#esgrisk

Introduction

The regulatory landscape for sustainable finance is rapidly evolving to address investors’ growing concerns around transparency, reliability, and quality of ESG ratings. ESG Rating Providers (ERPs) are at the forefront of this shift, with their ratings influencing market transparency and affecting investment decisions. This blog gives an overview of what regional regulations are expecting of rating providers, with a particular focus on the EU and the UK and gives insight into how investors can expect the landscape of ESG ratings to shift as a result of these regulations.

Overview of the ESG Ratings Landscape

ERPs, which play a critical role in shaping investment decisions and market transparency, are increasingly coming under regulatory purview. Globally, several jurisdictions are moving forward with regulations for ERPs. The International Organization of Securities Commissions (IOSCO) is a global association of securities regulators. Its recommendations on ESG ratings and data products serve as a foundational framework for various jurisdictions, including the EU and the UK, in developing their regulatory frameworks for ERPs.

In the EU, the European Securities and Markets Authority (ESMA) has introduced a ‎regulation to enhance transparency and integrity of ESG rating activities. ‎

Meanwhile, in the UK, the International Capital Market Association (ICMA) and the International Regulatory Strategy Group (IRSG) have introduced a Code of Conduct for ESG ratings or data products providers.

In India, the Securities and Exchange Board of India (SEBI) has introduced a framework for ERPs.

Japan’s Financial Services Agency (FSA) has also issued a ‘Code of Conduct for ESG Evaluation and Data Providers’.

Various jurisdictions present slight variations in their regulatory requirements, all of which are equally important; however, the regulatory developments in the EU and the UK hold primary significance due to Inrate’s geographical focus.

Read more: ESG Risk Ratings vs ESG Impact Ratings

1 Regional Regulatory Developments — A Focus on the EU and the UK

1.1 Regulatory frameworks in the EU and the UK

‎EU: Transparency and Integrity of ESG Rating Activities ESMA has taken the lead in regulating ERPs within the EU. It has introduced a regulatory framework ‎that aims to enhance the transparency, reliability, and comparability of ESG ratings. This framework ‎includes several key aspects, such as registration requirements, which mandate ERPs operating in the ‎EU to register with ESMA and adhere to specific registration requirements. Additionally, providers are ‎required to disclose information related to key areas, including transparency, conflict of interest, ‎processes & procedures, and quality. Furthermore, ESMA monitors the performance of ERPs and may ‎take enforcement action when deemed necessary.‎‎

‎UK: Code of Conduct for ESG Ratings and Data Products Providers In the UK, ICMA and IRSG outlined a voluntary Code of Conduct, comprising six ‎principles, ‎emphasizing good governance, quality, conflicts of interest, transparency, ‎confidentiality, and ‎engagement. Upon signing the Code of Conduct through ICMA, ‎ESG ratings and data providers are ‎required to implement their provisions. After ‎implementation, they must publish a ‘Statement of ‎Application’ on their website, ‎notifying ICMA with the pertinent details. The Code is designed to be ‎closely aligned ‎with IOSCO’s recommendations, aiming for international interoperability.‎‎‎

1.2 Focus area of the regulations

Although both the EU and the UK regulations are largely aligned, there are some differences in their scope, particularly regarding governance, applicability to data products, and other related areas. While these regulations directly target ERPs, they are designed to enhance the overall credibility and integrity of the ESG ratings market, ensuring that investors can rely on high-quality, transparent assessments.

1.3 Deep dive into the EU’s regulation and how it impacts investors

With the recent publishing of the EU’s regulation on the transparency and integrity of ESG rating activities, it is important to deep dive into how the regulation is expected to change the ESG ratings landscape for investors:

1) Transparent disclosure of rating methodologies: Investors and companies will have access to clear information on how ratings are calculated including the assumptions used, data sources, and the weightage of E, S, and G factors. You can read more about Inrate’s rating methodology here.

2) Clearly defined assessment approach: Investors will have a clear indication on whether the rating focuses on financial risks, societal impacts, or both (i.e., distinguish between ESG risk ratings, ESG impact ratings, and ESG ratings that focus on double materiality).

3) Increased confidence in conflict-of-interest management: The regulation requires rating providers to separate rating activities from consulting, auditing, or credit rating services. This helps reduce investor concerns around conflicts of interest, impacting the reliability of the ratings.

4) Supervision by ESMA: The ESMA will authorize, enforce, and monitor compliance and will impose penalties for non-adherence. This will help increase accountability among rating providers and improve reliability of ratings.

5) Greenwashing prevention: The regulation’s focus on transparency across the board supports investors to avoid any misleading sustainability claims.

6) Trickle-down effect on data quality from ESG Data Providers: The investors purchasing ESG data solutions from rating providers can expect an improvement in the data transparency and quality of the data solutions that they are currently receiving.

2 Inrate’s Approach to Transparency, Accuracy, and Quality

Inrate understands the implications of the new regulatory requirements for ERPs and is naturally positioned to be fully compliant. Our ratings have always been underpinned by a focus on transparency, recency, and quality, which aligns seamlessly with the expectations laid out by regional regulations. Some actions that underpin our preparedness include:

• Transparency: Inrate currently offers separate aspect scores and grades. We have already published a preliminary outline of our methodology, available here, which is to update in line with the expectations of the regulations.

• Conflict-of-Interest Management: Inrate has procedures for employee independence and does not participate in any consulting, auditing, or credit rating services.

• Quality: Inrate has always assessed alignment with international agreements, and will continue to do so, as recommended by the EU’s regulation.

• Governance: Inrate has clear governance structures in place and will be ensuring documentation aligns with the principles in the Code of Conduct.

As an active participant and member of the European Association of Sustainability Rating Agencies (EASRA), Inrate gains insights into emerging regulations for ERPs in the European region and Swiss jurisdiction, while continuously monitoring updates to align its practices with evolving compliance requirements.

With the emergence of regulations such as the EU Taxonomy, CSRD, and Sustainable Finance Disclosure Regulation (SFDR), the concept of impact materiality has proliferated in the market, marking an increased scrutiny on the comprehensiveness of ESG risk ratings. In this context, there has been increased interest in impact ratings leading investors to question, what really is the difference between ESG risk and ESG impact ratings?

Overview of Risk vs Impact

ESG risk ratings primarily assess how well a company manages its exposure to ESG-related risks that could potentially affect its financial performance. These ratings focus on the materiality of ESG factors to the specific industry and company, evaluating how effectively the organization mitigates these risks.

In contrast, ESG impact ratings measure the actual effect a company’s operations have on environmental and social outcomes, regardless of the financial implications for the company itself. These ratings attempt to quantify a company’s positive or negative contributions to issues such as climate change, biodiversity, human rights, or community development.

In terms used by global sustainability regulations, ESG risk ratings focus on financial materiality while impact ratings focus on impact materiality.

ESG screening has evolved into a vital and versatile component in the toolkit of responsible investors looking to align their investment portfolios with Environmental, Social, and Governance (ESG) principles. While it originated primarily as an exclusionary practice, ESG screening has transformed into a customized, sophisticated tool for both exclusion and inclusion, particularly relevant in today’s market for creating thematic sustainable portfolios and funds.

It helps investors achieve a variety of objectives, including but not limited to:

Mitigating ESG risks

Developing Article 8 or 9 funds

Supporting business models that address ESG issues

Developing regulatory-aligned portfolios

Improving or maximizing a portfolio’s overall ESG rating

The Evolution of ESG Screening

Initially, ESG screening was primarily used as a negative screening tool, allowing investors to systematically exclude companies that conflicted with their ethical standards or sustainability goals. This approach has deep roots in responsible investing, dating back to faith-based investment strategies.

However, as sustainable investing has matured, so has the application of ESG screening. Today, it serves not only as a method for exclusion but also as a powerful tool for positive screening, enabling investors to actively select companies aligned with specific sustainability themes or goals.

In an investment landscape increasingly shaped by sustainability, understanding the risks associated with Environmental, Social, and Governance (ESG) factors is crucial. One of the most effective ways to manage these risks is by closely monitoring ESG controversies—events or issues that highlight a company’s failure to adhere to responsible practices. Inrate’s ESG Controversies Scores offer a powerful tool for investors to navigate these risks, providing valuable insights into how companies respond to and manage ESG-related challenges.

What Are ESG Controversies Scores?

ESG Controversies Scores are a key metric used to assess a company’s involvement in significant ESG-related controversies. These scores reflect the severity, frequency, and impact of events that may harm a company’s reputation, financial performance, or compliance with ESG standards. By analyzing these scores, investors can gain a clearer picture of the potential risks associated with a company’s operations and decision-making processes.

Why ESG Controversies Matter

Identifying High-Risk Companies:

Companies involved in frequent or severe ESG controversies are often at higher risk of facing regulatory fines, legal actions, or reputational damage. ESG Controversies Scores help investors identify these high-risk companies, allowing them to make more informed decisions about their portfolios.

Enhancing Due Diligence:

In the due diligence process, understanding a company’s history of ESG controversies is essential. These scores provide a comprehensive view of past and ongoing issues, enabling investors to assess whether a company is taking adequate steps to address these challenges.

Mitigating Long-Term Risks:

ESG controversies can have long-term implications for a company’s performance and sustainability. By incorporating Controversies Scores into their analysis, investors can better anticipate and mitigate potential risks that could affect their returns over time.

Supporting Responsible Investment Decisions:

For investors committed to responsible investing, avoiding companies with poor ESG performance is a priority. Controversies Scores provide a clear metric to screen out companies that do not align with an investor’s ethical standards.

Inrate’s ESG Controversies Scores: A Comprehensive Tool

Inrate’s ESG Controversies Scores are designed to offer a detailed and nuanced understanding of a company’s ESG-related challenges. Our scoring system takes into account several factors to provide a balanced and accurate assessment:

Severity and Frequency: The score reflects the seriousness and recurrence of controversies, giving investors a clear indication of how significant the issues are.

Company Response: Inrate also considers how effectively a company has responded to controversies. This includes actions taken to mitigate the impact, improve practices, and prevent future issues.

Sector and Regional Context: Understanding the context in which a company operates is crucial. Inrate’s Controversies Scores are adjusted to reflect sector-specific and regional risks, providing a more relevant and precise evaluation.

The Value of ESG Controversies Scores in Today’s Market

As ESG factors become increasingly integrated into investment strategies, the ability to navigate related risks is more important than ever. Inrate’s ESG Controversies Scores offer investors a powerful tool to identify and manage these risks effectively. By leveraging these scores, investors can build more resilient portfolios that not only achieve financial returns but also align with their values and contribute to a more sustainable future.

Inrate’s comprehensive approach ensures that our Controversies Scores provide the insights needed to make informed, responsible investment decisions. Whether you’re an individual investor or managing institutional assets, our ESG Controversies Scores are an essential part of a robust ESG risk management strategy.

Why Choose Inrate: 1. Impact Lens 2. Flexible Data Models 3. Dedicated Client Support 4. Regulatory Alignments About Inrate: Inrate, a Sustainability Data and ESG Ratings company, helps financial institutions view sustainable finance from an “impact” lens. The contemporary responsible investor needs data that supports a variety of use cases and stands up to scrutiny. Inrate scales the highest quality and standards and deep granularity to a universe of 10,000 issuers, allowing portfolio/fund managers, research, and structured product teams to make confident decisions.