ESG (environmental, social, governance) sustainability factors
- Category: European Union Carbon Market Glossary
ESG (environmental, social, governance) factors are becoming increasingly significant in sustainable finance decision making, for example, asset managers in the EU are required to integrate ESG considerations into their fiduciary duties from January 2022.
EBA Discussion Paper of 3 November 2020 on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03) observed, however, that the policy framework lacked a common definition of ESG factors and, consequently, market practices also varied across institutions.
Institutions have been relying on various international frameworks and standards defining ESG factors, although some of them use their own definitions.
Examples of ESG factors that are common across those definitions and practices for financial and non-financial firms include greenhouse gas emissions, biodiversity and water use and consumption in the area of environment; human rights, and labour and workforce considerations in the area of social; and rights and responsibilities of senior staff members and remuneration in the area of governance.
Taking the above into consideration, the EBA proposes the following definition for the ESG factors: 'environmental, social or governance characteristics that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual’ (p. 26).
Article 2(24) of SFDR provides a broad definition for the types of sustainability factors which may influence investment decision-making and impact, in this context sustainability factors refer to “environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters”.
SFDR defines also sustainability risks, they mean an “environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment” (Article 2(22)).
ESG ratings and ESG data products
As observed in the ESMA Call for evidence of 3 February 2022 on Market Characteristics for ESG Rating Providers in the EU (ESMA80-416-250) ESG ratings are used by a wide variety of investors to take into account risks and opportunities linked to ESG issues.
Moreover, these products are having an increasingly important impact on the operation of capital markets and on the confidence of investors in sustainable finance products.
IOSCO Report of November 2021 (FR09/21, p. 6) observes the global market for ESG ratings and data products is concentrated around a small number of providers with a global presence, alongside a larger number of providers with a more regional focus or offering more specialized services.
The said Report refers to number of 160 ESG ratings and data products providers worldwide in 2020 (including both for-profit and non-profit companies that offer large or specialised ESG-related products) and 30 to 40 other smaller providers of ESG ratings, data and research products and services domiciled in the European Union (EU).
It is estimated that global revenues generated by ESG data and services could more than double by 2025.
Although the Credit Rating Agencies Regulation (CRAR) includes a number of requirements relating to the disclosure and presentation of credit ratings, the above ESMA Call for evidence of 3 February 2022 notes a low level of comparability between ESG ratings, and potential conflicts of interest.
With these inconsistencies in mind, in July 2019 ESMA issued Guidelines that seek to improve the quality and consistency of the information disclosed in credit rating press releases (ESMA Final Report - Guidelines on Disclosure Requirements Applicable to Credit Ratings, ESMA 33-9-320, 18 July 2019).
Given the increased focus on ESG factors within investment decisions, an additional goal of these guidelines is to ensure greater transparency around the consideration of ESG factors, where they are material to a credit rating action.
In particular, the Guidelines indicate that, where ESG factors have been key drivers behind a change to the credit rating or rating outlook, CRAs are expected to:
– identify the relevant factors;
– elaborate on their materiality; and
– include a reference to where an explanation of how ESG factors are considered as part of the credit rating process can be found (e.g. a reference to their credit rating methodologies).
The Guidelines began to apply on 30 March 2020.
When it comes to the payments structure, on the basis that the business model for providers of ESG ratings is predominantly an investor pays model in the current state of play, clients of ESG rating providers are likely to also be the users of their ESG ratings.
However, it is possible that alternative business models exist where the users of an ESG rating providers’ products do not have a contractual relationship with the provider, for example in the case of not for profit ESG rating providers.