Rethinking the rush to regulate ESG rating providers

Stringent new rules for environmental, social and governance (ESG) ratings reveal a fundamental misreading of what these ratings are for, and regulatory resources could be better directed elsewhere, argue Deepak Kumar, Gourishankar Hiremath, Jitendra Mahakud and Sangeeth Selvaraju.

The demand for information on companies’ environmental, social and governance (ESG) practices has increased dramatically in the past decade, driven by institutional investors, regulators and wider society keen to assess corporate commitments to sustainability and the management of ESG-related risks. Multiple participants have entered a new market to provide this information, from traditional credit rating agencies launching specialised ESG arms to new sustainability-focused entrants.

These diverse providers, including data aggregators and ESG rating providers, offer varying perspectives on companies and different products for investors. The rapid growth in the number of ESG rating providers (ERPs) has led regulators to draw analogies between ERPs and credit rating agencies, viewing the expansion of ESG ratings as a possible source of systemic financial risk. The International Organization of Securities Commissions has recommended enhanced oversight of ERPs over concerns about transparency and conflicts of interest, and policymakers around the world now advocate the regulation of ERPs as gatekeepers of sustainable finance.

Regulators are applying stringent oversight of ESG ratings similar to that historically applied to credit ratings, evident in the EU’s authorisation requirements and India’s licensing regime. But a question remains: are we addressing the right challenge by focusing regulatory efforts on ERPs?

ESG ratings are not credit ratings

The premise that ESG ratings carry systemic importance comparable to credit ratings warrants examination. Credit ratings serve a specific, well-defined purpose differentiating creditworthiness and predicting the probability of default. We can measure their accuracy by seeing whether the rated entity actually defaults, providing a clear binary check for validating and back-testing ratings. The 2008 financial crisis showed how failures of credit ratings can cascade into systemic risk.

ESG ratings operate in a different space. There is no single target variable against which their performance can be measured. Studies linking ESG strategies to corporate goals such as credit quality, share-price returns, profitability, cost of capital and reputation have produced mixed and inconclusive evidence. This is not a bug, but an inherent feature. ESG ratings are multidimensional, stakeholder-focused and dependent on context. Some investors weigh environmental impact most heavily, others social factors. Climate-focused investors, by contrast, are less interested in a company’s impact on the environment than the environment’s effect on the company’s valuation.

ESG rating providers are equally diverse. Some emphasise values-based or ethical screening – for example, excluding companies with links to tobacco, weapons or with poor labour practices; others are climate-focused; some weigh a firm’s impact on the environment, others the environment’s effect on the firm; and some include assessment of corporate transition plans. This methodological diversity produces lower correlations between ERPs than between credit rating agencies. Such rating disagreement is not evidence of incompetence, but a result of different ERPs measuring different things for different stakeholders, allowing investors to find ratings aligned with their specific concerns.

A misconception about investors’ behaviour

The increasing regulation of ERPs appears to rest on the assumption that investors rely heavily on ESG ratings, as they do on credit ratings in fixed-income markets. This analogy is misplaced as the yield curve that prices a fixed-income security is primarily determined by credit ratings, whereas ESG-linked investments are not. ESG factors instead complement financial metrics, market conditions, industry trends, management quality and competitive positioning. Within ESG itself, investors examine many data points, from carbon intensity to board diversity. The single score is a high-level indication, rarely used in isolation.

The evidence on how ESG ratings are used is nuanced. A survey in 2020 found ESG ratings were the most frequently referenced source investors used to gauge ESG performance, cited by around 55% of respondents and on a par with direct company engagement. Yet survey evidence also shows that investors treat ESG ratings as one input among many rather than a decisive screen. Ratings are influential, sometimes disproportionately so, for investors lacking in-house capacity. But they rarely operate as the automatic, mechanical trigger that credit ratings do in fixed-income markets.

Most large institutional investors have established in-house ESG capabilities, generating their own scores, conducting due diligence and engaging companies directly. Among the most sophisticated investors, this dynamic pushes ESG ratings toward being self-correcting, since unhelpful ratings are discarded. But self-correction is uneven, and some sizeable allocators place outsized reliance on third-party ratings. This situation, rather than justifying a credit-rating-style licensing regime, points to a narrower need for transparency and integrity in how ratings are built and then used.

Empirical research also suggests ESG scores may facilitate access to capital markets, particularly bond markets. Companies with higher ESG ratings tend to reduce their level of borrowing and rely more on market-based instruments, an effect stronger for companies with major institutional investors compared with companies with a single owner or sponsor (promoter-controlled). If ESG scores create value by improving market access, that itself gives firms a natural incentive to improve their ESG performance and disclosure, without heavy regulation of ESG raters.

The systemic risk: a reality check

Regulators have finite resources and there are pressing priorities related to systemic risk, including climate-related financial risks, cybersecurity, digital currencies, AI and geopolitical risk. The ESG rating industry, by contrast, does not transmit risk through the financial system in the same way.

There is no ESG equivalent to the AAA-rated assets that proved worthless in the 2008 financial crisis, taking down major institutions. ESG ratings inform decisions, but they do not determine capital requirements or investment eligibility. Intervention premised on protecting investors from ERPs may even dull the incentive of capable investors to do rigorous analysis, while doing little for those who rely too heavily on ratings. Greater transparency on what ESG ratings measure would be more helpful for investors.

Where should regulatory resources be directed?

Resources spent on ERP oversight would be better used improving corporate sustainability disclosures and their measurement, reporting and verification. This is also the most effective way of addressing greenwashing: unsubstantiated environmental claims are defeated not by regulating raters, but by ensuring transparency around the actual use of funds and measurable impact. Standards such as those from the International Sustainability Standards Board tackle the root cause – information asymmetry – by making sustainability information standardised, comparable and auditable, so that investors can form their own assessments.

But these can be handled through existing securities regulation and voluntary codes. The International Organization of Securities Commissions itself favours a principle-based approach rather than a prescriptive one, and the EU’s and India’s stricter regimes, while well-intentioned, may inadvertently restrain innovation in an evolving field.

The Indian experience is instructive. Stringent licensing led several established global ERPs to exit the market rather than compromise their methodological independence, creating space for domestic providers with shorter track records. The result was less diversity of perspective for investors with different ESG priorities, undermining the very market efficiency regulators sought to enhance.

Regulating the fundamentals to serve investors better

The move to regulate ERPs may reflect a category error, applying a credit-rating framework to ESG ratings despite fundamental differences in their objectives, measurement and use.

The heterogeneity of ESG ratings, the very feature that makes them valuable, is also their central risk when investors over-rely on a single score. That warrants a fit-for-purpose role focused on the integrity and transparency of methodologies and clarity on conflicts of interest, not on authorising who may issue a rating. The priority is robust regulation of the fundamentals: disclosure, verification, taxonomies and enforcement against greenwashing, coupled with targeted transparency requirements for raters. This will serve investors and society better than a hands-off market or a credit-rating-style licensing regime.