Regulatory Landscape for ESG Rating Providers in India

Kiran Malik

10 Apr, 2023

The COVID-19 pandemic has highlighted the importance of sustainability and responsible business practices, leading to increased focus on Environmental, Social, and Governance (ESG) standards globally. In India, the regulatory landscape for ESG is evolving, with the Prime Minister expressing support for high ESG scoring companies. However, there is currently no specific legal regime governing ESG ratings and ERPs are not under regulatory supervision. To address this, SEBI has released a consultation paper on ESG Rating Providers for Securities Markets, aiming to establish a regulatory framework. In this blog, we will explore the regulatory landscape for ESG rating providers in India, the challenges in the current system, and the proposed framework in the SEBI consultation paper.

ESG Ratings and the Need for Regulation:

1. Lack of Definition: The absence of a standardized definition for ESG ratings creates uncertainty and inconsistency in the industry. While there are various methodologies and approaches used by ERPs to assess ESG performance, there is no globally accepted definition or standard. This lack of clarity can lead to discrepancies in ratings and interpretations, making it challenging for investors to compare and evaluate companies based on their ESG performance.
2. Importance of ESG Ratings: ESG ratings have gained increasing importance as investors and stakeholders demand more transparency and accountability from companies in their ESG practices. ESG ratings provide a quantitative and qualitative assessment of a company’s performance in key ESG areas such as environmental impact, social responsibility, and corporate governance. Investors use these ratings as a tool to assess the long-term sustainability and resilience of companies, and to align their investment decisions with their ESG objectives. Companies with higher ESG ratings are perceived as more sustainable and responsible, which can attract investment capital and positively impact their reputation in the market.
3. Comparison with Credit Ratings: The comparison of ESG ratings with credit ratings provided by credit rating agencies highlights the growing importance of ESG factors in investment decision-making. Credit ratings assess a company’s creditworthiness and ability to meet financial obligations, while ESG ratings provide insights into a company’s ESG performance and potential risks and opportunities. The analogy drawn by IOSCO between credit ratings and ESG ratings underscores the increasing significance of ESG considerations in evaluating a company’s overall performance and risk profile.
4. Complexity of the Market: The market for ESG ratings and assessments is still evolving and can be complex due to the lack of standardized methodologies, data quality issues, and potential conflicts of interest. ERPs employ different approaches and criteria for evaluating ESG performance, which can result in varying ratings for the same company. Moreover, the availability and reliability of ESG data can be inconsistent, making it challenging to ensure accurate and reliable ESG ratings. Additionally, conflicts of interest may arise when ERPs are paid by the companies they rate, potentially impacting the impartiality and credibility of the ratings.
5. Proposals by IOSCO: IOSCO’s proposal for regulatory oversight of ERPs highlights the need for greater scrutiny and supervision of the ESG ratings industry. Regulators can consider examining the use of ESG ratings and data products, as well as the activities of ERPs, to ensure compliance with established organizational, conflict of interest, and transparency requirements. This regulatory oversight can help enhance the integrity and reliability of ESG ratings, provide greater transparency to investors, and promote confidence in the ESG market.
6. SEBI’s Acknowledgment: SEBI’s recognition of the need for a transparent and regulated environment for ERPs in India underscores the growing awareness and importance of ESG considerations in the country’s financial markets. SEBI acknowledges the interests of all stakeholders, including investors, companies, and the wider society, in ensuring that ERPs operate in a transparent and accountable manner. This acknowledgment reflects the regulatory commitment to creating a conducive environment for ESG ratings and aligning them with broader sustainability goals.

Proposed Framework by SEBI

1. Accreditation: SEBI has proposed accrediting Environmental, Social, and Governance (ESG) Rating Providers (ERPs) in India for assigning ESG ratings to listed entities and securities. Listed entities and SEBI-registered entities like mutual funds or Alternative Investment Funds (AIFs) must use only SEBI-accredited ERPs for ESG ratings. Index providers using ESG ratings for formulating indices on Indian securities are also required to use services of SEBI-accredited ERPs. Eligibility requirements for accreditation include minimum net worth, skilled manpower, and necessary infrastructure, along with meeting SEBI’s “fit and proper person” criteria under SEBI (Intermediaries) Regulation, 2008^[1]. Credit rating agencies and research analysts registered with SEBI can also act as ERPs, subject to meeting the accreditation criteria.
2. Classification of ESG Rating Products: SEBI has proposed that accredited ERPs should offer at least one of the following rating products to ensure the consistent use of terminology in ESG ratings:
   • Impact ratings, which assess the positive and negative impact of companies on the environment, society, and corporate governance profiles.
   • Risk ratings related products, which assess a company’s resilience to ESG-related risks and the impact of social or environmental issues on the company’s enterprise value, further classified as ESG corporate risk ratings or ESG financial risk ratings
   • Any other category of ESG-related rating products that are appropriately labeled, such as ESG fund ratings or carbon risk ratings.

3. Standardization: While standardized rating scales have not been proposed at this stage, accredited ERPs are recommended to consistently apply their ESG rating scales and disclose on their website the ESG rating reports and rating scales (symbols and their definitions) used by them. Credit rating agencies and research analysts, if accredited ERPs, are required to ensure there is no confusion between ESG ratings and their other offerings such as credit ratings.
4. Transparency: The proposed framework requires ERPs to disclose various information, including the type of ESG rating products offered, rating methodology for all products, data and information sources relied upon when actual data is not available or publicly disclosed, a statement that ESG rating is not a recommendation to buy, sell or hold any security or financial instrument, sector classification standard followed, and other relevant disclosures up to at least two levels of sector classification. ERPs are also required to disclose their policy on managing conflict of interest, conduct annual evaluation of ESG rating methodologies, including definition of individual components of ESG, Key Performance Indicators (KPIs), weightage of each KPI in the rating report, and how incomplete and unreliable data inputs are dealt with.
5. ESG Rating Process: SEBI has proposed steps to be followed by ERPs to ensure a proper rating process, including consistent application of rating methodology for the same product across ESG ratings, in-depth rating research to support evaluations, exercising due diligence and independent professional judgment for objectivity and independence, maintaining an efficient system to track material ESG-related developments, continuous surveillance of ESG ratings, and prompt review of ratings after any ESG-material event. The framework also includes requirements related to personnel and specialist committee for the rating process, and formulation of an operations manual or internal governing document as a comprehensive guide for criteria, policies, and procedures related to the ESG rating process.
6. Reporting and Disclosures: The proposed framework mandates ERPs to publish ESG rating reports on their websites, along with the rating rationale, methodologies, and any limitations or caveats associated with the ratings. ERPs are required to maintain archives of their published ESG rating reports for a minimum of five years. The framework also requires ERPs to periodically review and update their methodologies and disclose any material changes in their rating methodologies, along with the reasons for such changes. ERPs are further required to disclose their policy on data confidentiality and information security, and ensure that their processes are in compliance with applicable data protection laws.

Conclusion

In conclusion, SEBI’s proposed framework for ESG ratings in India aims to establish a credible and transparent ecosystem for ESG ratings through accreditation of ERPs, standardization of rating products, transparency in the rating process, governance measures, and reporting requirements. The framework emphasizes accuracy, independence, and integrity in ESG ratings, with a focus on mitigating conflicts of interest, ensuring data confidentiality, and promoting transparency through disclosure of rating rationale and methodologies. Overall, this framework is a significant step towards enhancing the quality and reliability of ESG ratings in India, fostering sustainable and responsible investing practices, and contributing to a positive impact on the economy, society, and environment.

Also Read:
ESG and Sustainable Development: How are they Related?
Future of Environmental, Social, and Governance (ESG): Emerging Trends and Opportunities for Investors