A regulated future for ESG ratings?

Last week the FCA published CPs on extending mandatory TCFD reporting to standard listed companies and buyside firms.

Somewhat hidden in CP21/18 on standard listed companies, there was some commentary on ESG data and rating providers, amongst other discussions relating to the capital markets. You may have read our post about these capital markets topics.

EU and UK regulators have woken up to the prominence of ESG data and ratings providers as the market for ESG products grows, and to the risks they pose where there is no requirement for standardisation or transparency in their methodology. 

The FCA's discussion is clearly just the beginning, opening up a number of questions and indicating future policy developments, including the potential for regulation of ESG ratings in a similar way to the regulation of benchmarks or credit ratings (i.e. focus on transparency, governance and conflicts of interest). We understand that the FCA is intending to release a further consultation in respect of this issue in the near future, and we will keep you updated on that.

In summary, the discussion focuses on the following points:

• The FCA comments on (1) the importance of ESG data and rating providers both in terms of value and their use by firms; and (2) the lack of regulation or consistency in the market.
• The FCA notes that under current rules, asset managers who rely on third-party services are expected to have carried out a level of due diligence on their providers (e.g. under the UCITS rules), and this might reasonably be expected to extend to ESG ratings and data providers. However, they note that is inherently challenging because ESG performance is multi-dimensional, and ESG ratings are subject to significant data gaps.
• The FCA flag that problematic ESG rating provision has potential to cause particular harm where:
  • ratings are hardwired into investment processes;
  • there is a lack of transparency of the methodologies and interpretability of ratings;
  • there are governance and conflicts of interest issues amongst rating providers; and
  • where lack of consistency and selective prioritisation in issuers responding to data requests could lead to market distortion.
• The FCA then goes on to explicitly compare the position of ESG rating providers currently to credit rating agencies before the financial crisis (noting that the financial crisis led to greater regulation of credit rating agencies).
• The FCA notes that there are several policy options that could be adopted:
  • Guidance for firms on their use of third-party ESG data and ratings – develop guidance to enhance risk management processes supporting the use of ESG ratings and other third-party ESG data, reiterating expectations around the management of outsourcing arrangements, due diligence and the use of ratings in benchmarks and indices.
  • Best Practice Code for ESG data and rating providers – encourage voluntary, industry-led adherence to minimum conduct standards in areas such as transparency, governance and management of conflicts of interest.
  • Regulation of ESG data and rating providers – work with the Treasury to bring ESG ratings within the regulatory perimeter, as has been suggested in the EU by ESMA, and the AMF and AFM. Again, such a regime might focus primarily on transparency, governance and management of conflicts of interest.

The consultation is open until 10 September 2021 if you would like to respond with your thoughts on this FCA discussion.