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Risk Fraud & Compliance

SEC elevates ESG priority in credit-rating firm exams, some firms push back

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

U.S. credit rating agencies are now facing exam scrutiny over how they compile environmental, social, and corporate governance (ESG) ratings for companies

The Securities and Exchange Commission recently issued an annual report on its oversight of credit-rating firms that for the first time listed ESG rating practices as a key examination focus. The SEC staff report also looked at other event-driven issues such as the impact of the pandemic, crypto-assets, and cybersecurity as ratings concerns.

The report did not cite any specific deficiencies arising from ESG-rating practices. It focused, however, on compliance risks the SEC staff sees emerging in the practices of the credit rating firms, or nationally recognized statistical rating organizations (NSROs), adding that the agency will look at such practices in future examination cycles. The risks increase as NRSROs extend their services into non- regulated businesses where they could face conflicts of interest.

SEC Office of Credit Rating Director Ahmed Abonamah said his unit uses “a comprehensive and integrated overview” in regulating the industry. The SEC in April signaled increased concern over ratings industry ESG practices with its Division of Examinations Review of ESG Investing report that cited the need for rating-agency disclosure. That report listed dozens of potential compliance deficiencies in ESG practices of the investment industry.

Earlier annual reports on credit rating agencies had focused on issues such as conflict of interest management, ethics policies, internal controls, and governance. The new staff report ventures for the first time into ESG and other content offerings in both regulated and non-regulated formats.

The SEC cited potential concerns of cross-selling operations, in which credit-rating firms mingle regulated services with new research products. It saw the need for ratings firms to put protections in place to prevent them from giving favorable ratings to firms the subscribe to new products.

The agency saw potential ESG-related examination deficiencies if rating firms’ ESG methodologies fail to include documentation, rely on third-parties for research, or lack the staffing and expertise to meet long-established SEC requirements.

Some ratings firms push back on ESG role

The study included comments by some of the covered rating firms that pushed back on the agency’s effort to nudge firms to play a larger gatekeeping role in ESG research.

The skeptical views expressed echoed the prior SEC administration’s reluctance to impose ESG benchmarks based in part on the use of subjective, qualitative measures that are harder to standardize than financial performance and balance-sheet data.

Amid booming investment in so-called sustainable funds, however, the SEC has heard calls from investor groups and some asset managers to provide guidelines for ESG claims in formats that make it possible to compare performance. And the SEC has warned the securities industry that it will monitor a range of sources to flag inconsistent or misleading ESG disclosures.

In recent years, regulated credit-rating firms have added significantly to the flow of ESG information. Many offer ratings, or “evaluations,” to guide to investors’ growing demand for guidance. The agencies sometimes use subsidiaries specializing in ratings for ESG investors in specific asset classes.

The SEC report noted pushback from firms concerned that the regulator is increasing scrutiny over ESG practices before it has new rules in place. The SEC cited the view of Kroll Bond Rating Agency that ESG is “best examined through the lens of risk management analysis for corporate, financial institution, and government debt issues and issuers.” Kroll added that in its credit ratings it “does not deploy subjective value-based ESG scoring rubrics.”

Credit-rating firms have offered varying comments on ESG activities, the SEC said. One covered firm cited in the SEC report, DRBS Morningstar, published research on “the potential impact of climate change on portfolios” that include power plants or risks to power suppliers “due to more frequent weather-related outages caused by climate change.”

No ban on special reports

The SEC report noted that there is no rule prohibiting rating firms issuing such analysis outside of their statistical ratings models and that special reports on topical issues would generally not be considered covered by NRSRO regulations.

But the agency also warned of regulatory risk if firms issue content in ways that imply or certify statistical ratings standards in non-regulated content. The SEC also cited other ESG compliance concerns that it drew from examinations and staff monitoring, including:

      • inconsistency in adhering to methodologies or policies and procedures;
      • inadequate disclosure regarding the use of ESG factors applied in rating actions;
      • lack of effective internal controls involving the use in ratings of ESG-related data from affiliates or unaffiliated third parties; and
      • the need to manage potential conflicts of interest if an NRSRO offers ratings and non-ratings ESG products and services.

The SEC report was the latest signal of the wide-ranging efforts of regulators to adopt the Biden Administration’s push for agencies to use their regulatory clout to promote investing in climate-change mitigation efforts, sustainability, and social concerns such as racial and gender bias.

The report also showed the SEC and the credit-rating industry taking ESG concerns seriously as ways to better promote transparency and accuracy that serves “their credit ratings businesses, and the market more broadly,” said SEC Chair Gary Gensler, adding that ratings firms performed a gatekeeper role that is “critical to the Commission’s focus on investor protection.”

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