5.5 Sustainability ratings and the ratings’ process

Below in a figure created by the Global Initiative Sustainability Ratings (GISR) (figure 9), the standard-setter who developed a benchmark of excellence for corporate sustainability ratings in harmony with other standard setting entities, we can see the different market participants involved in the world of ESG ratings and how they relate to each other.1 In this figure, the GISR identified the information sources (e.g. assurers, companies), the intermediaries (e.g. raters, researchers) and the users (e.g. indices, investors, regulators) involved in the sustainability information value chain.2 These organizations depicted by GISR are part of a cycle where information is generated, gathered, translated, assured, communicated and rated. All of the ratings market’ participants has their own business model and different responsibilities. Who are the most influential in the ratings industry? Which of these organizations contributes the most for communicating valuable information to capital markets? Is this information cycle working well? Does it deliver material and valid information? Looking at the GISR figure below, we can also see the standard setters. The standard-setters have been set-up to bring a common ground of basic principles to be followed by the organizations to guide them to deliver best practices. For example, the accounting firms are bound by a set of accounting and assurance principles (IAASB) to guide them all in a similar way to the deliver similar quality results; ARISTA does the same for the information aggregators; for sustainability reporting there are different organizations developing standards. The GRI, the International Integrated Reporting Council and the Sustainability Accounting Standards Board (mentioned in the figure below) all work to provide global standards for sustainability reporting. Each of these organizations specializes in different disclosures and different audiences. As for the raters, the GISR is the only organization developing rating standards. The final destination of all the information is the users, e.g. the investors, indices and the regulators as shown in the figure below. These are the main reason for which the information is generated going through a long process of translating it in the most digestible and user friendly way for the users. In any cycle, it is important to have the market participants, responsibilities and objectives clearly defined. In the ratings’ business we often see more than one market participant providing the same service and although intentionally working towards the same goal, not doing it effectively as the tasks, responsibilities and objectives are often doubled. For example, ratings are provided both by raters and by indices; consultancy is provided not only by the researchers but also by the accounting firms (represented as the assurers) and researchers as MSCI also have indices. To prevent double work and miscommunication, the market would benefit from a detailed definition of responsibilities, business models, individual and common objectives, standard- setters and information users. This could be done with a minimum intervention of the regulator as a starting point.

Figure 9 - Sustainability information value chain, with illustrative players and linkages (as provided by GISR).

Source: Global Initiative for Sustainability Ratings3

It will be interesting to understand who is driving the topic forward and fostering the quality of both the ratings and the raters. For now, there are significant efforts from the standard-setter organizations to drive the quality of the ratings and of the raters’ services. In my perspective, all other participants in the ratings industry although active and engaged still need to determine their core responsibilities, long- term objectives and find their unique place in the sustainability information value chain.

Raters gather information about the companies through public available information, directly engaging with the companies, through questionnaires, ESG research providers and also through cross checking information with other raters. The raters develop their own methodologies and strict criteria through which they produce a ranking of the best-positioned companies and sometimes of the worst ESG performances. Different types of ranking have been developed, some are general as the DJSI, and some are very specific, as the CDP (former Carbon Disclosure Project). ESG research providers also play an important role in the ratings industry, providing ESG tools and information to the responsible investment industry.4 These may also include ratings of corporate ESG practices and performance, but also countries’ ESG assessments in areas such as corruption, human rights and environmental protection. This information is used by raters (e.g. sustainability indices and sustainability rating agencies), investors and companies. Companies are often clients of the ESG research providers.

According to the GISR, a rating should apply to all portions of a rated company’s value chain over which the company exercises control or significant influence. The data gathered and published during the rating process is supposed to generate value to all the intervenient in this process. This is called the value chain principle, represented in figure 10 below.

Figure 10 – Ratings Value Chain

Source: SustainAbility “Rate the Raters Phase Four”, pp. 6.5

In figure 10 above, as explained by SustainAbility, each market participant has a clear function and specialization. This specialization is expected to increase efficiency (for raters and companies) and competition in research, analysis and ratings. The companies, research providers, raters and users are all dependent on each other. If attracted by the potential added value of a rating, companies will respond and engage more promptly. As investors are expected to increasingly search for the information which would add more value to their investment decisions. Raters should bring accurate, truthful and material information to capital markets (also forecasting information), adding value through transparently providing this information.