Environmental social and governance (ESG) factors are increasingly important both globally and in India. ESG investments are now a separate investment class and private equity and venture capital investors often require ESG compliance by their portfolio companies. The law on ESG compliance in India is evolving; the Ministry of Corporate Affairs has issued voluntary guidelines for ESG compliance while the Securities and Exchange Board of India (SEBI) has mandated ESG-related disclosure for the top 1,000 listed companies.
As most Indian companies are not subject to ESG requirements, investors often rely on third-party ESG rating providers (ERP) to determine ESG compliance by portfolio companies. ERPs assess performance on ESG parameters based on the portfolio companies’ initiatives, disclosures and reports, and by directly carrying out due diligence. ESG ratings are new to India, with the first ERP being established in January 2021. As a result, ERPs are presently unregulated.
ERPs do not appear to use uniform assessment criteria and attach different weighting to environmental, social and governance indicators. How ratings are presented also varies internally in ERPs. For example, Thomson Reuters expresses ratings variously as numerals, alphabets and percentiles, and risk assessment is based on a weighting of 34% for environmental indicators such as resource use, emissions and innovation, 35.5% for social indicators including workforce, human rights, community and product responsibility and 30.5% for governance indicators like management, shareholdings and corporate social responsibility strategies. CRISIL, on the other hand, rates companies on a scale of 0-100 with a weighting of 35% assigned to environmental indicators, 25% to social indicators and 40% to governance indicators. Ratings may also be influenced by the ERP’s perception of government data and sector-specific parameters.
While some ERPs score listed and unlisted companies differently, especially in regard to governance factors such as disclosures, board gender diversity and board independence, others fail to take into consideration the regulatory landscape in which the companies operate and apply a uniform standard.
In its final report on Environmental, Social and Governance Ratings and Data Products Providers, the International Organization of Securities Commissions recommended that regulatory authorities take steps to improve the governance and transparency of ERPs, thereby enhancing the reliability, comparability and interpretability of ESG ratings. Over the last year, SEBI has been taking steps towards mandating ESG compliance and, in January 2022, issued a consultation paper proposing a regulatory framework for ERPs that rate listed companies. The consultation paper listed, among other matters, the lack of transparency in methodology and rating, potential conflicts of interests, and the lack of India-specific considerations as reasons for the proposed regulation of ERPs.
SEBI has proposed that ERPs be SEBI-accredited and that only credit rating agencies and research analysts be eligible for such accreditation. Further, SEBI has proposed criteria for the accreditation of ERPs including net worth, knowledge, sustainability, infrastructure, quality of staff and technical know-how. SEBI has proposed two categories of ratings, namely impact rating and risk rating, which will not assess environmental and social risks, while providing that ERPs may also offer other bespoke rating products. To mitigate potential conflicts of interest, SEBI has proposed disclosure requirements regarding the staffing of personnel in consultancy and ESG rating services. Finally, SEBI has recommended that ERPs adopt a subscription payment model to ensure their independence.
The subject of ERP regulation has now been referred by SEBI to an advisory committee on ESG constituted in May 2022.
The proposed regulatory framework for ERPs is a promising move to increase the reliability and transparency of ERPs. However, given the nascent stage of ESG compliance, SEBI has deliberately refrained from spelling out methodologies for producing ratings. It is unclear whether the regulations if implemented will do so. If not, it may be expected that the issues relating to the comparability of ratings and the risks of greenwashing by companies will persist.
Swathi Girimaji is a partner, and Harshita Kakar is an associate at Bharucha & Partners.
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