Sustainable investments grew 15 per cent between 2018 and 2020 to around $35.3 trillion, or more than a third of all assets in the world’s five largest investment markets (Europe, the US, Japan, Canada, and Australia/New Zealand), according to Global Sustainable Investment Alliance’s 2021 report. In India, too, sustainable fund inflows surged by 76 per cent in FY2021 to ₹3,686 crore ($484 million). Driving these trends is the increasing recognition that environmental, social, and governance (ESG) factors have significant impact on society, economy, sustainability, and financial performance.

The growing demand for ESG ratings is a reflection of investors’ eagerness to incorporate ESG risk factors in their investment appraisal. The quality and timeliness of ESG ratings impact investors’ capital allocation decisions and the cost of raising ESG-compliant capital.

In February, the Securities and Exchange Board of India (SEBI) released a consultation paper to regulate the nascent and growing field of ESG ratings. In India, ESG ratings and assessments are currently provided by certain credit rating agencies (CRAs) and standalone ESG raters like ESGRisk.ai and Futurescape.

SEBI’s paper discusses the ‘issuer-pay’ and ‘subscriber-pay’ models for compensating ESG raters and has sought feedback regarding the adoption of the subscriber-pay model.

Issuer-pay model

The issuer-pay model, which is the current compensation mechanism for CRAs, raises conflict of interest concerns since the issuer/borrower mandates and pays the CRAs. Hence, CRAs are perceived to assign more favourable ratings and in certain instances fail to downgrade ratings in a timely manner.

The advantages of the issuer-pay model are that issuers, having mandated the CRAs, are likely to co-operate with them, and it is cost-effective for subscribers. Irrespective of whether issuers or subscribers pay CRAs, the cost of raising debt including interest and credit rating fees is identical.

Subscriber-pay model

While issuers wield less influence on CRAs in the lender/subscriber-pay model, there is the risk of subscribers influencing CRAs to undertake rating actions to their benefit. Other drawbacks of the subscriber-pay model include certain issuers’ reluctance to co-operate with CRA(s) mandated by subscribers and the difficulty in subscribers concurring to mandate a CRA and/a standalone ESG rater.

According to the International Organization of Securities Commission’s (IOSCO) November 2021 report on ESG ratings, the subscriber-pay model has been dominant internationally. However, the report suggests that if the perceived financial benefits of such ratings increase over time, issuer pay models may be used more frequently.

A third compensation model — the ‘regulator-pay’ model — has been discussed but not implemented. It is not the regulator’s role to pay for research underpinning pecuniary transactions and the regulator may have budgetary and manpower constraints.

Stakeholder-pay model

To overcome the conflicts of interest in the issuer- and subscriber-pay models and the rigidities in the regulator-pay model, SEBI should consider implementing the ‘stakeholder-pay’ model. The stakeholder-pay model will involve SEBI directing issuers of ESG-compliant capital, accredited CRAs and stand-alone ESG raters, and investors including banks, NBFCs, mutual funds, insurance companies’ investment arms, and brokerages, who will represent retail investors, forming an association headed by a governing board.

This association will host a web portal for its members. Issuers intending to raise ESG-compliant capital will post details of the proposed issue on the portal. CRAs and standalone ESG raters desirous of rating these issues will indicate their willingness. Subscribers interested in investing in an issue will vote for a CRA and a standalone rater of their choice. In the case of a tie, the issuer will cast the deciding vote. Once the rating is assigned, subscribers will pay the raters in proportion to the quantum of investment they make.

The governing board will catalyse a fair competitive environment, oversee the development of robust ESG rating methodologies and processes, improve access to ESG ratings and research, and reduce ratings shopping and conflicts of interest. The governing board’s functions will include devising a compensation structure taking into account subscribers’ and issuers’ inputs and monitoring the voting process so that the system is not gamed (Figure 1).

According to a study by BDO USA LLP, a US-based accounting and financial advisory firm, the correlation of ESG ratings provided by six raters ranged from a low of 7 per cent to a high of 74.4 per cent (Figure 2).

In contrast, the correlation between credit ratings assigned by Moody’s and S&P is 96 per cent. Hence, the governing board ensuring the ratings are correctly labelled and those provided by various providers are mapped accurately is important.

The stipulations that ESG-compliant capital must be rated by one CRA and one standalone rater and CRAs being prohibited from offering discounted credit rating and research fees are essential prerequisites for a fair competitive environment.

As several subscribers and issuers are credit-rated entities, CRAs enjoy a first mover advantage in the ESG ratings industry. Discounted credit rating fees will further incentivise credit-rated-subscribers and issuers to vote for the CRAs with whom they have existing relationships.

In the absence of sufficient mandates, standalone ESG raters will be marginalised or exit the industry. ESG is an evolving, multidisciplinary, body of knowledge that requires the inputs of several professionals such as scientists, engineers, lawyers, accountants and analysts; stand-alone raters could add considerable value.

If implemented with the aforesaid checks, the ‘stakeholder-pay’ model offers multiple advantages (Figure 3). First, it ensures a level playing field. Second, it facilitates the creation of a fair rating environment characterised by limited ratings shopping and diminished influence issuers have over the ratings process and outcomes. Third, price competition is eliminated.

Fourth, SEBI can treat the implementation of stakeholder-pay model for ESG raters as a sandbox. Our discussions with global CRAs-cum-ESG-raters indicate that ESG ratings fees is much lower than credit rating fees. If the stakeholder-pay model is successfully implemented for ESG ratings, then it can be extended to the conflict-of-interest ridden credit ratings industry.

SEBI’s draft ESG ratings guidelines indicate a preference for the ‘subscriber-pay’ model. If SEBI decides to implement this model, the regulator should at the very minimum prohibit CRAs from offering subscribers discounted ESG and/ credit rating and research fees.

ESG and green investing is justly poised for an explosive growth. Robust, timely, and conflict-of-interest-free ESG ratings are critical risk assessment and pricing tools that would reduce greenwashing. It is in the planet’s, society’s and investors’ interest to ensure a fair operating environment for ESG raters.

Nandini is the Head of Research at Korea Development Bank. Views expressed are personal. With inputs from Savita Shankar, Lecturer at the School of Social Policy & Practice, University of Pennsylvania

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