LONDON: Vladimir Putin’s invasion of Ukraine is shining the spotlight on the largely unregulated business of environmental, social and governance (ESG) ratings, after investments billed as socially conscious bought into a regime that’s now being accused of war crimes.

       On the eve of the invasion, about US$9.5bil (RM40.09bil) in funds meeting European ESG standards were in Russia, often on the basis of ratings from companies such as Sustainalytics and MSCI Inc.

       While ESG raters weren’t alone in misjudging Russia’s belligerence, their exposure is particularly awkward given their analysts are paid to focus on factors such as democracy, human rights and other social and governance factors.

       Regulators are now calling for urgent work to clarify the myriad standards and practices being used to produce such ratings.

       “We need to do some kind of rethinking here,” said Erik Thedeen, chairman of the Sustainable Finance Task Force at the International Organization of Securities Commissions (IOSCO), in an interview.

       “This disastrous war is an eye opener. The whole ESG community needs to think through how to handle state-owned companies” in countries that violate human rights.

       ESG raters crunch vast amounts of data on everything from water use to gender balance to arrive at a grade that can look similar to traditional credit ratings from firms such as Moody’s Corp or Fitch Ratings.

       The difference: Credit ratings have evolved over decades, tend to be well understood by investors, and are regulated.

       By contrast, there are more than 600 standards and frameworks, data providers, ratings and rankings that are working to measure ESG-related risks, according to the European Banking Federation, a lobby group.

       Despite most raters marking Russia down for its record on suppressing dissent at home and aggression abroad, that wasn’t enough to stop it having a green light for ESG investing. MSCI rated it BBB until the Feb 24 invasion. It subsequently cut the government grade to B, and then to CCC.

       In an email, MSCI said Russia’s earlier rating, which benefitted from a skilled workforce and an abundance of natural resources, had been “offset” by very low scores on political governance due to issues such as democracy, press freedom and political rights. The rating also had taken into account the annexation of Crimea in 2014, the company said.

       IOSCO, whose members regulate the world’s securities markets, said in November that ratings companies should provide greater transparency on how they reach their conclusions and regularly review their methodology.

       The European Securities and Markets Authority is currently surveying the industry ahead of likely recommendations for regulating it.

       European Federation of Investors and Financial Service Users spokesman Arnaud Houdmont said Russian issuers and bonds should have been downgraded from an ESG perspective immediately after the country occupied Crimea in 2014. The Brussels-based non-profit represents individual savers and investors.

       In a recently released study, professors Elizabeth Demers, Jurian Hendrikse, Philip Joos and Baruch Lev (who recently retired from New York University’s Stern School of Business) questioned why companies were able to retain their high ESG scores after investing so heavily in Russia.

       Among other observations made was an absence of any statistical association between companies’ ESG scores and their exposure to Russia.

       “If you’re an investor who has been picking stocks based on ESG scores under the assumption that your money is likely to be funding more socially responsible corporate behavior, you should be very disappointed,” the professors wrote.

       In their defence, ESG ratings firms didn’t misjudge the situation in Russia any more than most other analysts and commentators in the West. Florian Berg, a researcher at the MIT Sloan School of Management, said that while the industry needs reform, no one had a war on their radar. — Bloomberg