Interoperability of FCA-backed ESG Ratings Code a Key Concern

Consultation responses flag risk of regulatory fragmentation, while highlighting role the code could play in building transparency in ESG data and ratings products. 

The importance of interoperability with domestic and international standards has been highlighted by respondents to a consultation on a new voluntary Code of Conduct for ESG ratings and data product providers supported by the UK’s Financial Conduct Authority (FCA).

The objective of the code, which was developed by the ESG Data and Ratings Working Group (DRWG), is to improve the availability and quality of information provided to investors at product and entity levels, enhance market integrity through increased transparency, good governance and sound systems and controls, and improve competition through better comparability of products and providers. 

It also aims to translate the International Organization of Securities Commissions’ (IOSCO) recommendations, including transparency, good governance, and management of conflicts of interest, to a UK setting. 

In its response to the consultation, global non-profit disclosure platform CDP said that defining ESG ratings and data products has been “one of the most challenging and yet most important steps in pursuing clear, effective, and globally aligned regulation in this space”. 

In November last year, the FCA announced the formation of the DRWG convened by the International Capital Market Association and the International Regulatory Strategy Group. The group is co-chaired by investment manager M&G, ratings agency Moody’s, London Stock Exchange Group and law firm Slaughter and May.  

The DRWG is expected to finalise the code of conduct by the end of the year.   

Seeking domestic clarity 

Earlier this year, HM Treasury consulted on regulating ESG ratings providers, with proposed rules aiming to bring the industry under regulation to improve transparency of methodologies, governance, and processes.  

The UK government announced the consultation on ESG ratings as part of its December 2022 Edinburgh reforms. The consultation closed on 30 June, having been open to submissions for a three-month period. 

The UK government was urged by respondents to ensure harmonisation with a draft code of conduct commissioned by the FCA, as well as rules in other jurisdictions. 

In its consultation response, the UK Sustainable Investment and Finance Association (UKSIF) said that there is still “some uncertainty” over the interplay between HM Treasury’s upcoming regulatory approach and the FCA’s code. 

UKSIF said that a “clearer, over-arching” policy vision is needed from UK policymakers on the two initiatives, the extent to which they will be integrated, and their respective objectives. 

Raza Naeem, Partner at law firm Linklaters, told ESG Investor it is “not quite clear” how much overlap there will be between HM Treasury’s ESG ratings regulation and the FCA code. 

UKSIF said that after the code is finalised later this year, it would “strongly welcome” HM Treasury and the FCA “outlining this clarity to stakeholders on the alignment across both initiatives”. 

The organisation also called for the publication of “specific timelines, envisaged phases, and the overarching objectives” for both initiatives, and for this to be regularly updated for the market going forward.  

Naeem echoed this concern, adding that the “timing is unclear, as is how all this fit together” and that the risk of regulatory fragmentation is “very significant”. 

International interoperability 

In June, the EU proposed its regulatory framework for ESG rating providers which aims to crack down on conflicts of interest and boost transparency of methodologies. 

Experts warned that while new rules offered increased transparency, they also risked “potential fragmentation” in the regulatory architecture of ESG ratings and data products “at the global scale”.   

Alongside the EU and UK, India, Japan, and Singapore have also introduced or proposed a code of conduct or regulation for ESG data and ratings providers.  

Naeem said that while ESG data and ratings codes and regulations in different regions are to “some degree” based on the IOSCO principles meaning there is some commonality, they are slightly divergent and, therefore, risk fragmentation. 

He also said that interoperability is “very much a concern”, adding that the current regulatory landscape cannot be considered alone because the “bulk of the regulation hasn’t hit yet”. 

Carbon credit ratings provider Sylvera warned that “without coordination” the market could face a “hodgepodge of overlapping regulation”. 

It added that the interoperability of future sources of regulation is critical to ensuring the regulatory burden remains “proportionate and effective”. 

Moody’s, which was part of the DRWG, said that markets are “best served by internationally consistent regimes [that] appreciate the evolution of ESG disclosure while promoting innovation in products and services”. 

UKSIF said it was particularly “positive” to see the Code’s close alignment with the recommendations outlined by the IOSCO, as well as other existing voluntary codes from across different jurisdictions such as Japan and Singapore. 

The FCA’s code should “benefit from its relative clarity, flexibility, and alignment with the IOSCO’s recommendations”, it added.  

CDP said that it “advocates for a globally aligned approach” to ESG ratings and data products regulation utilising a “global baseline” founded on IOSCO’s guidelines. It also noted that it has not identified any “contradictory guidelines” that could limit the Code’s interoperability with other initiatives. 

Trust and transparency 

UKSIF said that it was encouraged by the “swift progress” made by the DRWG, as well as the “direction of travel pursued”.  

It added it is “optimistic” that the code can help “build greater trust” in ESG data and ratings products in the UK, protect market integrity, promote more effective competition among providers.  

“We anticipate that the Code of Conduct will, in the shorter-term, swiftly enhance standards, transparency, innovation, and competition across the market,” UKSIF said, adding that the code represents a “very strong starting point” ahead of the finalising of proposals later this year. 

It also said that it sees “considerable opportunities” in creating greater transparency and high-quality standards in the UK’s ESG data and ratings industry, as well as “more confidence” to investors and other users in these products. 

CDP added that the code is an “important step” towards supporting the transition to a “more transparent and sustainable” financial market. 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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