Regulating ESG ratings providers

HM Treasury (HMT) is consulting on a potential new regulatory regime for ESG ratings providers, which would bring them within the regulatory perimeter of the Financial Conduct Authority (FCA). As the use of ESG ratings increases, HMT is seeking to improve transparency and promote good conduct in the ESG ratings market. HMT's proposals cover a wide range of ESG-linked data and ratings products, including all products which make an `assessment' of ESG factors, even if not labelled as such. The new regime could affect all firms providing ESG assessments to users in the UK, even if the providing firm is based overseas. The consultation closes on 30 June 2023.

HMT's proposals reflect increasing global regulatory concern around ESG ratings — see our previous article.

In the UK, under the Financial Services and Markets Act 2000 (FSMA), firms carrying out activities which are specified under the Regulated Activities Order (RAO) must be authorised by an appropriate regulator, unless exempt. HMT determines which activities are specified in the RAO.

HMT's consultation relates to proposals to expand the regulatory perimeter, using an amendment to the RAO, to require all firms carrying out the activity of a direct provision of an assessment of environmental, social or governance factors to a user in the UK to become FCA-authorised, meet specified Threshold Conditions and comply with the FCA principles of business. Once the regulatory perimeter has been formally expanded, the FCA would then set firm-facing requirements in its rules.

HMT is also legislating, through the Financial Services and Markets Bill, to create a new Designated Activities Regime (DAR). Any person conducting a designated activity will be required to follow rules for it, unless they are exempt. However, unlike the RAO, persons carrying out activities under the DAR would not automatically have to be authorised. HMT is also considering whether the DAR could be used to regulate the provision of ESG ratings.

HMT and the FCA have indicated that the regulatory requirements eventually put in place for ESG ratings providers are likely to be in line with IOSCO recommendations and will cover transparency, good governance, management of conflicts of interest and robust systems and controls.

HMT's proposed definition of ESG ratings is broad and would cover 'an assessment regarding one or more environmental, social, and governance factors, whether or not it is labelled as such'. Because the aim of the proposed regime would be to improve the reliability of information which affects the allocation of capital, only assessments used in `by persons in the UK in relation to an RAO specified investment' (a wide range of investments related to financial services) would be included. This approach requires ESG rating providers to understand how their ESG rating is being used, therefore the consultation asks whether they currently capture such information.

Under HMT's definition, the following products would not be captured:

• Raw data
• Minimally processed data (for example summarised or formatted data)
• Estimates and proxies used to fill gaps in a data set

Other data and ratings products would be in scope, including those which are currently marketed as data-only products. This would include assessments which have been produced directly by analysts, but also those generated by AI/algorithms, due to the human assessment involved at the inception of the AI or algorithmic process.

At a minimum, HMT proposes to include ESG ratings that are provided to users in the UK, even if the providing firm is located overseas. This would include ratings provided for institutional and retail users. HMT asks UK users of ratings whether this proposal would hamper the choice of ESG ratings available.

The consultation notes that "both the scope of who any potential regulation applies to, and the regulatory requirements themselves, should be targeted and proportionate to the risks that ESG ratings pose." HMT is trying to balance the benefits of applying a regulatory regime to all sizes of provider with the possible negative impact that the disproportionately greater cost of being regulated could have on small providers and thus on competition and innovation. 

Many of the larger providers of ESG ratings are already authorised under FSMA as credit rating agencies or benchmark providers — for them the impact of other ESG-related products becoming regulated will be less. HMT is therefore considering a baseline regulatory regime applied to all firms, with larger providers then subject to greater regulatory oversight and obligations. The consultation also asks for evidence of impacts on smaller providers and questions what criteria should be used to define them. 

HMT proposes a number of exclusions to the regime to try to ensure that its scope is appropriate and proportionate. These include:

• The provision of ESG-ratings by not-for-profit entities
• Credit ratings which consider the impact of ESG factors on creditworthiness — as these are already subject to requirements under Credit Ratings Agencies Regulation
• Investment research products, such as equity research reports
• Ratings which are created by an entity solely for use by that entity — although HMT does question whether `intra-group rating' should be excluded

When the consultation closes, HMT will consider the responses before finalising its approach. HMT's preferred approach is through amendment to the RAO in conjunction with a new DAR. Once agreed amendments have been made to the regulatory perimeter, the FCA will be able to further refine and clarify the details of the regime through consultation on specific rules for firms.

In the meantime, a voluntary code of conduct for ESG data and ratings providers is being developed by an FCA working group, with the first outputs expected in Q3 2023. Firms engaging voluntarily with this code are likely to find the transition to a more formalised regulatory regime significantly less resource-intensive.

Firms providing ESG data-linked products and services should review HMT's proposals in the context of their offerings to understand how they might be impacted. Firms which do not have a clear understanding of the processing and assessment features of their data products may face greater challenges when the final regulatory regime is implemented.