Sustainability put to the test: Stricter regulations for ESG ratings

The European Parliament is sharpening the approach of ESG rating agencies

ESG ratings

Author: House of Eden

  • ESG ratings analyze environmental, social and governance of companies to ensure transparency in their sustainability practices
  • The European Parliament has tightened the rules for ESG ratings to improve reliability and comparability
  • The stricter rules are intended to strengthen trust in ESG ratings and thus help investors identify sustainable companies

Sustainable investments like ETFs or eco-funds offer an opportunity for the environment in many ways. For example, you can use them to support environmentally friendly projects such as renewable energies or efficient use of resources. But how do you really invest your money sustainably? In order to provide guidance, so-called ESG ratings were introduced in 2020. In order to make this assessment tool even more trustworthy, the European Parliament is now tightening its rules. Find out everything about ESG ratings and their current developments here.

What is behind ESG ratings?

With ESG ratings, investors can better decide which company they want to invest in. The abbreviation "ESG" stands for "Environmental, Social and Governance" and evaluates the sustainability performance and social responsibilities of companies.

  • Environment Factors shed light on topics such as the company's ecological footprint, energy consumption, CO2 emissions, environmental impacts of production processes and the use of renewable resources.
  • Social (Social) covers aspects such as working conditions, human rights, diversity and inclusion, job security, labor law and social responsibility towards the community.
  • Corporate management (governance) considers corporate governance and structure, including board structures, transparency, ethical behavior, anti-corruption and compliance with ethical principles.

ESG ratings are carried out by various agencies such as MSCI ESG Research, Sustainalytics from Morningstar or Institutional Shareholder Services (ISS). The information used for the assessment either comes directly from the company itself or is researched independently by the agencies. Companies with positive ESG ratings are perceived as sustainable and responsible.

But how trustworthy are ESG ratings really?

Last year in particular, ESG ratings came under harsh criticism because there are no uniform standards for them. Different rating agencies use different methods and criteria. The result: inconsistencies, varying results and confusion. Some rating agencies also do not provide sufficient information about how they arrive at their ratings. This can further affect investors’ trust in the objectivity and integrity of the reviews.

Action should now be taken against misleading information

In order to at least curb this confusion a little, the European Parliament is now tightening the rules on ESG assessment. The agreement is intended to improve the reliability and comparability of ESG ratings. How? Rating agencies must be approved by the European Securities and Markets Authority (ESMA) before they can carry out the ratings. To this end, transparency requirements must be met and potential conflicts of interest must be avoided. This creates more precise areas of application, spatial scope and more information about the methods used. Rating agencies are becoming increasingly standardized so that there should be less dissonance.

Are ESG ratings even necessary?

ESG ratings are definitely helpful. They provide investors with important information about companies' sustainability practices and identify risks related to environmental impacts, social aspects and corporate governance. Greenwashing is also made more difficult: the stricter procedures give rating agencies less room for interpretation, which puts pressure on companies to improve their sustainability practices. The long-term orientation of ESG criteria also helps to identify companies that could also be economically successful in the long term.

So: ESG ratings are a good approach to making companies transparent about their environmental impact. However, this system does not work if there are large fluctuations among the respective ratings. Tightening the approval of ESG rating agencies is a good step towards transparency and trust.

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