The ESG rating conundrum

India must put forth its own regulatory framework to accredit ESG rating providers as universal consensus is a distant dream

Globally, ESG or environmental, social and governance investments have emerged as a subject of great interest and significance in recent years. It is no longer just a fad or a buzz word. Increasingly, corporates are adopting higher ESG norms, and investors are preferring such investments. There is a growing realisation that focussing on ESG not only results in public good but also makes business sense. It is beneficial for both —the shareholders and all other stakeholders.

There are no universally recognised or accepted ESG reporting standards and frameworks yet; though a number of international bodies are grappling with the idea. Globally, the investors and corporates have been using different standards and frameworks which have come up over a period of time, viz., GRI, TCFD, SASB, among others. There is no consistency in disclosures and transparency of the methodology and rating process.

The type as also the objective of rating products offered vary significantly across ESG rating providers (ERPs). For instance, ESG rating product categories may include “risk” ratings and “impact” ratings. Typically, risk rating is an assessment of a company’s resilience to ESG related risks and does not take into account the impact of the company’s functioning on the environment or society. This is akin to an assessment of “adaptation” capability and preparedness of a company to deal with the changing scenario. Aspiring for a higher risk rating should be in a company’s own commercial interests. As compared to this, impact rating is an assessment of the impact of a company’s operations on the environment and society. To get a better score on such a rating, the company would need to demonstrate credible mitigating actions to contain the negative externalities on account of its operations. The impact rating has more of a societal relevance. Assessing impact rating would be more complex and arduous compared to risk rating. Also, at least in the short term, investors might be more concerned about risk rating, which is likely to have a direct and obvious correlation with returns. No wonder, then, that ESG impact ratings are not the mainstream ESG rating product currently being offered by most providers.

While the cumulative worldwide ESG investments are being reported in trillions of dollars in various media articles and publications, it is unclear as to which standards and frameworks are being followed in compiling such figures.

In an attempt to initiate developing universally acceptable reporting standards and frameworks, which may provide consistent and comparable reporting of relevant ESG information, the setting up of the International Sustainability Standards Board (ISSB) was announced by the International Financial Reporting Standards (IFRS) Foundation at COP 26 climate conference in November 2021 at Glasgow. The ISSB will be overseen by IFRS Foundation Trustees, who also oversee the International Accounting Standards Board (IASB) — with a view to giving equal footing to both financial accounting and sustainability accounting.

Illustration: Binay Sinha

Given the complexities involved, it is going to be a long haul for the ISSB to come out with consistent and comparable standards and frameworks. Notwithstanding this status about setting standards, the meteoric rise globally in what are supposed to be ESG investments is baffling to say the least.

The inevitable question that needs to be addressed is, what should we be doing in India about ESG reporting standards and frameworks in such a scenario?

ESG investing is relatively still in the nascent stage in India. As of now, many of the large institutional investors primarily rely on in-house research. Generally, they supplement this with the ESG rating or data products offered by global rating providers. Typically, foreign ERPs provide ESG rating for companies which are included in an index, and the companies are benchmarked to global or regional benchmarks.

Of late, there has been a surge in the number of domestic investors participating in capital markets, either directly or through mutual funds. Many of them are unlikely to understand the nuances of ESG investing. The absence of consistent and comparable ESG reporting standards and frameworks  is likely to lead to greenwashing and misselling, and raises concerns about the potential risks it poses to investor protection, transparency and capital allocation in markets, among others. 

Without waiting for a universal consensus on ESG standards, for the reasons explained below, there is an urgent need for putting in place a regulatory framework in India to accredit ERPs.

The first reason is that the development of universally acceptable ESG standards and frameworks is a distant dream. In fact, some would even debate whether the same is desirable or workable, considering the different levels of development across different countries in the world. Can or should the emerging economies adopt the same ESG standards as in the developed world?  For instance, on environment issues, which have global ramifications, different countries have made different commitments during international climate change negotiations in COP meetings about their plans to contain environment degradation. Typically, such commitments depend upon the stage of development of a country and are based on the broad principle of “Common but Differentiated Responsibilities and Respective Capabilities”. To mandate environment standards’ reporting under ESG framework that goes beyond a country’s commitments made in global climate change negotiations would amount to negating the efforts made for equity and climate justice in these forums.

Coming to the second reason, we have already developed and put in place our own sustainability reporting standards for the corporates. These standards viz. business responsibility and sustainability reporting standards (BRSR) have been finalised by the Securities and Exchange Board of India or Sebi, taking into account international best practices, domestic considerations and the viewpoint of stakeholders including industry groups. Sebi’s guidance note on the subject provides for inter-operability of BRSR reporting framework with international frameworks like GRI, TCFD and SASB. Sebi regulations mandate compulsory reporting in accordance with the BRSR standards by top 1,000 listed companies from the year 2022-23 onwards. Other listed or even unlisted companies could voluntarily adopt these standards. The ERPs rating Indian corporates/issuers or rating ESG investments in India should base their framework on these standards. This would provide both consistency and comparability. In case some foreign investors demand information in accordance with other standards and frameworks and wish to get their investments rated based on those standards, the domestic corporates/issuers could supply such tailored information to them, which could be in the form of BRSR+ information.

 The third and the last reason is that while the domestic ESG rating providers industry in India is still at a stage of infancy, the demand gap for such ratings is being met by foreign ESG rating providers. The dominance and entrenchment of foreign ERPs, which are themselves unregulated and follow varying standards, in the domestic ESG rating business is likely to impede the growth of indigenous ERPs and also slow down the adoption of domestic standards and frameworks. Going forward, we might face issues similar to the ones we are facing relating to the country’s sovereign rating by global credit rating agencies; though ESG rating is altogether a different ball game compared to credit rating and no one is talking of sovereign ESG rating!

Sebi had brought out a consultation paper in January 2022 on the need to regulate ESG rating providers. The matter may be taken forward and an appropriate regulatory framework finalised.

The writer is a retired IAS officer and former chairman, Sebi