analysts are not yet subject to regulatory scrutiny on conflicts of interest, and they work in part on unaudited environmental, social and governance data, rather than in audited financial statements.”
These perceived conflicts of interest and unreliability of underlying data have many questioning the legitimacy and accuracy of ESG ratings. While companies and investors cry foul, ratings firms are sticking to their guns, arguing that they use a variety of methods to ensure that scores are accurate and unaffected by any conflicts of interest. As long as raters’ methodologies and practices continue to be opaque, there will be speculation that there is impropriety in ESG ratings.
Regulators around the world realize that ESG ratings can have a major impact on the market. The EU, UK, and to a lesser extent the US are eyeing the industry for regulation. While increased regulation is generally resisted, it would come with an upside for raters. If there is an independent body providing oversight and setting the rules, then perhaps raters would gain more credibility. No matter how many assurances raters give about their internal controls and practices, the accusations of conflict of interest will persist until an independent body oversees the industry.
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