The coming crackdown on the ESG ratings industry

To start today, I want to highlight our colleagues’ recent interview with the Philip Morris chief executive Jacek Olczak. Big index providers such as MSCI and FTSE exclude tobacco makers from their sustainable indices, but Olczak said the Marlboro maker was charting a path to becoming an ESG stock.

With PMI expanding its vaping business, could the company sell a convincing argument to sustainable investors?

The comments under the story suggest PMI has an awful lot of cajoling to do. As our colleagues point out, cigarettes are the leading cause of preventable death globally.

For today, Kenza has an interview with one of the most important names in ESG. Two years ago, Sacha Sadan made a bold career move. He left Legal and General where he was then the director of investment stewardship to join the Financial Conduct Authority. Now tasked with policing financial companies like the one he left behind, Sadan’s comments on the ESG sector are watched closely. He spoke at our European conference last week and Kenza interviewed him on the sidelines. Please see her conversation with Sadan below.

Also today, I take you on a woodsy walk through the market for wood pellets. Drax, the UK power producer, is expanding its wood pellets production in the US just as Enviva, the world’s largest producer of this fuel source, announced a stumble earlier this month. Please read on. (Patrick Temple-West)

We won’t wait for a crisis to act on ESG ratings, says UK regulator

Data pumped out by the multibillion-dollar sustainability ratings industry is increasingly used to determine whether a company is added to a popular green fund or benchmark.

And while the global giants who score companies on climate and governance risk have so far largely been left to their own devices, the UK is preparing to crack down on how these data providers operate. 

“We’re not waiting for a crisis,” Sacha Sadan, head of environmental, social and governance issues at the UK’s Financial Conduct Authority, told Moral Money last week. The industry has “grown up very fast . . . it’s a very big part of the investment chain now”.

The FCA’s approach will take lessons from the regulatory tightening around credit rating agencies following the 2008 financial crash, when they were accused of underestimating risks linked with subprime mortgages. One of these credit rating agencies, Moody’s, is co-chairing the FCA’s working group on ESG ratings.

“It’s not that hard, because we’ve had it with credit ratings,” Sadan said. Areas of focus include conflicts of interest, market concentration and whether companies should get a “right to reply” if inaccurate data is used about them to build a rating.

A few large companies such as MSCI and Sustainalytics, both based in the US, dominate the ESG rating space. But smaller players are increasingly shaking up the sector with new tech including artificial intelligence.

The concern often raised about ESG data is a lack of internal firewalls clearly separating analysis, sales and consultancy teams. The fear is that analysts paid to assess a company’s climate performance, for example, could be more lenient if their colleagues also need the company’s help to hit a sales target. There is also some confusion about the way ratings are designed, as methodologies are considered proprietary information. 

The FCA is working on a voluntary code of conduct for data and ratings providers, inspired by recommendations that have come out of Japan and the International Organization of Securities Commissions. 

One solution to manage “conflicts of interest” could be to formally separate companies’ consulting and ESG rating arms, “a bit like an audit firm now has to split the advisory and the consulting”, Sadan said. The UK’s largest accounting firms have been told to split into separate business units by next summer, to increase competition and minimise conflicts of interest.

And while the UK government is weighing whether the FCA should have more formal regulatory oversight of ESG data companies, Sadan expects to get a green light soon: “If you’re a betting person, it’s looking good.” 

When asked about the possibility of regulation, MSCI said it would support a code of conduct that promotes best practice and “protects the independence of rating and methodologies”. Arthur Carabia, ESG policy research director at Sustainalytics, said he hoped both regulation and a voluntary code of conduct would allow for more innovation, greater coverage and higher investor confidence.

The regulator is also probing the market for sustainable loans, following concerns that the environmental targets in such deals are too easy for companies to meet, Sadan told me.

But coming down too hard on companies that have cashed in on enthusiasm for green investing in recent years comes with its own risk. Even as anti-ESG political sentiment in the US has caused investors to recoil from green funds, criticism by regulators in Europe designed to improve the quality of ESG products may have scared some companies off climate action.

Greenwashing warnings by the UK’s Advertising Standards Authority and by the FCA last year, along with a rise in lawsuits over corporate sustainability claims, may have led to a drop-off in “excitement” about green finance projects, Sadan admitted. “Companies are seeing this litigation and this risk and are just starting to slow down,” he said. (Kenza Bryan)

Drax crosses the Atlantic

In April, UK power provider Drax made a landmark announcement: the company had eliminated coal from its Yorkshire power station after nearly 50 years of operation. Once the largest coal-fired power station in western Europe, the plant east of Leeds now burns renewable wood pellets for electricity.

But this conversion is proving expensive. On Tuesday, Drax said it was going to America: surveying sites in the US to build new wood pellet facilities to feed its hungry power needs in the UK. Drax said it planned to spend £7bn from 2024 to 2030, helped by tax credits from the US Inflation Reduction Act.

“The planet cannot solve the climate crisis without the combination of reliable, renewable electricity and carbon removal technologies,” chief executive Will Gardner said last week.

But hiking into the world’s forests for power involves dark and deep risks. Drax, the world’s second-largest wood pellet producer, acknowledged that it faces some of the capital expenditure challenges that roiled its rival Enviva earlier this month. The US-based company, which tops Drax as the largest wood pellet producer, was forced to eliminate its big dividend to continue developing wood pellet plants. Its shares are down 60 per cent this month.

“Similar to peer Enviva, Drax has seen significant inflation with regards to new pellet plant capacity capital expenditures,” analysts at Morgan Stanley said in a report on Tuesday. 

Part of Drax’s plan to pay for its biomass efforts includes selling carbon credits. But this effort also carries risks: as Morgan Stanley noted, “the voluntary carbon market continues to face integrity challenges and remains in its nascent stages”. While Drax’s biomass can contribute “relatively high-quality carbon credits”, the market is not very big yet and this serves “as a key uncertainty” for the company’s ambitions, the bank said. 

Drax faces further woes too: in April, the FT reported that the company was under investigation by the UK’s energy regulator over its compliance with sustainability rules. The regulator Ofgem started looking into whether the energy company had complied with the UK’s biomass sustainability rules after a BBC documentary raised questions about whether wood it had procured from Canada was sustainably sourced.

In the EU, the investment thesis for wood pellets providers remains intact. Two years ago, wood pellets were a controversial piece of the bloc’s clean energy plans. Advocates say this source of energy is sustainable and green because it emits only as much carbon as was captured by trees while they were growing — but critics say it can create perverse incentives for deforestation, and is an unhelpful distraction from scaling up solar and wind power. Still, wood pellets have been provisionally included in the EU’s latest renewable energy directive, which is expected to be finalised later this year.

“The [regulatory] backdrop is favourable for biomass and I don’t think there is any inherent threat to the business in the near term,” Jonathan Levy, an analyst at Truist, told us.

Still, some of the world’s biggest impact investors have been burnt by wood pellets. Activist investor Jeff Ubben, who turned to sustainable investing three years ago, has been a big backer of Enviva. Ubben added to his stake late last year after short seller Blue Orca released a report saying it believed Enviva’s profitability was inflated, and predicted that it would have to cut its dividend. Inclusive Capital, Ubben’s impact investing firm, bought $27.8mn of Enviva shares from October through December last year. 

Inclusive Capital’s total stake in Enviva was valued at $165mn at the end of March 2023, according to its latest regulatory filing. Those holdings are now valued at about $50mn, based on the current share price, which has fallen 88 per cent in the past year. (Ubben, who is also on Enviva’s board of directors, declined to comment.)

Though questions about its strategy remain, Drax won applause from analysts after its announcement. Despite a decline in recent months, the UK company’s share price is looking relatively healthy compared with Enviva’s valuation collapse. Drax shares are down 10 per cent year on year, but up 35 per cent from this time two years ago.

“Drax remains our pan-European preferred generator” among renewable and non-renewable companies, Barclays analysts said this week. (Patrick Temple-West)

Smart reads

• From EU energy policy to the “degrowth” debate, and from the green skills shortage to electric grid bottlenecks — this new FT special report digs into some of the hottest topics around climate action and the energy transition in Europe.

• The insurance sector has become enmeshed in the climate culture wars, Kenza reported yesterday with the FT’s insurance correspondent Ian Smith. And for a club of insurers committed to net zero, it’s the anti-ESG forces that are winning.