The Financial Times reports that the UK government is due to go ahead with plans to regulate ratings providers that evaluate the environmental, social and governance performance of companies.
Minsters intend to unveil formals proposals as early as January 2024, Whitehall insiders told the FT. This follows a three-month HM Treasury Consultation (HMT Consultation) which closed in June.
Treasury consultation
ESG ratings are increasingly driving investment decisions in financial markets. UK Chancellor Jeremy Hunt announced that the government wanted to ensure improved transparency and good conduct in the ESG ratings market as part of the Edinburgh reforms in December 2022.
The proposals set out in the HMT Consultation aim to bring ESG ratings providers within the regulatory perimeter and under the FCA’s remit where the assessment is used in relation to a specified investment under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), unless an appropriate exclusion applies.
“The main concern at this stage is that the UK is contemplating to go beyond the EU and regulate both ESG data and ESG ratings in one single text.”
Arthur Carabia, ESG Policy Research Director, Morningstar Sustainalytics
HMT expects that these changes will involve adding one or more new regulated activities to the RAO. It’s proposed that both UK and overseas ratings providers who directly provide ratings to UK users would be caught by the regime with the possibility that further activities may be brought within its scope.
HMT anticipates that the FCA’s regulatory approach would take the main elements of the IOSCO recommendations as a starting point.
IOSCO told financial regulators around the world that they should consider “focusing more attention” on providers of ESG ratings and data.
“Well-calibrated regulation can inspire greater investor confidence in ESG ratings while continuing to foster innovation and a diversity of ESG-rating methodologies and opinions.”
Arthur Carabia, ESG Policy Research Director, Morningstar Sustainalytics
The FT reported that the Treasury is examining whether regulating ESG agencies will require fresh legislation or could be achieved through measures implemented under existing laws. Although a proposal to create a new watchdog has not been ruled out, the FT reported that expanding the remit of the Financial Conduct Authority is considered the likelier option.
An FCA spokesperson did not confirm or deny the report and told GRIP: “We continue to work with government on their consultation for a regulatory regime for ESG ratings providers.”
Voluntary code for ESG providers due next month
A working group created at the instigation of the FCA is due to publish the voluntary code for ESG data and rating providers at the end of 2023.
The draft code was published in July. It said providers should disclose measures they take to avoid conflicts of interest and publish more information about their methodologies, among other reforms. The code aims to enhance consistency, transparency, and accountability in the financial services industry to ensure that the market is able to have confidence in the integrity of ESG Ratings and Data products through enhanced systems, processes and controls.
Sacha Sadan, head of environmental, social and governance issues at the FCA, said in July that the code “has been developed with international consistency in mind”.
European Commission approach
The European Commission proposed new rules for ESG rating providers in June 2023 with measures to introduce a number of requirements for ESG data providers, including:
- Registration and authorization: ESG data providers would be required to register with and be authorized by ESMA
- Transparency and disclosure: ESG data providers would be required to disclose information about their methodologies, data sources, and conflict of interest policies.
- Data quality and integrity: ESG data providers would be required to ensure that their data is accurate, reliable and complete.
- Governance and risk management: ESG data providers would be required to have adequate governance and risk management systems in place.
- Conflicts of interest: ESG data providers would be prohibited from providing consulting services to investors or selling credit ratings and benchmarks.
The proposals are currently under review by the European Parliament and the Council. The regulation is expected to be finalized and adopted in 2024.
Industry response
We asked Arthur Carabia, ESG Policy Research Director, Morningstar Sustainalytics to comment on the new regulatory focus on ESG ratings providers.
He said: “We understand why regulators are taking a close look at ESG ratings. They play an increasingly important role in the investment process and can influence fund flows. Well-calibrated regulation can inspire greater investor confidence in ESG ratings while continuing to foster innovation and a diversity of ESG-rating methodologies and opinions.
“Regarding the EU regulation, we believe the EC’s proposal is a positive start. It acknowledges that ESG ratings assess many aspects and that diversity of approaches is a feature rather than a bug. While we welcome overall the proposal, we have spotted and shared with co-legislators some important areas of improvement to make sure the regulation does not introduce new conflicts of interest and provisions that are not suitable for ESG ratings, and avoid market disruption as result of the entry into application of the regulation and in particular the third country regime.
“Regarding the UK regulation, we have yet to see proposal yet (we only had a consultation). The main concern at this stage is that the UK is contemplating to go beyond the EU and regulate both ESG data and ESG ratings in one single text. The inclusion of data in the context of the ESG rating regulation creates significant challenges that will result in confusion, impede the availability of ESG analysis, and reduce flows based on ESG data. Additional and separate regulation of ESG data requires clear purpose and adequate consultation to avoid the unintended consequences mentioned above.