IOSCO should back off ESG ratings providers

19 August 2021

IOSCO and its members must not direct ESG analytics providers on how to govern themselves, argues Bill Harrington

The International Organization of Securities Commissions (IOSCO) must first fix its own poor governance and, second, wait a good long while before establishing governance guidelines for providers of environmental, social, and governance (ESG) ratings and data products.Bill Harrington

ESG analysis is a nascent discipline that needs time, space, and open-ended public dialogue with the whole wide world to define the most useful sustainable practices and then evaluate them. Regrettably, IOSCO recommends that ESG information providers hurry up and emulate credit rating agencies by settling for robust processes at the expense of robust content. See the IOSCO Consultation Report "Environmental, Social and Governance (ESG) Ratings and Data Products Providers" of July. Responses are due September 6.

The IOSCO recommendation is itself a massive governance failure that mimics and reinforces a predecessor governance failure, namely the 2015 IOSCO "Code of Conduct Fundamentals for Credit Rating Agencies".

If adopted in current form, the IOSCO recommendations for ESG analytics providers will undermine ESG analytics and sustainability practices in at least two ways:
(1) Providers will be incentivized to dilute ESG content in ESG analytics as comprehensively as credit rating agencies have diluted credit content in credit ratings.
(2) ESG analytics will ossify, rather than evolve organically to suit as many entities around the world as possible.

IOSCO members, such as the US Securities and Exchange Commission (SEC), zealously "regulate" credit rating agencies in accordance with the IOSCO credit rating blueprint. Collectively and individually, the blueprint undermines economies and financial systems by greenlighting credit rating agencies to assign credit ratings that buttress commercial interests at the expense of analytical robustness.

Propelled by the IOSCO blueprint, credit rating agencies inflate the credit ratings of constituent entities and sectors, which in turn distorts debt prices to favour credit rating agency cronies and disadvantage projects with maximum utility. As big-picture corroboration, consider the endemically disappointing economic growth that major economies recorded after 2008 even as the market for credit-rated debt mushroomed.

The IOSCO ESG recommendation and credit rating blueprint both unravel at the first step, namely taxonomy. Business enterprises such as Fitch Ratings, Moody's Investors Service, and S&P Global Ratings, and not government "agencies" or regulated utilities, develop credit rating methodologies, assign new credit ratings, and monitor existing ones. The term "credit rating company" is both more accurate than "credit rating agency" and more instructive on the primary driver of unreliable credit ratings—namely, the unrelenting push by the ultimate owner of each credit rating business to maximize franchise earnings.

Likewise, both the IOSCO ESG recommendation and credit rating blueprint unravel at first inspection, as well as deep review. Neither IOSCO document offers credible mitigation for the business owner conflict of interest. Instead, both documents harp on the much posited but unconvincing premise that rogue analysts and managers are the main distorters of information, be it credit ratings, ESG ratings, ESG credit ratings, or other ESG data products. As a result, the IOSCO ESG recommendation, like the IOSCO credit rating blueprint, tasks business owners of ESG analytics providers to clamp down on potentially rogue staff by establishing processes and procedures for developing the analytics. Conspicuously absent from both blueprints are constraints on the ultimate business owners or reviews of analytical content.

The absences are intentional. IOSCO and members disingenuously claim that "free markets" preclude meaningful regulation of analytical business owners and that "free speech" precludes any and all regulation of content, including demonstrably flawed ratings, methodologies, and other products.

Tying the regulatory gap back to ESG analytics, Fitch Ratings, Moody's Investors Service, and S&P Global Ratings transparently leverage their free speech to post and cite transparently toothless credit rating methodologies that hoodwink users into believing that credit ratings incorporate the credit exposures of ESG factors.

Upping the misrepresentation, the credit rating companies' respective parents are extending their oligopoly into the ESG analytical sector by acquiring formerly independent providers. What might be a system of reliable information is morphing into a mutual admiration society in which neither credit rating companies nor ESG analytical providers critique each other's products.

I submitted a comment on ESG disclosures to the SEC on June 14 that urges the regulator to fix its governance and that of credit rating companies. A good start is to immediately end the charade that the content of credit ratings and methodologies are subject to any scrutiny, let alone meaningful scrutiny. In short: Credit rating users, beware! Be fully aware!

Likewise, IOSCO and members must not direct ESG analytics providers on how to govern themselves unless the goal is to undermine all forms of sustainability as quickly as possible.

Bill Harrington is Senior Fellow at Croatan Institute, an independent, nonprofit research and action institute in Durham, North Carolina. Bill spent more than a decade at Moody's Investor Services, including as a Senior Vice President.