Recent 'call for evidence' report from ESMA highlights significant issues with ESG ratings that investment firms need to understand—and why waiting for standardization may not be the right approach.
Key Findings from ESMA
The ESMA report identified several critical issues in the ESG ratings market:
- Multiple providers required: The majority of users contract data from multiple ESG providers, mainly due to lack of standardization and the early stage of the ESG ratings market.
- Depth and coverage matter most: These were the most important attributes for selection of an ESG provider, followed by data quality and transparency.
- Coverage gaps: Lack of granular data on small/medium enterprises and non-listed companies is affecting usability and relevance of ESG ratings.
- Resource constraints: ESG ratings providers lack enough skilled resources to keep up-to-date on the ratings of the entities they cover.
- Geographic concentration: There is an increased concentration of ESG ratings providers from the US—an 'US Bias'.
- Methodology concerns: Key issues around ratings methodologies include data accuracy, transparency on the rating process, and data sources.
The Real Question
Are existing ESG data vendors the right players for sourcing, validating, and distribution of ESG ratings data?
The challenges around sourcing, validating, and analysis of entity data is as important as keeping it up-to-date if the data has to be useful for end users. Unlike credit rating firms which have 'armies' of people looking into it and the ratings process mastered, the ESG ratings market is relatively new, and the ratings process is in early stages.
Market Evolution
Consolidation of data providers will happen over time where 'groups' of niche ESG ratings providers catering to specific industry/market will develop, resulting in 'usable' data such as we see in data on credit ratings.
The ESG ratings market needs to mature before end users can use this data with 'full' confidence for all entities in their portfolios—lest we continue to experience 'green washing.'
Why Firms Should Act Now
It is good to know that investment firms are seeing greater demand from investors for ESG data, and this will continue. Given this demand, pro-active investment firms should continue to work on centralizing their data management and include existing available ESG data until standards develop.
Specifically, firms should:
- Assume ESG ratings data will need to be sourced from multiple providers
- Provide ability to merge data to create a golden copy
- Enable analysts to review and change data accordingly
- Maintain transparency in how ESG data is used in the investment process
The Path Forward
For investment firms, having an open and transparent approach to how ESG data is being used in the investment process is essential. Communicating the same to all investors will go a long way in reducing risk of 'green washing' and building trust.
Don't wait for perfect standardization—build the infrastructure now to handle multiple data sources and create transparency in your ESG integration process.