Governance watchdogs are to probe the impact of ESG ratings agencies and proxy advisers on investors and companies. At least one news outlet this week claimed the review comes as concerns grow in the City that “left-wing ideology” underpins the ratings agencies.
The UK’s governance regulator, the Financial Reporting Council (FRC), is commissioning the review, but declined to comment. However, a tender document published online states that the Stewardship Code already asks investment managers to explain the extent to which they “use the default recommendations of proxy advisers”.
The document suggests that the underlying problem is concern that the “comply or explain” principle underpinning UK corporate governance is being stymied by proxy adviser decision making.
The document goes on to say: “The aim of this research project is to examine how investors’ stewardship and behaviour is affected by those recommendations and ratings.”
The review does come at a time when polarisation around ESG is increasing. There are concerns about the reliability and comparability of ESG data used by ratings agencies, as well as the proliferation of such agencies. There are also worries that ESG will not permit investors to place their money into controversial industries, such as defence or fossil fuels.
Last week HSBC’s global ESG investing chief, Stuart Kirk, resigned after causing controversy with a speech in which he said, “climate change is not a financial risk and nothing to worry about.” The speech led to his suspension. In an earlier outburst, veteran City investor Terry Smith complained about the use of ESG as a guiding star by consumer goods giant Unilever. The company’s position on ESG has been vociferously defended by CEO Alan Jope.
Elsewhere, some argue that companies may “inflate” their ESG performance to boost their ratings. There have been worries about the exaggeration of ESG credentials by companies and investors.
The head of the UK’s environment agency, Emma Howard Boyd, recently warned companies against “greenwashing”. “If we fail to identify and address greenwashing, we allow ourselves false confidence that we are already addressing the causes and treating the symptoms of the climate crisis,” she said.
Meanwhile, new recommendations aim to embed ESG outcomes in better relationships between asset managers and asset owners, such as pension funds.
The FRC reveals that its new research is, in fact, based on complaints that proxy advisers and ESG ratings agencies may be subverting the “comply or explain” nature of the UK’s governance code.
The argument goes that the principle is undermined by an assumption among proxy advisers and ratings agencies that an “explanation” of non-compliance (permitted under the code) is “automatically” considered a reflection of poor governance. This then leads to “negative” voting recommendations for investment managers at AGMs. According to the FRC, companies complain they are often unable to engage with proxies to explain their governance decisions.
The FRC wants to understand the impact of decisions made by proxy advisers and ESG ratings agencies on FTSE 350 “behaviour and reporting” and on investor voting. The watchdog also wants to better understand the conversations that happen between companies and proxy and ESG agencies, as well as between investment managers and the agencies.
The FRC’s actions seem uncontroversial and efforts to badge them a new front in the “anti woke’ agenda appear misplaced. While there is general agreement on some elements of ESG, others are harder to define and even more difficult to turn into policy and metrics. Definitions and outlooks may vary, depending on the institution and industry. ESG looks to be here to stay. Better to understand the relationship dynamics it creates than ignore them.