Close Co-ordination Advised on UK’s ESG Ratings Rules

Regulation should aim to “reduce ‘black box’ methodologies” in ESG ratings market, says UKSIF. 

Following HM Treasury’s consultation on regulating ESG ratings providers, the UK government has been urged to ensure harmonisation with a draft code of conduct commissioned by the Financial Conduct Authority (FCA), as well as rules in other jurisdictions. 

The Treasury’s proposed rules aim to bring the ESG ratings sector under regulation, with a view to improving 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. 

Separately, the FCA has proposed an industry-led voluntary code of conduct for ESG data and ratings providers that looks to foster “greater transparency and trust in the market”.  

The UK Sustainable Investment and Finance Association (UKSIF) published its response to the Treasury’s consultation, in which it advised drawing on the FCA’s code of conduct. 

“We would very much encourage further co-ordination between the Treasury and FCA’s respective initiatives”, UKSIF added. 

Alignment on ESG ratings rules 

UKSIF described the Treasury’s consultation on ESG ratings and the ongoing work on the FCA-commissioned voluntary code of conduct as a “primary regulatory overlap”, calling for a “clearer over-arching vision” from UK policymakers on the link between the two initiatives, the extent to which they will be integrated, and their respective objectives.  

It argues for a “much better” dialogue between providers and users of ratings, saying the Treasury and FCA could consider wider work to enhance understanding on how ratings are used in practice, as well as promoting consensus around metrics for different sustainability factors. 

A major stumbling block cited by UKSIF and others is the ‘black box’ methodologies used by ESG ratings providers, which restricts their transparency.  

“There is, at present, a relative lack of clarity on the underlying rationale for different approaches adopted by some ratings providers, while investors and other users have concerns on ‘what happens under the hood’ of an ESG rating,” UKSIF said in its response. 

Joe Dabrowski, Deputy Director of Policy at the Pensions and Lifetime Savings Association (PLSA) told ESG Investor that the “common industry grievance” was the “lack of consistent and comparable metrics” from ESG ratings and data providers, and underlying companies.  

“It is essential that the UK Treasury take steps to address this and ensure there is transparency across the market”, he added. 

UKSIF recommended the Treasury consider introducing a wider transparency rule, or an over-arching principle, as part of the UK’s regulatory regime for ratings to introduce “clearer expectations of all providers in regards to transparency”. 

Speaking at City & Financial Global’s recent Climate and ESG Data summit, Mark Manning, Strategic Policy Advisor on Sustainable Finance at the FCA, said the regulator sees the Treasury’s proposals as an “important direction of travel to build a trusted market for the provision of ESG data and rating services”. He underlined that transparency of the methodologies that data and rating service providers are using is “absolutely crucial”.  

Transparency and timelines 

In their joint consultation response, the International Swaps and Derivatives Association (ISDA) and the Association for Financial Markets in Europe (AFME) also said the ESG ratings rules should be aligned with the FCA’s code of conduct as much as possible. Both organisations suggested this would help “foster high standards and transparency while allowing for enough of the necessary flexibility needed for such a diverse market”. 

Carol Thomas, Head of Sustainability and Responsible Investments at the Investment Association, said the organisation supports regulation of ESG ratings providers to “ensure that all aspects of the market for sustainable and responsible investment products are rooted in clarity and transparency that delivers for end clients”. 

UKSIF also said it would welcome the publication of specific timelines, envisaged phases, and the overarching objectives for both initiatives. 

Dabrowski said that he expected a “fuller picture” of the regulatory landscape for ESG ratings and data providers by the end of this year, given the government’s commitment to present the UK green taxonomy in the autumn. 

The ESG Data and Ratings Code of Conduct Working Group (DRWG) has also released its consultation on a draft code. Convened by the FCA in November 2022, the DRWG is co-chaired by M&G, Moody’s, London Stock Exchange Group and Slaughter and May. The group expected to finalise its code of conduct by the end of the year.  

Developed alongside the International Regulatory Strategy Group and the International Capital Market Association, the code 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. The consultation is set to run until 5 October. 

A Moody’s spokesperson told ESG Investor that the DRWG had focused  on ensuring the code is “internationally consistent”, with close alignment with IOSCO’s recommendations while “taking into account developments in jurisdictions such as Japan, Singapore and the EU”.  

“We hope the code of conduct will be a significant step in the development of consistent global standards for ESG ratings and data product providers,” the spokesperson added. 

The DRWG confirmed that the code is not restricted to the UK and can be adopted by providers in other jurisdictions, as it was designed with the intention of developing a “globally consistent” voluntary code for ESG data and ratings providers to “foster an effective, trusted and transparent market”.

Sacha Sadan, Director of ESG at the FCA, said that the consultation marked an “important step in increasing transparency and trust in the growing market for ESG data and ratings products”, with the code being “developed with international consistency in mind”.  

International coherence 

UKSIF also called on the Treasury to draw on the criteria of European Commission’s recently published draft regulatory framework for ESG ratings providers.  

Sanctions for ESG ratings agencies’ conflicts of interest could trigger fines of up to 10% of annual turnover, as the Commission attempts to increase transparency as part of its greenwashing crackdown. 

UKSIF noted the EU’s criteria as being rigorous, objective, continuous, and reviewed at least annually to promote accuracy, suggesting UK adopt similar criteria to boost the transparency in rating providers’ methodologies. 

Pietro Bertazzi, Global Director of Policy Engagement and External Affairs at environmental non-profit CDP, had previously warned that the ESG ratings rules in different jurisdictions risk a “potential fragmentation” in the regulatory architecture of ESG ratings and data products “at the global scale”.

ISDA and AFME’s response also underscored the importance of the Treasury and the FCA continuing to “coordinate with their international counterparts to avoid a fragmented approach”. 

Enhanced comparability across regions “will be helpful” for global investors, PLSA’s Dabrowski said. 

India become the first country to officially regulate ESG rating providers this week. Extending its credit rating regulations, the Securities and Exchange Board of India’s rules will apply to both domestic and foreign providers if their ratings are utilised by users in the country. 

Japan’s Financial Services Agency (FSA) has already finalised a code of conduct for ESG data providers operating in the country, with the code covering the quality of the country’s ESG ratings and data, and the transparency and disclosures of the methodologies used in such ratings. 

Last week, Singapore also proposed an industry code for ESG ratings and data product providers. The Monetary Authority of Singapore launched a public consultation on an industry code of conduct for providers, which will run until 22 August, as the proposed code looks to establish minimum industry standards of transparency in methodologies and data sources, governance, and management of conflicts of interest. 

“Given the inherently global nature of the ESG ratings market, as much harmonisation as is possible with the recommendations from IOSCO, as well as regulations from the European Union and other regions of the world, would deliver benefits for this market”, UKSIF said.  

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