The Environmental Social and Governance (ESG) rating market is a jungle, where each rating relies on specific indicators and points to different characteristics of companies. This lack of standardization leads to greenwashing, and is thus a barrier to the massive mobilization of financial flows necessary to keep global warming under 1.5°C. The European Commission intends to tackle these issues with its June 2023 proposal on the transparency and integrity of ESG ratings. Yet, the Commission falls short of its objectives by focusing on transparency and failing to secure minimal requirements on ESG factors in ratings and their respective weights.
For years, the unregulated ESG rating market has been criticized for its lack of transparency, the absence or uncertainty of the relation between the ratings and the real practices of companies, and its concentration. The European Commission’s proposal to improve the transparency of ESG ratings and regulate providers aims at addressing those concerns and – if amended – could help navigate and tame the ESG rating jungle. The proposal will be discussed by the European Parliament and the Council of the EU, and is expected to be finalized by the end of 2023.
The problem
There are ongoing debates regarding the consistency, comparability, quality, and usefulness of ESG ratings. These flaws can be attributed to a lack of standardization and transparency. This has led to widespread confusion about the meaning and use of ESG ratings by many financial as well as economic actors. Indeed, the definition and the use cases for these ratings do not even make consensus. In this context, the text proposed by the European Commission would bring welcome progress on transparency and the regulation of conflicts of interest. However, the critical problem is not addressed: nothing is said about the composition of ESG ratings.
It is important to note that ESG ratings are not designed to assess the actual impact of a company on the environmental, social issues, and governance. Today, ESG ratings are too often used as a tool for greenwashing, social or pink washing, in order for companies to cast themselves under better lightnings.
Furthermore, companies can choose their ESG rating providers. Some are more lenient than others, and obtaining great ratings depends on the ESG rating provider. Take, for example, a fossil fuel company that still develops new oil and gas fields despite the crystal clear scientific finding that fossil fuel expansion must end to avoid a climate breakdown. It can be poorly rated by an ESG rating provider with a “science-based” methodology, but could obtain a much better score from another ESG rating provider that would overlook scope 3 emissions and/or production trajectories. In such a situation, companies are not pushed toward making an actual change and can “shop” for the ratings they want. This creates a challenge for investors who struggle to differentiate between companies engaged in greenwashing and those implementing genuine sustainability measures.
The transparency on the aggregation of ESG ratings further complicates the issue. As of today, it is sometimes impossible to know how much weight a certain factor represents in the aggregated rating. An ESG rating can today be composed, for example, of 5% from E, 5% from S and 90% from G, without stating this repartition clearly and thus enabling misleading information and contributing to the confusion surrounding ESG ratings.
These many flaws in ESG ratings can be addressed, and EU regulation is a large part of the solution.
Regulating as part of the solution
The proposal contains no minimum requirement for the E, S, and G factors. This lack of standardization is worrying as it means ESG ratings will not even have to abide by main international standards. Company ratings will therefore remain decorrelated from their compliance with the most important international goals.
The proposal must be amended in the European Parliament and through the Council of the EU to contain clear minimum requirements for E, S and G. These minimum requirements for all would allow a standardized comparability and improve the readability of the ratings. For the E factor, for example, these requirements should include the need to implement a 1.5°C aligned transition plan, based on clear scientific data covering the entirety of the value chain, and on all scopes. These baseline criteria should also include the necessity to immediately end the development of fossil fuel production, as well as any other harmful activities.
Beyond the content of each E, S and G factors, their aggregation must be further regulated. In an extreme case, a fossil fuel company could have excellent Governance practices and very poor ratings in Environment and Social and yet obtain a superb aggregated ESG grade, by attributing its G factor 99 % of the final rating. The proposal would not force ESG rating providers to actually take into account a significant part of each factor, but only requires disclosures on the issue. This could lead to unbalanced aggregated ratings that would disproportionately favor a specific factor over others. Minimum weightings must be put in place, to ensure that each factor represents at least 25% of the final aggregated rating (e.g. 40, 35 and 25%).
Without sufficient guidance and standardization, ESG ratings will remain a tool for green or social washing. Reclaim Finance provides key recommendations for EU policymakers to remedy these critical flows, notably aligning the “E” factor of ratings with EU and international climate commitments. It is now up to Members of the European Parliament and to the Council of the EU to amend the text and commit to tackling greenwashing during the debates on the text, until the month of December 2023.
