Regulating ESG rating firms as the gatekeepers for sustainable finance

ESG ratings convey to investors implicitly a backward-looking verification of the original ESG information about a business entity, as well as explicitly a forward-looking, predictive assessment of its ESG performance and impact. Both the verification role and the guiding role make ESG rating firms the gatekeepers of sustainable finance, as they hold back businesses underperforming in ESG from accessing capital markets. Effective gatekeeping is premised on the provision of accurate and reliable ratings, for which the market and regulators need to deter ESG rating firms from misrating and incentivise them to improve the quality of ratings.

ESG ratings are integrated assessments from different aspects. As a compounded effect of the complex, multi-dimensional and variable attributes of ESG issues, as well as the predictive nature of ratings, it is very difficult to ex post verify the accuracy of ESG ratings. Therefore,the costs of poor performance in ratings are low. Neither the market-based reputational capital mechanism nor the disclosure-based regulations currently being proposed can solve this problem. This article proposes a disgorgement scheme, the contribution of which is two-fold: first, it favours the use of proxies for inaccurate ratings to avoid the bottleneck problem caused by the low verifiability of ratings; second, it requires ESG rating firms to have a stake in the negative consequences of their ratings and bear a share of allocative inefficiency, which will generate stronger effects in deterrence and incentives.