Wall Street’s Green Push Exposes New Conflicts of Interest

In the past two years, U.S. firms in the financial-services sector have spent more than $3.5 billion buying green-ratings companies and data providers, a review by The Wall Street Journal found. The Big Four audit firms are also moving into the environmental, social and governance, or ESG, arena. PricewaterhouseCoopers last year said ESG was a focus of its $12 billion investment plan.

When the United Nations last year asked the finance industry to back its plans to cut carbon emissions, many banks had to be cajoled into signing up. Financial-services firms eagerly jumped in, according to people involved in the effort.

These firms are betting on big profits as companies, responding to demands by regulators and investors, seek to reduce their carbon emissions and better disclose their ESG practices. The firms have bought up smaller companies to bolster their offerings.

The market for helping companies with corporate ESG reporting alone is worth an estimated $1.6 billion globally, and forecast to increase by 21% a year over the next six years, according to U.K.-based research firm Verdantix. “The growth rate across several areas of ESG professional services is very strong,” said Kim Knickle, a research director at Verdantix.

In many cases, firms that rate or evaluate companies on things like climate risk also sell services to help companies address these issues. Many of the firms providing these ratings, such as credit raters and auditors, are already managing deep conflicts of interest because they are paid by the companies they judge. Conflicts of interest in the credit-ratings industry were one cause of the financial crisis, according to lawmakers.

One new set of potential conflicts springs from the widespread practice of selling ESG ratings alongside consulting and other services.

Institutional Shareholder Services, the nation’s biggest shareholder advisory firm, sells to investors its climate-risk ratings for thousands of companies. It also sells to those companies advice on how to increase those scores.

“Improve ESG Ratings,” the Rockville, Md.-based firm says in its pitch to the roughly 5,000 businesses it covers. “Stand out among companies that you compete with for capital.”

The financial-services firms’ multiple ESG services create clear potential conflicts of interest, according to Anant Sundaram, a finance professor at Dartmouth College’s Tuck School of Business. “They earn cash flows by selling their services…to the very firms they’re supposed to be unbiasedly scoring and ranking,” he said.

ISS’s general counsel, Steven Friedman, said the firm, owned by German stock exchange operator Deutsche Börse, has taken steps to address potential conflicts of interest in its ESG work, including a firewall separating its ratings and corporate-advisory units. “ISS does not and will not give preferential treatment to any corporate issuer,” Mr. Friedman added.

ESG raters typically get most of their income from investment firms, which package together top-scoring companies to create green-branded products that are sold to investors. That creates an incentive to hand out high ESG scores, said Hans Taparia, a business professor at New York University.

“If the raters were to be tough on companies, there wouldn’t be any products to create for investors,” Mr. Taparia said.

Fund-ratings firm Morningstar Inc. gives out performance awards that are available only to companies that pay it for an ESG assessment.

Morningstar’s Sustainalytics unit sells companies an “ESG Risk Rating License” for an undisclosed amount. “Showcase that you are rated by a world’s leading ESG Rating agency,” its website states. Only companies that buy the license are eligible to potentially get a “Top-Rated ESG Badge.”

Badge winners include Freehold Royalties Ltd. , a Canadian firm with a portfolio of oil-and-gas properties. The company isn’t top rated by everyone. It is classified as a “poor” ESG performer, with a score of 23 out of 100, by ratings-firm Refinitiv, owned by London Stock Exchange Group. A Freehold Royalties spokesman declined to comment.

A Sustainalytics spokeswoman said Freehold Royalties is rated a low ESG risk—and therefore scores well—because it earns most of its money from owning land on which oil and gas are produced, rather than from drilling wells. She added that Sustainalytics views its management of potential conflicts of interest as “crucial to the independence and integrity” of its ratings.

Regulators are starting to look at potential conflicts of interest in the largely unregulated ESG sector. The International Organization of Securities Commissions, an umbrella group of finance watchdogs, last year highlighted the multiple services offered by many ESG-ratings firms.

It recommended its members, including the U.S. Securities and Exchange Commission, consider requiring ESG ratings and data firms to “identify, disclose and, to the extent possible, mitigate potential conflicts of interest.”

An SEC spokeswoman declined to comment.

Ratings firms are pushing back against potential new regulations. The “presence of any…potential conflicts does not necessitate regulation of ESG data,” Morningstar told IOSCO regulators last year.

Ratings giant Moody’s Corp. recommended to IOSCO that any new policies should allow firms to demonstrate how they address conflicts, “rather than construct narrow requirements.”

Moody’s, which last year paid $2 billion to buy climate and natural disaster analysis firm Risk Management Solutions Inc., sells ESG assessments of companies to investors. Moody’s also sells similar assessments to the companies themselves, saying it can help them “seize new opportunities for value creation” from climate-change.

Credit-ratings firms’ sales of ESG services create a further, troublesome, set of potential conflicts, according to Jeffrey Manns, a law professor at George Washington University.

Companies may feel pressured to buy ESG consulting services from a credit-rating firm to maintain a good relationship with that firm and safeguard their credit rating, he said.

Another risk is that credit-ratings firms may be more reluctant to downgrade companies that pay them big fees for credit ratings and, now, for ESG services, according to Mr. Manns. “Rating agencies have no interest in biting the hands that feed,” he said.

A Moody’s spokesman said the firm has safeguards to protect the independence and integrity of the credit ratings process. “Our credit ratings are not influenced by commercial considerations across any aspect of our business, including ESG,” the spokesman added.

Rival credit-ratings giant S&P Global Inc. has commercial interests in businesses that can affect companies’ ESG scores. It also issues such scores and sells ESG data reporting, auditing and risk-management services to companies.

S&P is part-owner of a San Francisco-based company called Xpansiv that runs the Aviation Carbon Exchange, a marketplace that allows airlines to buy and sell carbon credits. Airlines’s use of such credits to brand their operations as sustainable has been criticized by environmental groups, among others.

An S&P spokeswoman said the firm is committed to the independence and objectivity of its products and services. S&P has “controls in place to identify and manage actual, potential, or perceived conflicts of interests,” the spokeswoman added.

Write to Jean Eaglesham at jean.eaglesham@wsj.com