Policy guidance can help improve ESG market practices to support sustainability

Progress

Over the past decade, the use of Environmental, Social, and Governance approaches to assess investment risks and opportunities, and shape asset selection decisions, has become a leading form of sustainable finance. As of 2021, portfolios influenced by ESG investing approaches, such as ESG Integration, exceeded $40 trillion AUM by certain measurements.¹  In parallel, stock exchanges across advanced and emerging market economies have increasingly called for disclosures of ESG factors, and more than 80% of the market capitalisation of exchange-listed companies have an ESG score by at least one prominent ESG rating provider. ESG practices have grown across markets for several reasons, including the demand from end investors and other stakeholders to better understand how companies and financial institutions navigate environmental and social impact. This is particularly the case due to concerns over growing climate physical and transition risks, and the devastating effects of Covid-19 on employees. At the same time, businesses and institutional investors are broadly embracing ESG integration as an approach to embed forward-looking medium-term factors into the assessment of risks and opportunities to safeguard long term enterprise value. This is welcome progress, driven largely by market-initiatives and evolving client demand.

Challenges

While sustainable finance approaches are increasingly used by financial market participants, a number of challenges continue to impede the efficient allocation of capital to support sustainability objectives, including management of climate physical and transition risks. ² These challenges include limited transparency and comparability of ESG methodologies and metrics. In particular, the types of metrics used, their number, and weightings of such metrics vary enormously, and contribute to certain individual corporate entities being rated as an ESG leader by one ESG rater and a laggard by another rater.  OECD analysis found that, in aggregate, this has resulted in very low correlations of ratings of issuers across major ESG ratings providers, and raises questions as to the meaning and usefulness of such ratings for investors.³ In this context, ESG funds rated highly based on ESG scores of underling investments have not outperformed low-ESG rated funds over the past five years. Moreover, our assessment found a bias that firms with large market capitalisations were more likely to receive higher ESG scores, and smaller firms were less likely to receive high ESG scores, all else equal. To the extent that very large firms have greater resources to invest in ESG-oriented assessments and communications, this finding suggests that efforts should be made by exchanges and financial authorities to improve ESG capacity building among small and midsized companies to facilitate ESG reporting. This effort could include guidance on how to utilise metrics that are more readily available or less complex to calculate, which in turn could improve active reporting, quality of metrics, and enhance ESG ratings, thereby improving market efficiency.

Evidence from the environmental pillar score of ESG ratings sheds light on what it can and cannot contribute to support investment decisions. Certainly, ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies with respect to environmental and physical climate-related risks to the firm, and firms’ own risk management approaches, including metrics that measure environmental awareness, governance, and biodiversity. Yet, OECD research illustrates that the environmental pillar scores of ESG ratings of major providers often do not correlate with lower levels of overall greenhouse gas emissions or carbon intensity measures.⁴ In fact, for some ESG rating providers, high environmental pillar scores are often associated with higher absolute carbon emissions. Moreover, a comparative analysis of such scores with climate transition data from transition framework providers indicates that firms receiving higher “E” scores are more likely to acknowledge environmental risks and communicate policies to mitigate such risks, yet there is little evidence of progress in reducing emissions or carbon intensity.⁵ In this respect, such findings suggest that E scores may not necessarily be suitable for investors seeking to better align their portfolios with low carbon economies, and they may wish to combine ESG ratings with other tools to more effectively assess the alignment of their portfolios with the Paris Agreement.

Policy guidance to improve disclosure and market practices

Given the disparate range of ESG data and metrics being utilised in markets, policies are being considered to foster global comparability and interpretability of ESG approaches, as well as to strengthen the methodologies that underpin disclosure, ratings, and valuations in financial markets associated with ESG factors that contribute to long-term enterprise value and sustainability goals.

To this end, a measure of progress is being made in international fora with respect to disclosure, ratings approaches, and integrity of market products labelled ESG. The IOSCO⁶ report on Environmental, Social and Governance Ratings and Data Products Providers provides recommendations for securities markets regulators as well as ESG ratings and data products providers, users of ESG ratings and data products, to consider various factors related to issuing high quality ratings and data products, including publicly disclosed data sources, defined methodologies, and high levels of transparency.⁷ In turn, following a recommendation by the G20, at COP26 the IFRS⁸ Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB) to deliver a global baseline of sustainability disclosures to meet capital market needs, and has produced an exposure draft on climate-related disclosures, which is positioned for implementation in 2023. Efforts are being made by financial authorities and regulatory bodies to strengthen principles and taxonomies, depending on jurisdiction, to strengthen market integrity of the labelling and functioning of traded products, such as labelled green and climate funds and ETFs⁹.

In parallel, in 2022 the OECD developed policy guidance on market practices for ESG investing and to finance climate transition.¹⁰ It is a principles-based approach that serves policy makers and market participants, from financial authorities to ESG ratings providers to asset managers. In particular, the recommendations support policy makers in voluntarily engaging to strengthen ESG investing and climate transition practices, notably through the development of high-quality disclosures, metrics, ratings, targets and frameworks.

The OECD recommendations with respect to ESG seek to improve the transparency and credibility of ESG rating methodologies and promote market integrity. These policy recommendations encourage global comparability and quality of ESG metrics and approaches, such as through mandatory disclosure; and transparency of ESG rating methodologies to clarify and strengthen the high-level purpose of each of the alignment of each of the ESG pillars with long-term value and sustainability goals. As well, policy makers, financial authorities, central banks and other relevant authorities should encourage transparency and comparability of climate-related factors in the environmental pillar of ESG ratings, and encourage improved quality and integrity of metrics used by ESG rating providers to achieve climate-related objectives. As well, they should strengthen the availability and use of reliable, comparable and high-quality data to assess climate risks and opportunities in line with global baseline standards. Also, policy makers can consider ways to strengthen the quality of climate-related data used by market participants, as well as develop mandatory disclosure requirements and improve climate transition plans. Importantly, the guidance calls for science-based interim net-zero targets to ensure that transition plans and supporting material are credible in supporting markets in effectively allocating capital and managing climate-related risks. In this context, market efficiency and integrity are critical to ensure that capital is effectively allocated to support sustainability goals and low-carbon transition, and safeguard financial stability, while delivering long-term enterprise value.

The OECD’s policy recommendations for market practices on ESG investing and to finance a climate transition are complemented by OECD policy guidance on corporate transition plans, to improve credibility of environmental integrity in pathways and interim targets. Together, these policy recommendations for markets and corporates contributed to the development of the G20 Sustainable Finance Report 2022 which contains recommendations for scaling up transition finance, and supporting credible transition plans in the financial sector.¹¹ Yet, more work is needed at both global and national levels to turn guidance on reporting, ESG ratings, and sustainable finance products into good practices and, where appropriate, market regulation to ensure further scaling up of sustainable finance is supported by transparency, investor confidence, and market integrity.