Co-authored with Sudarshana Basu (Associate), Finsec Law Advisors
A growing global demand for sustainable business practices amongst investors, regulators and issuers alike, especially fuelled by the Covid19 pandemic, has shifted the focus on sustainability interventions. In fact, a Bloomberg report published in 2021 anticipated a rise in the global ESG assets to more than USD 50 trillion by 2025, constituting roughly a third of the total projected assets under management. Moreover, a subsequent PWC global survey conducted in 2022 reported ESG outcomes as a priority for investors while taking investment decisions.
Naturally, this increasing demand for integrating ESG factors into a company’s projected growth should be met with consistent and reliable disclosure of ESG information to market participants. Given the subjectivity of information that comprises ESG, coupled with the difficulty of measuring the impact of such factors, getting access to comprehensible ESG information that could be used to predict a company’s future performance could be challenging. ESG ratings, therefore, seek to address this gap by evaluating the performance of a company and its capacity to address ESG related risks and rendering an objective ESG score. Third-party service providers such as Sustainalytics, ESGRisk.ai ratings, MSCI offer such ratings which are relied upon by investors to gauge ESG performance.
In the past decade, many service providers have entered the ESG ratings industry, albeit without a regulatory oversight, or a uniform approach or benchmark for ESG ratings. The International Organization of Securities Commissions in its 2021 report had thus recommended securities regulators to increase scrutiny over ESG rating providers or ERPs. Following this, SEBI released a consultation paper on January 24, 2022 proposing accreditation of ERPs and disclosure of ESG rating methodologies. Upon receiving public feedback, the market regulator issued a draft framework on February 22, 2023, which was approved by the board of SEBI on March 29, 2023. While the actual text of the framework is yet to be notified, the approved framework seeks to regulate ERPs under the existing framework for credit rating agencies.
It should be noted that the term ESG ratings, however, lacks a common definition. In fact, one of the challenges to promoting the use of ESG ratings, as identified by the European Securities and Markets Authority in its July 2020 consultation report, is the lack of a legally binding definition and comparability amongst service providers. While on one hand ESG ratings are sought to measure a company’s impact on the welfare of its stakeholders (impact ratings), another view suggests that ESG ratings should assess the impact societal and environmental issues have on the company (risk ratings).
The framework approved by SEBI seeks to encompass both of the above, by defining ESG Ratings as “the broad spectrum of ratings products that are marketed as providing an opinion” regarding a listed or proposed to be listed entity, on “its ESG profile or characteristics or exposure to ESG, governance risk, social risk, climatic or environmental risks or impact on society, climate and the environment” based on a “defined ranking system of rating categories”. While the above definition offers clarity regarding the applicability of the framework on a vast number of service providers currently operating in the ESG space, it also allows ERPs to build on comparable methodologies and adopt flexible metrics depending on investors’ goals and expectations.
The flexibility to adopt metrics geared towards investor expectations is further supported by the fact that SEBI has permitted ERPs to opt for a subscriber-pays business model, meaning thereby that the detailed rating rationale and report in relation to a particular entity would be available to only those who pay for it. In its February 2023 consultation paper, SEBI had recommended that ERPs can opt for either issuer-pays or subscriber-pays model; however, a hybrid model would not be allowed. In our view, a subscriber-pays model would allow investors greater access to customized analysis in tune with their goals and also mitigate any conflict of interest that is usually found with issuer pays model. However, the problem with this model lies in getting companies to provide complete and accurate information to ERPs. This could be solved by mandating ERPs to frame a set of “terms of engagement” with the company for efficient procurement of information.
The recent consultation paper also seeks to classify ERPs under two broad categories for the purposes of registration with SEBI, on the basis of their activities. While Category I ERPs would be subject to higher net worth requirements of INR 5 crores and stricter promoter eligibility requirements, Category II ERPs are required to maintain a minimum net worth of only INR 10 lakhs as well as lesser eligibility and infrastructure requirements. While both categories can offer ESG Ratings on listed or proposed to be listed securities, only Category I ERPs would be permitted to certify green debt securities. Though this column has always spoken against capital requirements for intelligent work (as opposed to capital intensive work), lower eligibility requirements for Category II ERPs would thus encourage new entrants specializing in evaluation of such non-financial parameters to get registered with SEBI.
Another welcome feature of the new framework is the ‘BRSR Core’ format of disclosure, which comprises select key performance indicators assessing environmental, social and governance attributes. From FY 2022-2023 onwards, the top thousand listed entities by market capitalization are bound to furnish a Business Responsibility and Sustainability Report, which disclose a listed company’s performance against ESG parameters based on the principles contained in the National Guidelines for Responsible Business Conduct adopted by the Ministry of Corporate Affairs in 2020. These encompass principles guiding conduct of business in an ethical, sustainable as well as transparent and accountable manner.
To increase credibility of such BRSR disclosures and minimize green-washing, the BRSR Core format focuses on around 49 parameters, which have been identified as critical areas under each ESG attribute, and listed entities would be required to seek ‘reasonable assurance’ on their performance on such parameters. These KPIs include usage of quantifiable metrics and intensity ratios to allow for global comparability between reports provided by companies, for example, green-house gas emissions, waste generation, etc. At the same time, they focus on disclosure parameters based on India specific social and environmental challenges such as job creation in smaller towns, gross wages paid to females as a percentage of total wages, etc.
With respect to assurance on such KPIs, a separate category of ‘Core ESG Ratings’ shall be provided by ERPs based on the BRSR Core disclosures. This would in turn allow ERPs to create standardized rating products and afford credibility to disclosures made by companies. While top 250 listed entities based on market capitalization would have to obtain reasonable assurance on the stipulated KPIs from FY 2023-24 onwards, SEBI envisages subjecting top 1000 listed entities to the BRSR Core regime by FY 2026-27.
The BRSR Core disclosures shall also include disclosures pertaining to supply-chain of a company, as per SEBI’s recommendation. Supply-chain disclosures would include use of natural resources, employment practices, emissions and wastages associated with supply-chain or partner entities. However, considering the complexities involved in measuring and tracking of ESG metrics of partner entities, most of which may be small enterprises, SEBI has proposed to include BRSR Core for supply-chain of listed entities based on certain thresholds, to be subsequently specified by SEBI.
Further, SEBI aims to introduce a host of measures for ESG schemes, including investment of at least 65% of AUM in listed entities where BRSR Core assurance is obtained and disclosure of voting decisions, etc.
With the above framework, SEBI seems to adopt a balanced approach to address the complexities involved in complying with the extensive BRSR framework, as well as eliminate the risks of green-washing and mis-selling typically associated with ESG investments which has driven a lot of cynicism about the legitimacy of an ESG lable. A substance-based approach, rather than a tick-box set of disclosures, may be more beneficial to all stakeholders taking initiatives towards sustainability and social welfare.
This article was first published in the Financial Express: Link