ESG ratings have been a hot-button topic for some time, and a move towards regulating them is long overdue. First, they're inherently difficult to quantify and more multi-dimensional than credit ratings. So, providers have developed whole new methodologies and approaches to calculate them. These methodologies have significant variations, placing different emphases on a wide range of ESG factors. They also don’t tend to be particularly transparent, making it difficult for market participants to understand what an ESG rating is genuinely measuring. Some providers also offer consultancy services, which could present a conflict of interest.
There’s also the problem of ESG data, which is often of poor quality. Data comes from a range of sources, which can be tricky to verify, and there’s often little transparency over which data sources the ratings provider is using. However, under the current proposals HM Treasury targets ESG rating providers, but notably not data providers. Undoubtfully, the feedback on the consultation will raise questions as to the effectiveness of regulating ESG rating providers without tackling the issues with data. Arguably, the onus should be on the rating providers to demonstrate the robustness of the methodology they apply and the veracity and transparency of the data relied upon.
What are the proposed regulations?
If ESG ratings providers move within the FCA’s perimeter, it has indicated that it will follow IOSCO recommendations covering four key outcomes.
IOSCO recommends clarity over the methodologies applied, measurement objectives, and the underlying components for inclusion. This includes sharing data sources and information used, including any gaps, estimates or use of averages.
Good governance processes are essential to managing conflicts of interest effectively and providing consistent methodology within a provider. It also ensures that individuals are suitable for their given role, with sufficient resources available.
Management of conflicts of interest
ESG ratings' providers need to consider how they will identify, mitigate, disclose, and manage conflicts of interest.
Robust systems and controls
Firms need clear policies and procedures, to support consistent controls over processes and methodologies. This includes engagement with rated entities, and appropriate facilities for reporting complaints or misconduct (including regarding transparency, integrity, or independence).
Voluntary code of conduct
In November 2022, the FCA announced a new working group to develop a Code of Conduct for ESG ratings providers. This would see firms voluntarily adopt the IOSCO’s principles above, to establish consistency and good practice in line with international approaches.
In addition to ESG-data providers, the proposed scope includes a number of other exclusions, the most controversial being not-for-profits ratings providers and internal or intra-group ratings. While there's an argument for the latter, the benefits of excluding not for profits are unclear. This could lead to a backlash against the proposals, undermining the regulation itself and weakening the reliability and transparency of ESG ratings once under FCA supervision.
The proposed rules will also apply to all providers delivering ESG ratings to UK firms, for a fee. The territorial scope and fee exemptions are potentially another contentious area, leaving questions around ratings obtained elsewhere and the use of free ratings. However, the FCA will most likely refine the rules over the next couple of years, as the FCA tends to take a pragmatic approach to consultation feedback, and this is new territory for both industry and regulators alike.
For more information on ESG ratings, get in touch with Irina Velkova.