According to Global Sustainable Investment Alliances 2021, sustainable investments grew 15% between 2018 and 2020 to $35.3 trillion. This is more than a third the assets in the five largest investment markets worldwide (Europe, the US and Japan, Canada, Australia/New Zealand, and Canada). In India, the inflows of sustainable funds increased by 76% to 3,686 crore ($484million) in FY2021. These trends are driven by an increasing awareness that environmental, social and governance (ESG), factors have significant effects on society, economy, sustainability and financial performance.
Investors are keen to incorporate ESG risk elements into their investment appraisals. This is why ESG ratings are in high demand. ESG ratings can have an impact on capital allocation decisions by investors and can also affect the cost of raising ESG-compliant capital.
The Securities and Exchange Board of India released a consultation paper in February to regulate the rapidly growing field of ESG rating. ESG ratings, assessments and credit rating agencies in India currently provide ESG ratings and assessments.
SEBI has requested feedback regarding the adoption and future development of the subscriber pay model.
Model of issuer-pay
The issuer/borrower is responsible for paying CRAs. Therefore, CRAs are perceived as giving more favorable ratings and failing to downgrade ratings in time.
The benefits of the issuer/pay model include the fact that subscribers will be able to benefit from the co-operation of issuers and the mandated CRAs. Regardless of whether subscribers or issuers are paying CRAs, the cost to raise debt, including interest rates and credit rating fees, remains the same.
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. The subscriber-pay model has other drawbacks. Subscribers can force subscribers to mandate CRAs and/or standalone ESG raters.
According to the International Organization of Securities Commissions’ (IOSCO) November 2021 report about ESG ratings, the subscriber pay model is the most dominant worldwide. The report suggests that issuer-pay models could be more popular if they are perceived to have greater financial benefits.
The regulator-pay model is a third type of compensation model that has been discussed, but not implemented. It is not the responsibility of the regulator to pay research that underpins pecuniary transactions. However, the regulator may be limited by budgetary and manpower resources.
Stakeholder-pay Model
SEBI should look at implementing the stakeholder pay model to address conflicts of interests in the issuer and subscriber-pay systems and rigidities in regulator-pay. The stakeholder model will have SEBI directing ESG compliant capital issuers, accredited ESG CRAs and stand alone ESG raters. Investors include banks, NBFCs investment arms, insurance companies and brokerages.
This association will host its members a web portal. The portal will be used by issuers who wish to raise capital ESG-compliant. The portal will allow standalone ESG raters as well as CRAs to indicate their willingness to rate these issues. Subscribers who are interested to invest in an issue will vote for the CRA or standalone rater of choice. If there is a tie, the issuer will be the one to vote. Once the rating has been assigned, subscribers will pay raters according to how much they invest.
The governing boards will promote fair competition, oversee the development and maintenance of robust ESG rating methodologies, processes, and access to ESG ratings and research, as well as reduce ratings shopping and conflicts. Figure 1. The governing board’s functions include determining a compensation structure that takes into account subscribers and issuer inputs, and monitoring the voting process to ensure that the system is not rigged (Figure 1).
According to a study done by BDO USA LLP, a US-based financial advisory and accounting firm, the correlation between six ESG rating providers ranged from a low 7 to a high of 74.4 percent (Figure 2).
Contrary to this, the correlation between credit ratings assigned Moodys or S&P is 96%. The governing board must ensure that ratings are correctly labeled and that all providers are accurately mapped.
ESG-compliant capital must have one CRA and one standalone rating agency. Additionally, CRAs cannot offer discounted credit rating or research fees. These are prerequisites for a fair competitive atmosphere.
CRAs enjoy an advantage in the ESG ratings market because many subscribers and issuers are credit-rated entities. Discounted credit rating fees will further incentivise credit-rated-subscribers and issuers to vote for the CRAs with whom they have existing relationships.
Without sufficient mandates, standalone ESG rating agents will be marginalised or forced to leave the industry. ESG is a multidisciplinary field that is constantly evolving and requires input from many professionals, including scientists, engineers, lawyers accountants, and analysts. Stand-alone raters could be of great value.
The stakeholder-pay model has multiple benefits if implemented with the aforesaid checks (Figure 3). It ensures that everyone is treated equally. It allows for fair ratings and less influence from issuers. Third, price competition is eliminated.
Fourth, SEBI can consider the implementation of stakeholder pay model for ESG raters a sandbox. According to our discussions with global CRAs-cum ESG-raters, ESG ratings fees are much lower than credit rating fees. If the stakeholder-pay model for ESG ratings is successful, it can be extended to conflict-of-interest ridden credit rating industry.
The draft ESG ratings guidelines of SEBI indicate a preference to the subscriber-pay model. If SEBI decides implement this model, regulators should at the minimum prohibit CRAs offer subscribers discounted ESG/credit rating/research fees.
ESG and green investments are poised to experience 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 investors’, societies’ and planets best interests to provide a fair operating environment for ESG rating agencies.
Nandini, Head of Research at Korea Development Bank, is Nandini. All views are my own. Savita Shankar, Lecturer, School of Social Policy & Practice University of Pennsylvania
Published on
April 19, 2022
