Environmental, social, and governance (ESG) ratings have long been integral in assessing the risk profile of companies that adorn them. However, recent years have witnessed a significant shift in the landscape as investors increasingly use these ratings as a yardstick for a company’s sustainability. Yet, this gives rise to a challenge: the absence of stringent reporting regulations and standardized sustainability guidelines has allowed companies to secure favorable ratings without undergoing rigorous scrutiny. This also makes it difficult for sustainability-focused investors to make decisions.
The tide is turning, however, as the horizon is marked by a wave of financial reporting regulations gradually taking effect. From 2024, the Corporate Sustainability Reporting Directive (CSRD) will begin coming into force, on top of existing regulations such as the Sustainable Finance Disclosure Regulation (SFDR), and EU Taxonomy for sustainable activities. This signifies a paradigm shift in the investment and corporate landscape. The trio of regulations underscores a departure from companies merely securing positive ratings to taking tangible, accountable actions, reflecting a growing emphasis on genuine sustainability rather than a mere facade.
is a proposed European Commission initiative aiming to standardize and enhance sustainability reporting across the EU. Building on the Non-Financial Reporting Directive (NFRD), the CSRD expands the scope to include more companies, introduces detailed reporting standards, emphasizes digital reporting, and aligns with international standards. Its objectives are to improve the comparability, credibility, and accessibility of ESG information.
is an EU transparency regulation that mandates financial market participants and advisers to disclose how they integrate sustainability risks and consider adverse sustainability impacts in decision-making. Introduced in 2021, SFDR includes product and entity-level disclosure, and encourages the integration of ESG factors in decision-making processes, contributing to the EU’s broader sustainable finance agenda.
is a classification system to identify environmentally sustainable economic activities. Effective since 2020, it sets criteria for activities contributing to environmental objectives like climate change mitigation, circular economy, and biodiversity protection. The taxonomy aids investor decision-making by providing standardized information on the environmental sustainability of financial products.
One glaring issue with current ESG ratings is the lack of correlation between different rating suppliers, such as MSCI, S&P Global, and Sustainalytics among others, each of which employs different methodologies to rate firms. The result: companies can receive varying evaluations from different providers, creating confusion for investors seeking clarity and companies wishing to improve their scores and increase their attractiveness to investors.
Also, sometimes companies struggle to secure ratings as the methodologies for them are not transparent: clearly defined ESG terms, practices, and reporting have been lacking, which means that interpretations have fluctuated for different stakeholders. Hence numerous approaches have evolved, with varying levels of transparency, which has ultimately led to confusion and created a barrier to the consistent integration of sustainability factors into investment decisions. One example involves the recent exclusion of Tesla, a company specializing in electric vehicles, from the S&P 500 ESG Index, while ExxonMobil, a major player in the oil industry, was kept in.
Moreover, the prevalence of greenwashing – the deceptive exaggeration of environmental or social responsibility, presenting a false impression of genuine sustainability – has marred the credibility of ESG ratings, with companies exploiting them as marketing tools without clear or quantified contributions to positive social or environmental change. The lucrative ESG rating industry has profited immensely. While publicly traded companies spend between $220,000 and $480,000 annually on ESG ratings and related services, the true impact of their sustainability efforts has remained inadequately measured. Asset managers are also paying a princely sum for access to the data.
The impending regulatory deluge is poised to rectify these shortcomings, forcing the ratings industry (companies, ratings providers, and asset managers) onto a unified path. Investors will need to transition from relying solely on ESG ratings to incorporating more comprehensive fundamental analyses of companies into their calculus and quantifying their impacts if they are providing funds with sustainability as an objective.
“Investors are likely to undergo a paradigm shift in their objectives.”
This regulatory shift therefore necessitates proactive adaptations – not only from investors but rating agencies and companies alike.
For companies, acquiring the right internal expertise becomes the overarching imperative. Distinguishing between genuine sustainability and ESG, companies must cultivate the necessary knowledge to navigate the changing regulatory landscape. Understanding sustainability fundamentals and life cycles will be critical, as missteps can lead to unintended environmental consequences. Upskilling is essential to comprehend how the regulations align and to mitigate potential risks.
Rating agencies will witness a transformation, persisting with their lucrative business models but now under stricter regulation. Already, regulations for providers are being proposed. Greater transparency in ESG rating methodologies should prevail, with standardized sustainability reporting becoming the norm for listed companies. The burden on ESG raters to scrape disparate data could lessen as companies adopt uniform reporting practices. Alignment between rating agencies may increase, as will the need for skilled personnel to uphold regulatory standards. That will raise their costs.
Investors are likely to undergo a paradigm shift in their objectives. Beyond financial returns, environmental objectives may become incentivized, aligning with the broader goal of the EU Green Deal, a set of policies aiming to put the EU on the path to a green transition. Portfolio managers will need to delve deeper into company specifics, engaging in dialogue to ascertain the true trajectory of sustainability efforts. This shift is pivotal, aligning financial interests with environmental objectives and fostering responsible investment practices.
As the EU Green Deal gains momentum, the focus is on redirecting capital toward sustainable activities. COP28 in Dubai underscored the commitment to sustainable growth over time, with the final text highlighting the imperative for a substantial increase in climate finance, essential not only to mitigate climate change but also to address its consequences.
Looking ahead, companies will be compelled to increase revenues from taxonomy-aligned activities, necessitating long-term planning and reporting. Investors will scrutinize companies’ capital expenditure plans to ensure they align with sustainability targets, ushering in a new era where financial success is inseparable from environmental responsibility.
The views expressed in this article are those of the authors and do not necessarily reflect the views of Robeco.
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