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Why investors seek consistency in ESG ratings

Author: ICAEW Insights

Published: 05 Jan 2022

Institutional investors are increasingly turning to ESG rating agencies to help guide them through the minefield that is corporate ESG performance – but a lack of consistency in the metrics used by agencies results in wildly divergent and ambiguous scores, new research has found.

Two-thirds of the professional investors interviewed said they expect investor activism to increase over the next three years, and of those 14% predicted a dramatic increase, according to research conducted by quant technologies provider SigTech among institutional investors across North America, Europe and Asia with around $935bn of assets under management collectively.

As a result, around one in three pension funds and institutional investors say their use of ESG rating agencies will increase dramatically over the next three years, and a further 38% believe it will increase slightly. However, 66% said that they struggle with ESG rating agencies because they can provide wildly divergent ESG scores at a company level.

Daniel Leveau, Head of Investor Solutions at SigTech, said: “The divergence is attributed to how the ratings agencies define and measure ESG performance. Many of the criteria are hard to measure and assigning a rating for a specific criterion is often not as precise as using input from a firm’s financial statement. This ambiguity around ESG performance makes it hard to form a universal standard for ESG ratings.

“Investing in a pooled investment vehicle as opposed to owning the individual securities directly makes it even more difficult for an investor to become an active owner. A pooled investment vehicle only gives the investor indirect ownership of a security; investors don’t have the right to vote at a company’s annual meeting and it is more difficult to actively engage with these companies to constitute change. Lately, large institutional investors have increasingly come under fire for being anonymous owners and not taking full responsibility over their investments. 

“Instead, Investors would be better off tailoring equity investments according to their desired risk factor exposure and incorporating their unique ESG policy. ‘One-size-fits-all’ products are not the solution, investors need to embrace customisation and direct ownership of securities.”

A growing appetite for sustainable financial products has prompted concerns that the absence of universally-applied standards on ESG makes it difficult for stakeholders including investors to gain a meaningful understanding of an organisation’s ESG credentials. Consequently, UK financial regulators are increasing their focus on tackling greenwashing, which they say is crucial to boosting market confidence and ensuring a concrete response and positive corporate cultural shifts to tackling climate change.

Philippa Kelly, ICAEW’s Director of Financial Services, said: “Institutional investors need robust information to allow them to make the right claims about their funds to their customers and savers. All of the pieces of the puzzle have to come together – from the kind of information being reported by corporates to the choice of ESG reporting frameworks and the methodology for how the ESG scores are put together.” 

Kelly said some FCA-regulated firms were concerned about the potential for the regulator to take enforcement action against firms making dishonest or exaggerated ESG claims. “The FCA has said the ‘fair, clear and not misleading’ applies just as much to ESG as to, say, investment risk. When you get to some of the environmental or social impact claims being made by companies, it can get fuzzy and that’s where we need standards.”

Kelly said divergence in ratings should reduce over time as preferred frameworks come to the fore, as the quality of ESG data improves and corporates get more practiced at reporting ESG information. “In the meantime, the onus is on professional investors to understand ESG rating agency methodologies to ensure they align with their investment objectives,” Kelly added. 

The FCA’s consumer investments strategy, launched in September, aims to give consumers the confidence to invest, which Kelly warned adds further urgency to the need for high-quality ESG information. “If professional investors are struggling to make decisions about the ESG credentials of businesses, what hope is there for retail investors. ESG has become such a broad term. As well as high quality, clear information, assurance will be a key part of validating some of the key ESG claims being made, otherwise it could end up a free-for-all.”

An ICAEW explainer on ESG Assurance in financial services including the fundamentals of ESG reporting through to considerations for preparers and practitioners is now live – ESG assurance

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