By Huw Jones

LONDON (Reuters) -Global regulators took a first step on Monday to unlock the “black box” of corporate environmental, social and governance (ESG) ratings, suggesting formal oversight of a sector which helps channel trillions of dollars into climate-friendly investment funds.

Despite growing influence, ESG raters and data providers are largely unregulated, lack transparency in their methods, offer uneven coverage and harbour potential conflicts of interest, said the International Organization of Securities Commissions (IOSCO), which groups market regulators from the United States, Europe and Asia.

Asset managers running ESG focused funds increasingly rely on about 160 raters globally to help pick stocks and bonds, raising investor protection questions, IOSCO said. Users, however, generally do not conduct any formal verification of the ratings, calling the process a “black box”.

“Users have signalled that having multiple ESG ratings and data products can cause confusion, raising serious questions about relevance, reliability and greenwashing,” said Ashley Alder, who chairs IOSCO and heads Hong Kong’s securities watchdog.

Greenwashing refers to companies over-stating their green credentials in a bid to attract investors.

The sector has seen rapid consolidation with U.S. domiciled companies such as MSCI, S&P and Morningstar leading the pack.

IOSCO’s consultation paper recommends that regulators consider formally regulating the sector, echoing similar moves with credit rating agencies (CRAs) in the aftermath of the global financial crisis over a decade ago when similar concerns were aired.

Regulators could encourage industry to develop and follow codes of conduct, the watchdog said.

“ESG ratings and data products providers could consider making high levels of public disclosure and transparency an objective in their ESG ratings and data products, including their methodologies and processes,” IOSCO said.

ESG raters could maintain internal records to back up their ratings, and give assurance the scores are “free from political or economic pressures”, IOSCO said.

Raters should ensure there is no conflict of interest between selling ratings on companies they may also have a business relationship with, IOSCO said.

“Financial market participants could consider conducting due diligence on the ESG ratings and data products that they use in their internal processes,” it added.

MSCI said it was reviewing the IOSCO report. “At MSCI, we are firm believers of transparency and are committed to defining and applying sound practices in our operations,” it said.

IOSCO agrees high level principles which its member countries then introduce into national rules, with European Union and British regulators already noting that action may be needed.

(Reporting by Huw Jones; editing by David Evans)