As the UK looks to impose regulation, market calls for FCA to prioritise governance over convergence.
The UK’s Financial Conduct Authority (FCA) has decided that ESG data and rating services ought to fall within its regulatory orbit. That was the easy part. Now starts the hard graft of figuring out how regulation should be implemented.
Mainstream ratings agencies have been tightly supervised on both sides of the Atlantic since the collapse of firms such as Enron in the early 2000s; the energy group had been rated ‘investment grade’ by the big three agencies until four days before it went bankrupt.
Now, the FCA is proposing to bring ESG ratings into the regulated sphere. In its June paper, ‘ESG integration in UK capital markets’, it notes that as ESG becomes a more prominent aspect of the investment decisions of financial services providers, including asset managers, such providers “are increasingly reliant on ESG data and rating services”.
It adds: “These services are increasingly embedded within investment processes (including mandates and benchmark indices), directly influencing capital allocation.
“To avoid potential for harm to markets and, ultimately, consumers, we consider that ESG data and rating services should be transparent, well-governed, independent, objective, and based on reliable and systematic methodologies and processes.”
”Clear rationale” for regulation
When such services claim to be measuring specific ESG attributes, said the FCA, those using the services ought to be able clearly to interpret their objectives. “We expect this to lead, in turn, to better information for consumers and investors to make their investment decisions, and to more effective competition.”
The FCA has consulted on this proposal and found widespread support. “Most respondents,” it said, “supported increased regulatory oversight of ESG rating providers, noting that rating services rely on considerable judgment and/or data-driven methodological processes. Some considered that any enhanced regulatory remit should also extend to other ESG data providers.”
But while the agency sees “a clear rationale for regulatory oversight of certain ESG data and rating providers”, it is ultimately a political decision: “So, we will continue to work with [UK finance ministry] the Treasury, who are considering bringing ESG data and rating providers within our regulatory perimeter.”
Marie Luchet, ESG Managing Director for Europe at ACA, a governance, risk and compliance advisory firm, said it was time for regulation to shine a brighter light on ESG ratings and their underlying processes. “Rating providers should offer more transparency around their methodology instead of just keeping everything in a black box.”
However, she urged a degree of caution: “I am not sure standardisation at this stage would be ideal, but more transparency would be welcome. Understanding the agency’s methodology is crucial. It would help bring a common understanding of the different concepts of ESG. Regulation should be cautiously done, and not in a hurry.”
Some may argue regulators have already been too cautious given that they are only now looking to act. Users of ESG ratings have flagged issues with inconsistency and transparency for some time. More recently, Bloomberg reporters and research by think tank 2DII have noted a mismatch in expectations in terms of what ESG ratings actually measure.
Regulators in multiple jurisdictions are now alive to concerns and risks, prompted partly by guidance from the International Organisation of Securities Commissions (IOSCO) on how to intervene effectively in the market. Regulation of ESG ratings in Europe could be in place early next year as part of the European Commission’s Sustainable Finance Strategy.
Fear of stifling innovation
Charles Sincock, ESG Lead at Capco, the financial services management and technology consultancy, said: ““Without formalisation, we are likely to see diversification, the problem of different ratings people doing things in different ways. Is standardisation required? In a perfect market, perhaps, no. But in the real world, data providers would push their own versions. Regulation can streamline the Darwinian process of reducing the field of providers. To speed it up it feels like there is a place for standardisation to tidy up the Wild West. Currently it’s burgeoning, growing outwards and it needs to stop.”
But he was not entirely enthusiastic about the FCA proposals. “Is regulation the right thing to do? With ESG, the E especially is front of mind. ESG ratings become harder when you get to the subjective. Over time we’ll probably get better answers. But the danger is that by speeding up, streamlining and standardising ratings, you could stifle innovation.”
Looking at the wider global picture, Kurt Schacht, Head of Policy Advocacy at the CFA, the body for investment professionals, said: “People are naturally opposed to the mis-selling of ESG products. But in terms of ESG ratings, we are still in the early innings.
“Reliability and methodology is spotty, and we are using less than the full information from issuers. Currently, the rating of responsible investment is simply another advisory service, but whether it takes on the appearance of strongly regulated credit ratings is open to question.”
“Wildly” different assessments
The UK Sustainable Investment and Finance Association (UKSIF) welcomed the FCA’s plans but said they would need to go further. Oscar Warwick Thompson, Head of Policy and Communications, said: “We are strongly supportive of the FCA’s work exploring new measures for ESG data and ratings providers, and believe this group should be brought within the UK’s ‘regulatory perimeter’. This is particularly important as ESG data becomes more embedded in firms’ investment and lending decisions and the demand for reliable data grows further.
“Broadly speaking, transparency should be the over-arching objective policymakers rather than seeking greater convergence between providers’ ratings.”
He added: “To markedly improve the quality of data provided by ESG data providers, policymakers also need to strengthen corporate disclosures. As the demand for robust ESG data continues to grow, the role played by ESG data and ratings providers will become more fundamental to the finance sector’s transition.”
Demand for sustainable investment opportunities has spurred growth in ESG ratings by asset managers in particular, often as an input into a proprietary methodology. In October 2020, KPMG, the professional services firm, noted: “In the past year, asset managers and investors have increasingly been using ESG ratings to more effectively inform investment decisions.
“However, as there is no single, accepted methodology for calculating ESG ratings, various ratings agencies often have wildly different assessments of the same company, which can prove frustrating. Further complicating the problem is the fact that most data used in ESG ratings is retrospective, making it challenging to foresee how resilient companies are to future risks without the aid of supplemental data analysis.”
Robust governance needed
Internationally, said KPMG, there are roughly 30 significant ESG data providers, of which only a handful offer global coverage. It added: “Although ESG ratings are not perfect, they serve an important role in providing a snapshot of a company’s performance to support more sustainable investment decisions. We believe asset managers should make use of this data, as well as applying their own research. “
The FCA noted that there was currently a low correlation among different providers’ ESG ratings on any given company. It added: “We consider that this reflects the inherent multi-dimensionality of ESG, the multiplicity of ESG rating and rating‑like products (often with different aims and objectives), and the continued innovation in methodology as the sector grows and evolves.”
This, said the FCA, need not be a source of harm, provided the rating providers are transparent about their methodology and about information and data inputs, such as data sources and approach to data gaps; that they determine their outputs by applying systematic processes and sound systems and controls; that they identify and manage conflicts of interest and that they operate with robust governance.
The agency added: “These conditions are equally applicable to many value‑added ESG data products, especially where the provider exercises judgement. If these conditions are met, users may be more confident that the ESG data and rating products they rely upon are independent and free from bias. Users may also be better equipped to assess different products and to form a view on their fitness for purpose.”
But it warned: “However, some of these conditions may not be fully met in practice, thereby directly posing risks to our operational objectives.”
Misgivings in some quarters
The FCA identified two potential governance trouble-spots in the ratings landscape. The first was inadequate management of conflicts of interest. It said: “Good governance and conflict management, along with sound systems and controls are critical to ensuring that documented ratings methodologies and processes are followed systematically, and that ratings outputs are independent and free from bias.
“Any shortcomings in governance, controls or conflicts management could impact the quality, reliability and independence of ratings, and, ultimately, undermine trust in the market.”
The second related to insufficient engagement with rated companies, arising partly from the high cost of meeting ratings providers’ data requests. The FCA said: “Responding to data requests from multiple rating providers is costly. Companies may therefore prioritise responses to certain ESG rating providers, potentially leading to some market distortion.”
In its consultation, the FCA found misgivings about aspects of potential regulation among parts of the industry. “Some ESG rating providers specifically emphasised the need for ESG ratings to remain completely independent of third‑party influences,” the FCA noted. “Several respondents noted that any regulatory approach would have to accommodate appropriate protection of intellectual property.”
Furthermore: “The majority of respondents valued the diversity of opinions and approaches among rating providers, and therefore did not want to see a convergence in methodology.” But this was not a unanimous view; some respondents said the low correlation among different ESG ratings providers “remains problematic when the analysis of objective data leads to widely diverging interpretations between providers”.
While comparisons were frequently made with the mainstream credit rating agencies (CRAs), respondents pointed out some key differences. The CRA market is mature and well-established, while ESG ratings is a relatively young sector. ESG ratings measure a range of factors whereas CRAs focus on just one – the company’s creditworthiness.
The FCA added: “CRAs follow an ‘issuer pays’ model, while ESG rating providers typically have an ‘investor pays’ model, and CRAs issue information on what would trigger a rating upgrade or downgrade, which is not the case for ESG rating providers.”
To end where we began, assuming HM Treasury, as seems likely, approves the proposals, the hard work starts here.