Address the challenges of doing ESG ratings at the onset

News: Recently, the Securities and Exchange Board of India (Sebi) has come out with a paper on how credit-rating agencies (CRAs) should go about ESG exercise.

The article says there is need of proper assessment before allowing CRAs to become ESG rating agencies.

How Environmental, Social and Governance (ESG) investing is becoming the ‘next big thing’?

ESG compliance is becoming very important. The government is talking of issuing sovereign green bonds and the recipient of funds must be green-compliant. Foreign investors are keen to invest in ESG-complaint firms.

Is ESG exercise trivialized?

One, all companies claim that they are doing a lot for the environment. But while businesses say they have changed bulbs and use auto switch-on/off power devices, they make employees work beyond office hours, which consumes a lot of power with large servers running overtime.

Two, social responsibility is also unclear. During the pandemic, private companies with big reserves sacked employees or made them take pay cuts. Also, the top management corner more benefits in terms of increments.

Three, governance write-ups can also be questioned. It is well known that in some owner-driven businesses, even reputed directors are mere dummies. Also, typically members spend no more than 24 hours a year, earn ₹12 lakh upwards, and are not really interested. For instance, a recent episode of a stock exchange’s governance.

Why CRA cannot do the ESG rating job?

First, CRAs face problems with getting data from companies when they rate debt. The number of ‘Issuer not cooperating’ cases for surveillance has increased manifold. Once such firms procure a rating, their continued cooperation is not easy to obtain. For example, the recent announcement of entrusting CRAs to check the use of initial public offering (IPO) proceeds has drawn mixed reactions.

Second, there is an inherent conflict of interest. If a large company that pays a CRA, say, ₹5 crore in fees for a debt rating also asks for an ESG rating, then the risks of a compromised assessment cannot be ruled out.

Third, CRAs have little competence in evaluating environmental and social impacts. Some CRAs are talking of using artificial intelligence and machine learning for rating operations. It can be disastrous because algorithms will use annual-report data that can’t always be taken at face value. Hence, humans must decide ratings, not machines.

What is the way forward?

First, SEBI should mandate that ESG rating jobs be done by research institutions that specialize in ESG assessments.

Second, if CRAs have to be involved, it should be selective. Those CRAs should be specially qualified for the task. An external rating panel with experts in these fields should be compulsory until the system stabilizes.

Source: This post is based on the article “Address the challenges of doing ESG ratings at the onset” published in Livemint on 22^nd Feb 2022.