The regulation of ESG data and ratings appears to be a step closer to enforcement after UK regulator the Financial Conduct Authority (FCA) stated there is a “clear rationale” for the regulation of ESG ratings, following feedback from the market.
This week, the UK regulator published a feedback paper to its consultation document, ESG integration in UK capital markets, which recognised the need for a “globally consistent regulatory approach” and flagged the recommendations on ESG data and ratings developed by the International Organization of Securities Commission (IOSCO) in 2021. The FCA also noted other jurisdictions in the European Union and Asia are also contemplating closer oversight of these entities.
“Respondents agreed with [the FCA] assessment that a regulatory focus on transparency, governance/systems and controls, and management of conflicts of interest would help to achieve better outcomes for markets and consumers,” the paper said.
“Considering the global reach of ESG data and rating providers, many respondents strongly supported an internationally coordinated approach that had regard to IOSCO’s recommendations.”
The watchdog is awaiting confirmation from HM Treasury as to whether or not this will come under its remit.
However, if this proceeds, the FCA has confirmed it would introduce a voluntary code of conduct for rating agencies in the interim while new regulation was formalised.
“Given the potential lead time before any such regime could come into force, we would – in the interim – work with the Treasury to convene, support and encourage industry participants to develop and follow a voluntary code of conduct,” the FCA paper read.
“Such a voluntary code could potentially continue to apply for ESG data and rating providers that fall outside the scope of any future regulatory regime.”
Concerns amid rapid growth
The unregulated market for ESG data and rating provision has been growing rapidly over recent years and in 2020, KPMG estimated there are more than 150 major ESG data providers worldwide.
The feedback paper flagged concentration concerns as its research while a total of 32 different providers are used across respondents, the services of the top three providers are used by more than half of the respondents, and all those surveyed use the services of the largest provider.
It also said while it does not consider the different judgements reached by ESG rating providers “inherently to be a source of harm” as long as the providers are transparent about their methodology and data inputs, determine their outputs by applying systematic processes and sound systems and controls, identify and manage conflicts of interest and operate with robust governance.
See also: – Variability in ESG ratings makes a murky picture for investors
“However, some of these conditions may not be fully met in practice, thereby directly posing risks to our operational objectives,” it said.
“These risks are also further exacerbated as firms often embed ESG data and rating products into their investment processes. This includes, for example, using ESG ratings as a determinant input to benchmarks and indices, or including them as the basis for investment mandates and strategies. As a result, certain ESG data and rating products may be expected to influence capital allocation decisions, potentially creating systemic effects.”
It flagged a recent example of the holdings of some ESG‑labelled indices that embed specific ESG ratings within their methodologies, which have come under scrutiny following the sanctions imposed on Russia.
The FCA’s support for regulating ESG data and rating providers is welcomed by the AIC’s chief executive Richard Stone who said it is needed to avoid “consumer harm”.
“It’s clear that ESG data and ratings services must be well-governed, independent, transparent and have reliable methodologies and processes,” he said.
“Without proper oversight of these providers there are risks of misallocation of investments, greenwashing and consumer harm.
“ESG is an increasingly important investment consideration for investors, but too many claims still do not stand up to scrutiny. We look forward to working with the FCA and the Treasury to ensure ESG data and ratings are robust and credible.”
Robin Penfold, regulatory partner at law firm TLT, added: “The statement underlines the important role of data in enhancing transparency and promoting sound decision making by investors – something we’ve always known, but is harder to bring about than it sounds. That’s no longer an excuse though, and this direction of travel is promising. It lends further support to the work that HM Treasury is undertaking to consider bringing ESG data and rating agencies within the regulatory perimeter.”
ESG Clarity has contacted a number of ratings providers for comment.
Green bonds
Elsewhere, the FCA is proceeding with work on ESG-labelled debt instruments and indicated this is another area for potential increased regulatory oversight.
A common criticism of green bonds, which are being issued at an unprecedented rate, is their lack of transparency and that these securities’ proceeds can be used for non-ESG compliant projects.
The FCA has reminded green bond issuers of the importance of transparency via the paper: “We encourage issuers of ESG‑labelled Use of Proceeds (UoP) debt instruments to consider voluntarily applying or adopting relevant industry standards.
“We remind issuers, their advisers, and other relevant market participants of their existing obligation to ensure any advertisement is not inaccurate or misleading and is consistent with the information contained in the prospectus.”
It also warned that where advertisements do not meet the regulator’s expectations, it will consider the “case for market oversight or enforcement actions”.
The FCA also may reassess in the future, as part of the Treasury’s wider Prospectus Regulation Review, the case to develop an appropriate standard for UoP bonds.
Parts of this article were previously reported by Portfolio Adviser.
