ESG indicators increasingly drive investment decisions for companies and investors and ESG ratings providers could play a critical role in establishing trust in ESG products. As this is a relatively new area, the public are likely to rely on rating providers in determining what is or is not a “good” ESG investment.

Currently, there are challenges faced by market participants in deciphering what an ESG rating implies, amidst opaque decision making by the ratings provider. There are also concerns about how an ESG ratings provider interacts with the rated entity and the potential for conflicts of interest.

BNY Mellon and DWS, a subsidiary of Deutsche Bank, have been accused by regulators of exaggerating their ESG credentials. BNY has been fined $1.5m for the misstatements. While DWS, facing enforcement action for similar offences, has made a provision of €21m towards settlement according to its half-year report for 2023.

Then there is the mind-boggling decision to remove Tesla, an electric vehicle manufacturer from the S&P 500 ESG Index while Exxon and other oil companies top the list. This type of black box decision making confuses the aims of ESG ratings and potentially undermines public confidence in such indices – it is something the regulation of ratings providers is looking to address.

The International Organization of Securities Commissions (IOSCO) and Organisation for Economic Co-operation and Development (OECD) have recommended regulators pay more attention to ESG ratings and data. Meanwhile some jurisdictions, such as the EU, have published proposals for regulation of ESG ratings providers.

As part of the UK Government’s Green Finance Strategy, HMT recently completed its consultation on the future regulatory regime for ESG ratings providers.

Proposed UK regulatory regime

HMT's consultation relates to proposals on expanding the regulatory perimeter through an amendment to the Regulated Activities Order (RAO) under the Financial Services Act 2000. The change would require all firms providing an assessment of ESG factors to a UK-based user to become FCA-authorised, irrespective of the location of the rating provider.

Another option HMT is considering, is regulating the provision of ESG ratings under a new Designated Activities Regime (DAR), through the Financial Services and Markets Bill. Any person conducting a designated activity will be required to follow specific rules (unless exempt), but unlike the RAO, persons under DAR would not automatically have to be authorised.

Regardless of which route is taken, the FCA and HMT have indicated that final regulatory requirements will likely conform to IOSCO recommendations and cover:

• transparency,
• good governance,
• management of conflicts of interest, and
• robust systems and controls.

Although the FCA invited feedback in 2021 on the regulation of ESG data and ratings providers, HMT’s latest consultation only deals with the latter. HMT sees ratings providers as the area with the most risk of harm and the risks associated with ESG data may be addressed by the emerging International Sustainability Board standards, the first of which were published in June 2023.

HMT proposes a broad definition of what constitutes an ESG ratings provider . The proposals would capture anyone providing “an assessment regarding one or more environmental, social, and governance factors, whether or not it is labelled as such”.

Only assessments used “by persons in the UK in relation to an RAO specified investment” (a widerange of investments linked to financial services) would be included in the proposed rules, bar a few exclusions. This is irrespective of the location of the provider.

The following exclusions are proposed by HMT:

• not-for-profits;
• ratings used solely by the entity that generated them;
• credit ratings which consider the impact of ESG on creditworthiness (as these are already subject to the requirements under Credit Ratings Agencies Regulation);
• investment research products, such as equity reports;
• external reviewers;
• consulting services;
• proxy advisor services; and
• academic research or journalism.

Proposed EU regulatory regime

The EU commission is going through a similar process of consulting on a future regulatory regime for ESG ratings providers . Similar to the UK proposal, there is no need for the ESG rating to be explicitly labelled as such.

The regime would apply to all ESG rating providers in the EU and those from third countries that provide ratings to EU “regulated financial undertakings”, ie regulated financial services providers or funds. Exceptions, include those:

• developed in-house;
• by central banks in limited circumstances; or
• where the rating is not intended to be publicly disclosed or distributed.

Unlike the UK consultation, there is no carve out for academic research or journalism or ratings by not-for-profit entities.

ICAEW’s view

There is clear benefit to be gained from improving the transparency of rating methodologies, governance and processes of ESG ratings providers through regulation. ICAEW agrees HMT’s consultation is a step in the right direction, as described in its full response.

ICAEW believes the focus of any regulations should be on ensuring the integrity of outcomes and boosting standards – this will build trust in ESG ratings and help prevent greenwashing. It is through this lens that ICAEW has identified three areas that warrant further examination:

1. Promote the integrity of ESG data providers

While not currently in HMT’s scope of proposed regulation , ICAEW believes that promoting integrity of data providers is important. This can be done by explaining how data integrity is achieved. For example, by requiring ESG ratings providers to have strong internal control environments over ESG data. A consistent methodology of disclosure is also vital to enable comparability and transparency, both of which are key.

2. Include not-for-profits and clarify conditions for excluding intra-group ratings

Not-for-profits (NFPs) providing ratings specifically for investment purposes, which are excluded under current proposals, should be included in the proposed rules. NFPs cover a large swathe of the market, and there is potential for an NFP entity to dominate ratings and yet be subject to less scrutiny.

It should also be clarified that the proposed exclusion only applies to ratings used internally within a group and cannot be used for ratings that will be to marketed externally (ie the rating is not intended to be publicly disclosed or distributed). ICAEW believes these intra-group ratings should only be excluded from regulation if there is no chance that:

• the proprietary ratings are implicitly or directly included in the marketing of a fund; or,
• the ratings form the basis of inclusion of assets into a fund that is then offered to the public.

3. Expansion of territorial scope

ICAEW argues that UK regulation should include free-at-point-of-use ratings for the purpose of evaluating an investment and to bring in scope UK entities providing services to non-UK residents. This change would see the rules have a geographical equivalence to UK Consumer Duty and cryptoasset regulations.

Next steps

The consultation period closed 30 June 2023 and HMT are currently assessing the responses. Once the scope of regulation has been agreed, the FCA will be able to further refine and clarify the details of the supervisory regime through consultation on how the rule book would look like for firms.

In the meantime, a voluntary code of conduct for ESG data and ratings providers being developed by an FCA working party is likely to be available in Q3 2023. Firms engaging voluntarily with this code are likely to find it easier to transition to a more formalised regulatory regime.