<p "="">"'Cause the players gonna play, play, play, play, play, <p "="">... and the raters gonna rate, rate, rate, rate, rate, <p "="">... and regulators gonna regulate .. late ... late ... late ... late <p "="">... and participators gonna participate ... pate ... pate ... pate <p "="">Baby, I'm just gonna shake, shake, shake, shake <p "="">I shake it off, I shake it off" <p "="">Shake if Off, Taylor Swift <p "="">It seems that everyone has an opinion on what ESG ratings SHOULD do and whether / how they should be regulated ... <p "="">... or if you don't already have an opinion, you are asked by everyone who already has an opinion on the matter to form one. <p "="">Why?
... but stop!
<p "="">If you've not listened to Shake it Off recently or watched the video, take four minutes of 'work-life balance' time to do so. The video is fun and funny. It will make your day better; I guarantee.
Raters gonna rate...
<p "="">Are you back? Thank you. <p "="">ESG ratings are a product that some providers provide and some investors use and pay for. So long as they deliver something of value to these users (whether that be reputational cover, risk flagging, screening or even investment guidance) ratings will continue to be provided. <p "="">If / when investors stop paying for them; they will stop being provided. The quality of such ratings will always be a function of how much is paid for them (not enough) and how much those clients value quality and accuracy (not enough). <p "="">There is an open market that is adequately competitive with new entrant challengers at both the cost and quality ends of the spectrum => no need to intervene. The customers of such ratings (asset managers) are informed professionals spending their own money => there is no need to intervene.
... but regulators gonna regulate ...
<p "="">However, like Aesop's scorpion, regulators seem determined to regulate ESG ratings. The volume of simplistic (and largely self-defeating) arguments from companies is reaching a crescendo and is now being joined by those who want to use regulation (of ESG ratings) to undermine what they see as quasi-regulation of issues that they don't believe important (like climate change). <p "="">This Kafka-esque coalescence between soft liberals and the hard-right around a tool that has been central to the development of the sustainable investment industry would be deeply depressing ... if either [a] it were likely to be achievable or [b] if it mattered to people allocating capital towards sustainability. <p "="">Luckily, the aim of regulating ESG ratings is not achievable (in any meaningful sense) and - even more luckily - it probably doesn't matter.
Not achievable
<p "="">By and large, nobody knows:
- What an ESG rating (in general or individually) measures
- How ESG relates to sustainability
- Whether / how an ESG rating relates to any of the key financial metrics of a company (even in theory, let alone in practice)
- How they 'should' be used (in theory). (We do know how they are being used in practice; what we don't know is whether the investment logic behind any of the direct users is robust)
<p "="">If you don't know what you are regulating, it's a long journey to being able to regulate it. <p "="">"... but, Mike, maybe it's just you that doesn't know" <p "="">Possibly but I did spend much of 2020 conducting a globally reaching investor research project with >200 industry leaders ... and they didn't know. What is more, a sizeable majority of the investors didn't care ... which brings me to my next point.
It doesn't matter (... probably)
<p "="">Whether or not investors buy ESG ratings is not actually relevant; what is relevant is who these investors are and whether / how they use them. <p "="">Significantly, it appears to be the case that fundamental active investors (who are the marginal buyers and sellers of shares that influence share prices!) with experience of sustainable investment use ESG ratings as one tool amongst many - often for rough-cut screening or risk flagging or as inputs into the early stage of investment research ... but not for final investment decision-making. Ratings are a small part of a process that may ultimately lead to capital allocation. But we must keep things in proportion. (If I were concerned about urban sprawl, I wouldn't be regulating screwdrivers.) <p "="">There is, of course, some direct usage of ratings by passive investors but these cannot - by definition - be the marginal investors that influence stock prices. <p "="">So, it doesn't matter. ESG ratings are only one tool in a toolbox and while they may not be perfect, they do a job and that job is contextualised by other work.
... but it might matter ...
<p "="">If our objective is to maximise the efficient flow of capital towards sustainable industries and away from unsustainable ones, ESG RATINGS and DATA are only relevant at the margin. <p "="">Active capital transfer is undertaken by fundamental active investors. To make such transfers, investors need RESEARCH and ... as we highlight in this discussion paper: Data ≠ Ratings ≠ Research. <p "="">The only respect in which regulating ESG ratings might be relevant / detrimental to the sustainable allocation of capital is if it deflects regulators from fixing other more significant flaws in the sustainable investment value chain. <p "="">(Ask yourself: "What would climate change deniers like sustainable investors to be doing now?" Your answer will probably be: "Wasting time discussing the niceties of something that doesn't actually affect capital allocation")
So WHAT does actually need fixing?
<p "="">IMHO, the value chain suffers from 10 fundamental flaws
- There is clear evidence of market failure in sustainable investment RESEARCH (not DATA or RATINGS) ... which impedes active capital allocation towards sustainability
- There is a profound and deepening bias TOWARDS systematic data and AGAINST idiosyncratic data ... which a focus on ESG ratings exacerbates
- There is a lack of clarity about the fundamentals ... for example, the relationship between 'Sustainability' and 'ESG'
- There is no clear rationale for allocating capital based on an aggregation of E, S & G measures (even though rationale does exist for allocation based on specific aspects of each)
- Company communications to investors is largely passive and reactive ... which makes the whole process tremendously inefficient and is a breeding ground for misunderstanding
- Fundamental business context to ratings and data gathering appears (largely) absent ... making it nigh-on impossible to apply appropriate weightings
- There are inherent conflicts (six in fact) in the use of ratings for both pre-trade analysis and portfolio analytics (NB ... this one is complicated and the vested interests are big and getting bigger!)
- There is not enough money in the value chain ... to deliver the depth and quality of research that is needed
- Ratings divergence makes their use for portfolio analytics fundamentally inappropriate
- The disproportionate growth of passive sustainable investment strategy (relative to active) causes and embeds imbalances in the value chain that inhibit active allocation towards sustainability
Also...
<p "="">Sure there are issues (reported) with a lack of transparency in ratings methodologies and conflicts of interest and the understanding of business by ESG analysts and the volume of disclosure required and bias in coverage and the lack of comparable disclosure by companies and the communications between ESG ratings staff and companies ... but these are all easy to fix or can be ignored ... and there is no point fixing them until the fundamental flaws have been addresssed. <p "="">It appears likely that regulators are going to focus on these minutiae so...
... participators ...
<p "="">... you can participate ... pate ... pate in the process of working out what ESG ratings SHOULD be / do, if you want to ...
... but I'm just gonna 'shake it off'
<p "="">... and focus on the things that really matter.
Go on. Have another listen ;-) Shake if Off
