Environmental, social and corporate governance – transparency and consistency at last?

This article was co-authored by Maeve Morrissey, Trainee Solicitor, London, and Sally Milner, Trainee Solicitor, Sheffield.

The 2021 United Nations Climate Change Conference (also known as COP26) is taking place in Glasgow between 31 October and 12 November 2021. With the summit approaching, we have recently seen a plethora of proposed governmental policy supporting the UK’s commitment to transition to a net zero economy.

In June, the FCA launched two climate disclosure consultations. These are in line with the government roadmap towards mandatory climate-related disclosure throughout all sectors by 2025 (published in November 2020).

Both consultation papers 21/17 (CP21/17) and 21/18 (CP21/18) seek to extend the climate reporting requirements to corporations beyond commercial companies with a premium listing and will therefore include more investors and institutions, as well as their insurers. CP21/18 also seeks the public’s views on ESG (environmental, social and corporate governance) data and rating providers.

The consultations closed on 10 September 2021 and we have responded to CP21/18’s call for discussion on ESG data.

The current position

Rating agencies for ESG are facing tough challenges as to how diverse companies from different industries should be rated and compared. How can a steel company for example be compared with a healthcare group in terms of sustainability?

ESG rating agencies consider various factors in their ratings and measure or weigh them according to their own internal guidelines and policies. However, the differing methodologies implemented can lead to ranging ESG ratings, even when using the same raw data. As a result, scores for different companies can often not be easily compared as one agency might attach more importance to greenhouse emissions for example, whilst the other focuses more on human rights or working conditions. The current lack of consistency therefore means that a high ESG score in its current form (or conversely a low one) is not yet a reliable indicator for the very complex topic of sustainability.

ESG best practice is becoming increasingly important to investors and institutions. Hence, the present position and use of differing methodologies is a concern for investors, institutions and their insurers who are naturally keen to avoid the potential for ‘ratings shopping’ which may be harmful (for example in terms of investor protection, financial stability, inadvertent greenwashing and reputational damage) or simply, not reflective of the companies’ true advancement towards sustainability.

The inability to compare the findings of various ESG data and ratings collectors also makes it difficult for insurers at policy placement to properly assess a company’s risk exposure that is related to ESG data – from environmental/natural disasters to human rights abuses and governance issues.

Overall, it is the inconsistent approach in reporting ESG data by the companies, and the various different approaches in determining ESG scores by rating agencies that make it difficult for investors, financial institutes and their insurers to rely on ESG data and ratings for their risk assessments and investment decisions.

The proposal

We welcome commentary from the FCA on ESG ratings to ensure consistency and transparency.

Our view is that this should include clarification on how the ratings are measured, what factors should be considered and how providers should rate each company, particularly in relation to the due diligence requirements.

This clarification will address the present lack of consistency, allowing insurers and their insured investors and institutions to proceed with greater clarity when dealing with ESG ratings and rating providers. It will also allow insurers to confidently factor this into their assessment of risk (potentially reflecting the FCA statement in policy wording) and to have greater knowledge of the work of their insured investors and institutions and potential claim exposure.

Likewise, consistency in the interpretation of ESG ratings would ensure that investors and institutions are better placed to assess the effect of ESG factors on their financial position and provide assistance to their insurers when assessing the potential risks and also their own business.