Information Intermediaries and Sustainability
Sustainable finance has been steadily expanding over the last few years. The jury is still out on whether this is just a bubble inflated by greenwashing practices or a genuine step towards better ESG (environmental, social, and governance) conditions—or a combination of the two. In any event, these developments pose and will continue posing some difficult questions on the approach regulators should adopt when approaching ESG-oriented finance.
In the European Union (EU), the regulatory lining of this impressive growth was an explosion of new rules aimed at addressing a broad array of concerns that surround investors’ reliance on the quality of sustainable financial products. Our paper explores a limited aspect of sustainable finance, namely information intermediaries and, more specifically, ESG ratings and benchmarks. It does so by addressing a simple research question: how much should the law on sustainable finance mirror traditional financial law?
In answering our research question, we analyze the market failures that justify the regulation of traditional information intermediaries, and we explore to what extent they also affect their correspondents in the world of sustainable finance. In both worlds, information intermediaries play an essential role in addressing market failures by gathering relevant data and disseminating derived information of a synthetic nature that is easier for investors to handle. However, the dynamics of market failures are not necessarily identical in the ‘old’ and the ‘new’ world, which also affects the role of ESG ratings and benchmarks.
One of the differences between traditional finance and ESG finance lies in how investors use information as a basis for their investment decisions. In the traditional sense, this is by and large information that plays a role in the determination of risks and returns. When ESG factors come into play, things may change to some extent. In the first scenario, investors may include ESG factors in their strategies as one of many elements to be considered when quantifying the risk/return profile of an asset. In the second scenario, however, investors may want to look at the quality of their investments along with the impact on ESG targets, regardless of the potential ability of these calculations to backfire on the risks or the returns of their exposure. This approach, which is less profit-oriented and more focused on pure sustainability, is very different from the traditional one.
A main source of confusion comes from distinguishing when indicators are referring to the first, more traditional, scenario (as is the case with ‘ESG risk ratings’), or to the second one (‘ESG impact ratings’), as confusion is reportedly high on this matter. But institutions and scholars have questioned the very reliability of ESG-related indicators, as well. Therefore, we explore whether the regulatory strategies that addressed methodological concerns for traditional information intermediaries can provide some guidance for ESG indicators, and for ESG ratings in particular.
Through a comparison of sustainability ratings with two activities that are currently regulated and show material similarities with ESG ratings, namely credit ratings by credit rating agencies (CRAs) and investment recommendations by financial analysts, the paper shows that the ‘new world’ displays many similarities with the original markets for ratings, but it also has some distinguishing features.
One element to consider in this comparison is that market mechanisms may not work in the same way as in traditional finance when sustainability considerations are included in investment decisions and, hence, in the dynamics of price discovery. While in the traditional setting market participants will all look at the discounted expected value of an asset’s future cash flow, attention to ESG factors introduces a set of preferences which are typically more prone to value judgment compared to information that can be more easily quantified, such as the probability of default in credit ratings. Therefore, it is not surprising that a growing literature has noticed low levels of correlation among ESG ratings addressing the same issuers.
These and other differences that the paper highlights suggest that policymakers should be cautious when transposing rules from the ‘old world’ to the ‘new’ one. This is especially the case with ESG ratings. Here, credit ratings and their regulation are often the immediate references in the policymaking debate, but the common label of ‘rating’ can be rather misleading and may lead to the risk of an anchoring effect in the design of new rules. First, due to their multivariate nature, the assessments underlying ESG ratings are often more subjective than those supporting traditional indicators. Second, there seems to be a higher risk of regulatory failures connected to an authorisation system in the new world of sustainability, as registration may grant implicit quality labels despite the lack of a universal understanding of quality criteria for rating methodologies.
The paper, therefore, suggests that the future European legal framework on ESG ratings should start with a light-touch approach, one that focuses more on disclosure and surveillance by market participants rather than registration and public supervision. In this regard, the European rules on financial analysts could be a suitable model to consider at this stage.
Another salient feature of the EU approach to financial analysts is the calibration of duties based on the nature of the analysts as either a generic market participant, an expert, or an intermediary. Rules do not mandate any registration and focus on a few essential elements. These include the clear distinction between facts, interpretations and estimates, the duty to disclose the basis of valuations and the methodology adopted, together with their underlying assumptions.
Along this line, we suggest that the forthcoming European rules should address the methodological concerns on ESG ratings with a small number of targeted disclosure measures that focus on the very nature of the ESG ratings involved (in terms of ESG risk ratings or ESG impact ratings), on some methodological concerns and on the impact of conflicts of interest. Should market failures persist after a reasonable time, a higher bet can be made with a fully-fledged authorisation and registration system along the line of credit ratings.
The paper received the Best Paper Award at the 2022 Annual Conference of the European Capital Markets Institute (ECMI). Financial support from ECMI is gratefully acknowledged.
Matteo Gargantini is an Assistant Professor of Business Law at the University of Genova.
Michele Siri is a Professor of Business Law at the University of Genova.
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