Introduction

The Financial Reporting Council (FRC) recently published an insightful report on the ESG ratings and proxy research market. The report sheds light on the challenges and nuances surrounding the roles and responsibilities of stakeholders within this complex landscape. In this article, we will delve into the findings of the report and address the concerns raised by industry experts, fostering a deeper understanding of the issues at hand.

Understanding Roles and Expectations

One prevalent observation highlighted by industry experts is the significant gulf of understanding and expectations between different parties involved in the ESG ratings and proxy research market. This misalignment can lead to confusion and frustration, hindering effective communication and collaboration. To address this issue, it is crucial for all stakeholders to engage in open and constructive dialogue, seeking common ground and shared objectives.

The Problem of “Correlation and Causation”

Another concern that has reached epidemic proportions is the issue of “correlation and causation.” In the realm of ESG ratings, it is vital to distinguish between the correlation of certain practices with positive outcomes and the causation of those outcomes themselves. Misinterpreting this relationship can lead to misguided decision-making and undermine the credibility of ESG ratings as a whole.

Investor Perspectives and Accuracy Issues

Investors play a crucial role in the ESG landscape, relying on research and ratings to inform their investment decisions. While the FRC’s report suggests that investors value research and do not perceive significant accuracy issues, addressing any potential gaps in understanding is essential. Open lines of communication between investors, companies, and proxy voting service providers can help bridge these gaps, ensuring that research and ratings accurately reflect a company’s ESG performance.

The inconsistencies between company and investor perceptions of proxy research accuracy are particularly stark. A total of 41% of company respondents expressed dissatisfaction with the accuracy of proxy research, whilst only 18% of investors expressed the same dissatisfaction. Of course, these remain significant numbers, but they demonstrate a fundamental misalignment in the perception of the role of proxy research agencies. Discussing this misalignment, the report states “proxy advisor interviewees disputed the claim that their analysis was flawed and argued that it was instead a case of them applying a different interpretation to that of the company.” The percentages above would appear to support this assertion.

Unintended Consequences of Prepublication

One notable concern raised by industry observers is the unintended consequences of prepublication. The anticipation of ESG ratings can lead companies to manipulate their disclosures, tailoring them to what they believe rating agencies and investors are seeking. This practice, commonly referred to as “gaming,” undermines the authenticity and transparency of ESG efforts. Regulatory bodies, such as ESMA and the European Commission, should take note of these unintended consequences and work towards mitigating them through appropriate guidelines and oversight.

The Politicization of Corporate Governance Research

The narrative surrounding corporate governance research and shareholder voting has become increasingly politicized, mirroring the current climate around ESG issues. The report highlights the imbalance of power between market counterparties and the weight of financial resources influencing legitimate opinions. It is crucial to create an environment that respects the role of capital providers and risk takers in stewarding investments. Striking a balance between differing viewpoints and fostering healthy debate is essential for evolving and improving the ESG ratings and proxy research market.

Respecting Stewardship and Continuing the Debate

The FRC’s report serves as a welcome window into the complexities of the ESG ratings and proxy research market. It calls for a respectful and balanced approach that recognizes the importance of stewardship from capital providers and risk takers. The findings of the report should serve as a catalyst for ongoing debate and collaboration among all stakeholders. We can foster a more transparent, accurate, and effective ESG ecosystem by addressing the concerns raised and working towards common goals.

Conclusion

The FRC’s analysis of the ESG ratings and proxy research market provides valuable insights into the challenges companies, investors, and proxy voting service providers face. It highlights the need for improved understanding, standardized regulations, and transparent communication. To navigate the complexities of ESG ratings, it is essential for all stakeholders to engage in open and constructive dialogue, recognizing the significance of accurate research, respect for stewardship, and the unintended consequences that may arise. By continuing the debate and working together, we can foster a more informed and responsible approach to sustainable investing and corporate governance.

Last Updated: 19 June 2023