Mint Explainer: What are ESG rating providers and why should investors care?

The flurry of certifications comes after Sebi brought entities that provide ESG ratings under its regulatory ambit last year. ESG ratings, a relatively new phenomenon, were previously unregulated. These ratings affect the investment decisions of several large global funds, which take these parameters into consideration along with the financials before investing in companies and avoid those with poor ESG scores.

What are ESG ratings?

ESG ratings are an evaluation of companies based on their performance in addressing risks and opportunities on environmental, social and governance parameters. A company’s performance is evaluated on these parameters and they receive a composite score. This score considers factors such as emissions generated, efforts taken to curb these, labour practices, impact on local communities, and governance standards.

ESG ratings emerged as a response to the growing interest among investors and regulators in examining the wider impact of companies on all stakeholders. These ratings are an important gauge, especially for large funds that have various social or environmental mandates.

Why is Sebi regulating this sector?

ESG ratings are not standardised. Every rating provider has different criteria and assigns different weights to environmental, social and governance aspects. This leads to a wide variance in the ESG scores, and raises concerns about their legitimacy and transparency.

Last year, Sebi set up a regulatory framework for ERPs in view of the growing importance of ESG ratings to investors. Sebi noted that since ERPs were not subject to regulatory or supervisory oversight, “increasing reliance on such unregulated services in the securities markets raises concerns about the potential risks it poses to investor protection, efficiency of markets, risk pricing, capital allocation and greenwashing, among others”.

Greenwashing refers to providing false information about a firm’s environmental credentials to mislead investors.

What are the business models of ERPs?

Sebi rules allow ERPs in India to have one of two business models – issuer-pays or subscriber-pays. Under the issuer-pays model, the company receiving the ESG rating pays the ERP, similar to the way companies engage credit-rating agencies. Under the subscriber-pays model, ERPscharge investors for access to the ESG ratings of the companies they cover. This is similar to the way proxy advisory firms charge institutions such as mutual funds and wealth funds to access their advisory reports.

Sebi does not allow hybrid business models for ERPs, so they have to choose one model and stick to it. They are also not allowed to engage in ESG consulting or any other business.

“These restrictions make the market very limited,” said JN Gupta, managing director of Stakeholders Empowerment Services (SES). He cautioned that ERPs with a subscriber-pays model will issue ratings of all top listed companies, which could make the services of issuer-pays ERPs redundant. SES ESG Research Private Limited, a unit of SES, will follow the subscriber-pays model.

What does this mean for investors?

Regulating ERPs could help make ESG ratings more consistent, comparable and transparent, which in turn could make investors more confident of them.

“ESG ratings help align your investments to your values,” said Amit Tandon, managing director of Institutional Investor Advisory Services (IiAS). “Some communities are vegetarian or do not smoke or drink alcohol. Certain ESG funds take such preferences into account.”

“ESG ratings are also an important gauge for risk. A well-governed company may or may not perform to your expectations, but a poorly governed company will cause investors grief. We believe better ESG ratings will result in more long-term resilience and value creation,” he said. IiAS Sustainability Solutions Private Limited, a unit of IiAS, received ERP certification earlier this month.