Understanding ESG Ratings and Their Importance to Investors
In the last few weeks, about half a dozen entities have received approval from the Securities and Exchange Board of India (Sebi) to provide Environmental, Social, and Governance (ESG) ratings. These certifications include units of Credit Rating Agency (CRA) ICRA, CRISIL, and Care Edge, as well as proxy advisory firms, Stakeholders Empowerment Services (SES), and Institutional Investor Advisory Services (Ilias). Several firms, including units of MSCI and London Stock Exchange Group are also awaiting Sebi’s certification to become ESG rating providers.
This flurry of certifications and approvals follows Sebi’s move to bring entities that offer ESG ratings under its regulatory ambit last year. Rated by evaluating a company’s performance across environmental, social, and governance parameters, ESG scores are an essential gauge, particularly for large funds that have various social or environmental mandates. In this article, we’ll look more closely at what ESG ratings are, why they matter to investors, and Sebi’s regulatory framework for ESG rating providers.
What are ESG Ratings?
Environmental, Social, and Governance (ESG) ratings are an evaluation of companies’ ability to address risks and opportunities on environmental, social, and governance parameters. A company’s performance is evaluated based on these parameters, and they receive a composite score. This score takes into account factors such as emissions generated, efforts taken to curb these, labour practices, impact on local communities, and governance standards.
ESG ratings have emerged as a response to the growing interest among investors and regulators in examining the wider impact of companies on all stakeholders. These ratings are an important gauge, especially for large funds that have various social or environmental mandates.
Why is Sebi Regulating the Sector?
ESG ratings are not standardised. Every rating provider has different criteria and assigns different weights to environmental, social, and governance aspects. This leads to a wide variance in the ESG scores and raises concerns about their legitimacy and transparency.
To address these concerns, Sebi formulated a regulatory framework for ESG Rating Providers (ERPs) last year. Sebi noted that since ERPs were not subject to regulatory or supervisory oversight, “increasing reliance on such unregulated services in the securities markets raises concerns about the potential risks it poses to investor protection, efficiency of markets, risk pricing, capital allocation, and greenwashing, among others.”
Greenwashing refers to providing false information about a firm’s environmental credentials to mislead investors.
What are the Business Models of ERPs?
Sebi rules allow ERPs in India to have one of two business models – issuer-pays or subscriber-pays. Under the issuer-pays model, the company receiving the ESG rating pays the ERP, like the way companies engage with credit-rating agencies. Under the subscriber-pays model, ERPs charge investors for access to the ESG ratings of the companies they cover. This is like the way proxy advisory firms charge institutions such as mutual funds and wealth funds to access their advisory reports.
Sebi does not allow hybrid business models for ERPs, so they must choose one model and stick to it. They are also not allowed to engage in ESG consulting or any other business.
ERPs with a subscriber-pays model will issue ratings of all top listed companies, which could make the services of issuer-pays ERPs redundant.
What does this Mean for Investors?
Regulating ERPs could help make ESG ratings more consistent, comparable, and transparent, which in turn could give investors more confidence. ESG ratings align investments to individual values and can also gauge risk. A well-governed company may or may not live up to expectations, but a poorly governed company will harm investors. Good ESG ratings would result in more long-term resilience and value creation.
Sebi’s regulatory framework aims to increase transparency, standardisation, and the legitimacy of ESG ratings. By regulating ERPs, Sebi aims to make ESG ratings more consistent and transparent to investors, who can then align their investments with environmental and social values, and benefit from more long-term resilience and value creation.
Key Takeaways
- ESG ratings evaluate companies on their performance in addressing risks and opportunities on environmental, social, and governance parameters.
- Regulating ERPs could help make ESG ratings more consistent, comparable, and transparent, which could give investors more confidence.
- ERPs in India have two business models: issuer-pays or subscriber-pays.
- Sebi’s regulatory framework for ERPs increases transparency, standardisation, and the legitimacy of ESG ratings.
- ESG ratings help investors align investments with environmental, social, and governance values while gauging risk and benefiting investors from more long-term resilience and value creation.
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