Will ESG rating agencies be brought within the perimeter

With the current focus on ESG investments, over the last year the role of and the ratings produced by ESG rating agencies have been increasingly brought into focus. A key question being asked is whether ESG rating agencies should be brought within the regulatory perimeter.

It has been suggested that ESG rating agencies may be struggling to keep up with the speed at which the ESG market is growing. Most recently, a report published by the International Regulatory Strategy Group (IRSG) has ignited this conversation further.¹

The IRSG believes that regulation of ESG ratings is desirable to provide "more transparency around the basis for ESG ratings and mitigate against potential conduct risks". ²

What is the regulator's view?

Last summer, the FCA published its Consultation Paper CP21/18 "Enhancing climate-related disclosures by standard listed companies and seeking views on ESG topics in capital markets"³  It considered the methodological issues and risk models of ESG rating agencies. Within this consultation paper, the FCA invited views on whether the FCA should engage with the Treasury to consider bringing ESG data and rating providers' activities inside the FCA's regulatory perimeter, or whether to simply encourage ESG data and rating providers to adopt a voluntary Best Practice Code. Some of the areas of concern regarding ESG data and rating agencies include:

• the "hardwiring" of ESG ratings into investment processes;
• a lack of transparency of methodologies and interpretability of ESG ratings;
• the need to ensure good governance and management of conflicts of interest; and
• the costs for issuers of meeting providers’ data requests.

Following this, the FCA's Perimeter Report 2020/21⁴ articulated similar ideas and noted that the FCA will be publishing a feedback statement on the topic in the first half of 2022.

In the same month, the UK government also demonstrated its engagement by publishing its "Greening Finance: A Roadmap to Sustainable Investing".5  Within the publication ,it acknowledged that "different ESG ratings agencies provide opinions on different aspects of sustainability performance and their assessments may not always be comparable" and noted that as a result the government is "therefore considering bringing these firms into the scope of FCA authorisation and regulation".⁶ The government are expected to publish further detail on this during the course of this year.

Since then, the FCA's CEO (Nikhil Rathi) met with the Economic Secretary to the Treasury (EST) to discuss the issues set out in the FCA's Perimeter Report, including ESG data and ratings. It was recorded that "The EST noted that there have been discussions on ESG ratings and potentially bringing the providers into the perimeter. The CEO noted that there is support for the government’s work to consider bringing ESG ratings providers into the perimeter."⁷

Is regulation likely?

It seems like we're moving that way. It's hoped that this will improve the consistency and accuracy of ESG ratings and ultimately result in less risk for businesses when deciding what ESG investments to make.

There also seems to be a similar direction of travel in the European Union with the European Commission updating its sustainable finance strategy and ESMA launching a call for evidence back in February. We will watch this space.

1. IRSG, 'ESG Ratings and ESG Data in Financial Services – A view from practitioners' February 2022. Available here: https://www.irsg.co.uk/assets/Reports/IRSG-Accenture-report-on-ESG-Ratings-and-ESG-Data-in-Financial-Services-FINAL-2.pdf.
2. Ibid., p. 5.
3. Available here: https://www.fca.org.uk/publication/consultation/cp21-18.pdf.
4. Available here: https://www.fca.org.uk/publication/annual-reports/perimeter-report-2020-21.pdf.
5. Available here: https://www.gov.uk/government/publications/greening-finance-a-roadmap-to-sustainable-investing.
6. HM Government, 'Greening Finance: A Roadmap to Sustainable Investing', October 2021, p. 17.
7. https://www.gov.uk/government/publications/hm-treasury-and-financial-conduct-authority-regulatory-perimeter-meeting-december-2021/hm-treasury-and-financial-conduct-authority-regulatory-perimeter-meeting-december-2021.

Authors: David Capps, Laura Bell