A key outcome of the UK’s Financial Conduct Authority’s (“FCA”) ESG strategy is the promotion of integrity within the ESG-labelled securities market, supported by the growth of effective service providers. To that end, in June 2021 it released a Consultation Paper, which considered various topics relating to ESG in capital markets. Two of the matters about which the FCA asked for market feedback were: 1) ESG data and rating providers; and 2) issues related to green, social, sustainability and sustainability-linked debt instruments. In November 2021, the Regulator published its ESG Strategy, emphasizing that market participants and consumers “must be able to trust green and other ESG-labelled financial instruments and products.” On 29 June, having gathered industry and stakeholders views in response to the Consultation Paper, the FCA published its Feedback Statement on the above two issues, setting out potential future regulatory actions. This post considers the FCA’s announcement on the first issue- that the regulatory perimeter will be extended to include ESG data and rating providers.
The Feedback Statement acknowledges that, as the financial services industry more fully integrates ESG into its activities and augments the related products on offer, there will be increasing reliance on third‑party ESG data and rating services. The Statement concludes that, in order to avoid potential harm to both markets and consumers, ESG data and rating services need to be “transparent, well‑governed, independent, objective, and based on reliable and systematic methodologies and processes”. If these standards are met, users of those services will be better equipped to make investment decisions, thereby ensuring more effective competition.
The FCA recognizes that there is commonly a low correlation between ESG ratings issued by different providers in respect of a given entity. However, it attributes this, in part, to the inherent multidimensionality of ESG and the range of rating products, which often have different aims and objectives. However, whilst the Regulator does not consider the variance in the assessment of these ratings to be inherently a source of harm, the significance of these services and the need for them to meet certain standards presents a clear rationale for regulatory oversight. Accordingly, the FCA supports the UK Government’s consideration of bringing ESG data and rating providers within its regulatory perimeter.
Based on the Feedback Statement, if the FCA is granted formal oversight of ESG data and rating providers, it intends to implement a regime that is informed by IOSCO’s recommendations, recognizing the need for a globally consistent regulatory approach. The regime would have the following four pillars:
- Transparency of ratings and data products, including in respect of: the underlying methodologies used and measurement objectives; the data input sources, including where such sources are public; and the procedures for data gaps, including the use of averages and estimate.
- Management of conflicts of interests, including their identification, mitigation and disclosure.
- Good governance which enables: the effective management of potential conflicts of interest; internal consistency of methodology within a provider; sufficient resources and competent personnel.
- Robust systems and controls, including: written policies and procedures and/or internal controls on processes and methodologies; facilities for reporting of complaints and misconduct; and engagement with rated entities.
However, acknowledging the long lead time of any such regulatory regime, the FCA would, in the interim, likely implement a voluntary code of conduct for ESG data and rating providers. Although voluntary, businesses providing these services are likely to be best served by compliance: first, because any voluntary code is likely to reflect future requirements; and second, because compliance may make them more attractive to their customers.
Outside of how data and ratings providers themselves would be regulated, the Feedback Statement also provides some insights into how the regulatory expectations on investment product providers may develop. The paper notes that the FCA is considering including, among the other criteria for qualifying for a sustainable investment label1, the requirement that the product provider carries out appropriate due diligence on any sustainability‑related data, research and other analytical resources that it relies upon. The FCA will consider whether it is necessary to extend those requirements to beyond the management of those products that fall within the scope of its proposed rules on classification and labelling.
The Feedback Statement represents another example of the UK financial regulators’ growing interest and focus in ESG investment, which is directed at protecting the integrity of the industry and the interests of underlying consumers. Driving that focus is a policy to promote sustainable and green investment, which the UK Government hopes will assist it with meeting its climate commitment. In short, while the body of formal rules and regulatory expectations in the area continues to evolve, governmental scrutiny, and the resulting reputational and enforcement risks, will only ramp up. Whilst the Feedback Statement has obvious and direct implications for ESG data and ratings providers, the regulatory expectations set out therein make important reading for the consumers of those products. As mentioned above, regulated users of the products may be expected to conduct due diligence on the providers. However, the regulatory expectation is likely to be ongoing. For example, where businesses subsequently become aware of information or data which undermines a rating they could be duty bound to revisit their due diligence.
1 See DP21/4