SEBI seeks to develop ESG rating framework

Two people with knowledge of the matter, requesting anonymity, said the markets regulator is expected to soon release a discussion paper outlining regulatory and supervisory approaches to environmental, social and governance (ESG) ratings. The paper will seek to address two main issues – arriving at a standard definition for ESG factors and rating them, and avoiding conflicts during such ratings.

“SEBI has so far held two rounds of talks with rating agencies and other stakeholders. The regulator is trying to standardize a framework on how companies are rated on ESG metrics. The discussion paper suggests too many disclosures and will emphasize transparency on ESG metrics. ESG inputs have become increasingly important for investors when they take up equity stake in companies or provide them loans,” said a regulatory official familiar with the matter and one of the two people mentioned above.

Currently, the top 1,000 companies by market capitalization have been mandated to submit a Business Responsibility and Sustainability Report (BRSR) to stock exchanges as part of their annual reports with effect from May 2021. From April, companies will have to disclose the financial implications as well as plans to mitigate or adapt to ESG risks. The BRSR also sets out ESG metrics that companies are required to report.

Meanwhile, many third-party advisors and advisors are offering ESG scores to companies, but the lack of standardization has given such scores or ratings little credibility.

Since 2020, when several rating agencies have made their ESG ratings public for companies, a significant disparity has been observed in the ratings awarded to the same company. For example, NSE’s ESG Index methodology draws from Sustainability Assessment and BSE from S&P Global’s Corporate Sustainability Assessment. Both do not have the same set of top 10 companies by weightage. Both have only six in common, but they are not in the same order.

“The deviations in ESG ratings can be largely attributed to individual modalities and weightings adopted by rating agencies; another factor is probably the paucity of data resulting from the use of proxies. Regulatory standards address this. Will do,” said the other person.

Emphasizing the need for standardization of ESG scoring metrics, Shankar Chakraborty, CEO, Acute Ratings said, “Currently, different rating and score providers are following different interpretations of ESG, and many of them are unstable in the long run. “

“The characteristic of a rating is that it should be under continuous coverage, use a scientific classification and be based on high quality data, which is a matter of concern in most cases. Clarity on how the ESG rating/score should be provided and how it can be used by users (mutual funds and investors) will help in adoption of ESG principles.

The SEBI paper may also seek to understand how firms are implementing the recommendations of a task force on climate-related financial disclosure (TCFD). The recommendations, which were released last year, provide a broad-based framework for firms to systematically report the impact of climate risks and opportunities, allowing investors to analyze a company’s potential financial impact due to climate change. It becomes easier to do.

Another major issue that the paper will try to tackle is conflict of interest. Under the existing norms rating agencies cannot offer non-ratings-related services which are based on financial metrics. This regulatory gap has resulted in rating agencies either offering ESG as an advisory service or setting up various rating firms such as ESG Risk AI by Acute Ratings.

In some cases, certain third-party advisory services, which have arisen due to regulatory deficiencies, provide both scores and advice on improving ESG scores.

“Many agencies are providing grading of ESG scores as part of their research and consulting businesses as non-rating related services are currently not permitted to be offered by credit rating agencies. Therefore, clarity on that front should be welcomed. In the long term, ESG analysis may be inseparable from the detailed financial and non-financial analysis carried out to assess ratings,” said Ajay Mahajan, CEO, Care Ratings.

The third key area the ESG Ratings Paper will tackle is disclosure from asset management companies (AMCs) on how they use ESG disclosures and ratings to make investment decisions. In the past one year, AMC has launched seven ESG funds with its assets under management crossing 12,500 crore by December 2021.

“As with those using ESG ratings, their disclosure will be equally important,” said the first person.

The whole idea behind standardization is to avoid so-called ‘greenwashing’, the person said. Greenwashing is the process of giving a false impression of how environmentally sound a company and its products are.