ESG Data Providers: Useful Service or Corporate Strong-arming?

Are companies being strong-armed by ESG ratings firms??

A common refrain from public companies is that they are bending under the weight of the mountains of questionnaires from ESG rating firms. The ESG raters incorporate the responses in reports that they sell to investors. These reports aren’t cheap. A recent study by ERM found investors average $466,000 in annual spend for ESG data. It’s not a walk in the park for companies either. Declining to respond to the questionnaires is playing with fire. A bad ESG rating could make shareholders, and particularly ESG-focused funds, run for the hills. So most companies oblige the ESG raters. But this raises concerns that are coming to light.?

The Financial Times reported this week on mounting pressure on regulators to scrutinize ESG data providers . Pierre Bollon, a member of the European Economic and Social Committee said ESG raters should be subject to the same scrutiny as others in the financial services sector. He said companies are being asked to “produce more and more information on ESG, as this becomes more mainstream, but there is no standardisation of this information.”?

This is not a new issue, but it will continue to grow in the absence of standardized disclosure requirements. I wrote about this back in 2019 in Emerging Trends in Securities Laws (noting companies were dazed and confused by the information requests). The SEC’s Investor Advisory Committee expressed concern in its 2020 recommendations on ESG disclosures (“The plethora of ESG data providers, all with different standards and criteria, has led to a significant burden on US Issuers”). Most recently, IOSCO’s Sustainable Finance Taskforce published a report on ESG ratings and data providers expressing concern over how the ratings are derived and over potential conflicts of interest where ratings firms provide consulting services to those they rate.?

This system is costly to companies and investors who purchase the data. But perhaps more concerning is that smaller investors who can’t afford to buy the data don’t have equal access to this information. The idea of our disclosure system is that all investors should have access to important information at the same time. And investors shouldn’t have to pay for the information they need to make their investment decisions. Mind you, if ratings provide valuable analysis beyond company data, that is one thing but an earlier ERM study found that investors tend to purchase ESG ratings for the underlying data not for the analysis. This information should be available to all investors equally.

A clear answer is to have a disclosure system that requires a baseline level of disclosures that are provided to all investors equally. The SEC’s climate disclosure proposals would be a big step in that direction.

Regulatory Developments of the Week

UK Financial Regulator Extends Period for Introduction of Sustainability Disclosures

The Financial Conduct Authority (FCA), the UK’s financial conduct regulator, has extended its process for introducing asset managers’ sustainability disclosure requirements and ESG labeling rules for investment products. This process was planned to wrap in Q2 of 2022, but it is now planned for implementation in Q3.?

The upcoming disclosures are a part of the Sustainability Disclosure Requirements (SDR) Framework in line with the UK’s Green Finance Strategy to “green” the financial sector to meet the country’s 2050 net zero target. The SDR Framework supplements the Climate-Related Financial Disclosures (CRFD) rule which will require UK companies to report climate information in line with the TCFD framework.?

The FCA’s upcoming rules for asset managers and investment products seek to provide common standards and clear terminology and product classifications as investors seek transparency and anti-greenwashing measures in the sustainable investment landscape.?

EU Votes Against Excluding Nuclear and Gas from Green Taxonomy?

After a great bit of back and forth, the European Parliament struck down a resolution to exclude nuclear and natural gas energy from the EU Taxonomy . This will allow nuclear and gas to be labeled and marketed as “green” energy in the EU Taxonomy, the classification system that designates investments as environmentally sustainable.?

This has been a contentious process, with environmental activists and left-leaning members of the European Parliament campaigning for the resolution for months . In an effort to soften the blow, the chair of the environmental committee of the Parliament, Pascal Canfin, said that nuclear and natural gas “won’t be put in the same categories as renewables, and strict conditions are included. ” Still, Greenpeace and ClimateEarth have announced they plan to take legal action against the European Commission.?

Companies Ramp Up Scope 3 Reporting Following SEC Disclosure Proposal

Perhaps in preparation for SEC disclosure rules, Bloomberg reports that the number of S&P 500 firms reporting on indirect emissions has increased three-fold in the last year. In 2021, 17 firms discussed their Scope 3, indirect emissions in their 10-k reports to the SEC. In 2022, that number was raised to 54.?

Bloomberg’s analysis finds that United Airlines and Etsy disclosed Scope 3 emissions measurements in their 10-Ks, while others, including Phillips 66 and Hershey, reported reduction goals related to their indirect emissions. The degree to which Scope 3 emissions data is being included varies still, as seen by Ulta Beauty and T-Mobile, who include passing references to their Scope 3 emissions, without calculating or setting targets.?

Other Stories I’m Following?

• European Central Bank stress test results show that banks have not been sufficiently incorporating climate risks into their stress-testing models . While climate risks could cost EU banks over €70bn in credit and market losses, 60% of banks surveyed have no climate risk testing mechanisms to model these losses. [My take: Banks should expect a major focus by prudential regulators on climate risk and banks that are exposed will see adjustments to their capital requirements.]
• The Biden administration’s 2030 CO2 reduction goal could fall well off course in the wake of the SCOTUS EPA ruling. Six analyses reviewed in Science magazine predict that without major regulatory changes, GHG emissions will fall by only 6-28% compared to 2005 levels, well short of the 50% reduction targeted by the U.S. government. [My take: Obviously the Supreme Court is significantly unhelpful. tt will take a combination of federal and state regulations and the private ordering process to propel the necessary reductions. It is a tall order but not insurmountable if we get serious.]
• Over 70% of buy-side financial firms in the UK, US, and Asia use more than 5 sources for ESG data, according to a study conducted by Alveo. Most financial firms use 6-10 different ESG data sources, and they are forced to rely on third-party ESG ratings due to the lack of standardized, quality ESG data available from corporate disclosures. [My take: Further to the discussion above, this study reflects the need for standardized corporate climate disclosure rules. The lack of ESG data availability produces an expensive and time-consuming risk management problem for financial institutions.]