Climate change, social inequality and sustainability are some of the most pressing issues faced by society today. Investment decisions play a critical role in improving environmental, social, and governance (ESG) outcomes; and the use of ESG ratings to guide investors towards sustainable investment has become more important in recent years. However, it's not without scrutiny: conflicting interests between commercial relationships and the evaluation process that informs ESG risks can increase opportunities for manipulation — thereby reducing the trustworthiness of ESG ratings.
In particular, research by SMU School of Accountancy scholars has highlighted how the acquisition of independent ESG rating providers by major credit rating agencies can lead to more optimistic ESG ratings.
The paper “Do Commercial Ties Influence ESG Ratings? Evidence from Moody’s and S&P” by SMU PhD student Li Xuanbo, SMU Associate Professor of Accounting Lou Yun, and SMU Professor of Accounting Zhang Liandong takes a closer look at how this tension plays out and what steps can be taken to reduce risks from conflicts of interest influencing ESG ratings. Here are four top takeaways from the paper, which was first presented and discussed at the inaugural Nanyang Business School Accounting Conference in 2022:
1. ESG vs Credit Rating: Why do conflicts of interest exist?
Amid claims of “greenwashing” and concerns over “woke capitalism” — an emerging concept that calls for companies to be aware of the social and environmental implications of their operations — research firms play a critical role in helping businesses make informed decisions about their ESG activities.
Such firms provide research that covers global trends, best practices for mitigating risks associated with various ESG sectors, and insights on how to improve operations. Furthermore, ESG data and research firms are expected to conduct independent assessments of companies’ compliance with all applicable sustainability regulations.
On the other hand, Moody’s, along with other international rating agencies such as Standard & Poor’s and Fitch Ratings, play a critical role in providing assessments of securities and other investments that are used by investors to assess the creditworthiness or risk associated with an issuer. By applying analytics across multiple sources of data, these rating firms enable investors to make informed decisions when allocating their capital.
In 2019, however, risk assessment firm Moody’s acquired a majority stake in Vigeo Eiris, a global leader in ESG research, data and assessments; while the creator of financial indices S&P Global acquired the ESG rating business of RobecoSAM.
The paper’s authors, therefore, examined if the acquisitions have led credit rating agencies to give their existing clients higher ESG ratings.
“Client firms with stronger credit rating relationships with Moody’s or S&P and client firms that issue green bonds received more noticeable improvements in their ratings — a fact that deserves attention from investors and regulators,” notes Prof Lou during her presentation of the paper at the SMU School of Accountancy Accounting Research Summer Camp 2022.
2. The role of ESG disclosures in mitigating conflicts of interest
Prof Lou’s research thereby discovered a powerful correlation: firms with more intensive credit rating relationships with Moody’s and those issuing green bonds have noticeably higher ESG ratings. Yet firms with more transparent ESG disclosure and pension fund holdings show signs of a muted increase in ratings following the acquisitions.
ESG disclosure is a crucial component of transparency and responsible business practices. The implementation of clear and transparent ESG practices can not only provide alignment with stakeholders' values but also attract new forms of funding from like-minded investors who view these kinds of investments as part of their portfolios.
“Our study shows that transparent ESG disclosures are associated with less ESG rating inflation, consistent with the idea that ESG disclosure transparency mitigates the adverse effect of conflicts of interest on ESG ratings,” write the paper’s authors.
These differences suggest that transparency is key to gaining accurate ratings. By being open about their ESG performance, companies make it easier for investors to evaluate the legitimacy of their ratings — so they don't benefit from misleading, inflated scores. This finding has wide-reaching implications for every organisation serious about tracking its true ESG rating.
3. Why regulations aren’t always the solution
From the point of view of casual observers, regulations such as mandatory disclosure and increased accountability can help ensure more accurate assessments of companies’ ESG performance. With tightened regulatory structures firmly in place, one might assume that investors will receive fair and impartial evaluations when decisions must be made about how their funds are invested.
In reality, the researchers note previous studies such as those by Dimitrov, Palia, and Tang (2015), “show that credit rating agencies respond to increased regulatory pressure under the Dodd-Frank Act by issuing lower and less informative corporate bond ratings to protect their reputation”. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 to address the financial crisis of 2008.
Despite the potentially negative backlash of tightening regulations, regulators should increase vigilance and take decisive steps to ensure that conflict of interest does not occur. The existing credit rating regulatory framework should be seized by regulators to increase supervision over acquired ESG rating businesses, says the paper. It is critical that close attention is paid to such conflict of interest situations and decisive steps are taken to protect the public, investors and related stakeholders. Doing so will go a long way towards creating trust in socially responsible investments and keeping markets efficient.
4. Public awareness as a deterrent mechanism
We live in an era where ESG ratings play a prominent role in assessing ESG performance. Hence, it is paramount that the ratings paint an accurate and realistic story. For this to happen, the public should build insights into how ratings are generated and what methods are used by agencies to assess a company's ESG behaviour. Without a demand for greater accountability from consumers, it would be all too easy for some ESG rating providers to take advantage of their position of power by providing inflated assessments and disingenuous recommendations.
Moreover, financial services firms have a responsibility to provide accurate and reliable ESG ratings. To fulfil this obligation, they must take proactive measures to mitigate any conflicts of interest that could potentially arise from other business lines, states the paper.
