Growth by Regulation – an Oxymoron?

Vernon Dennis, Partner at Howard Kennedy, highlights the challenges facing the UK’s attempts to regulate ESG ratings at a time of global regulatory divergence.

Does the drive for economic growth require free market orthodoxy with accompanying deregulation, or can increased regulation providing transparency, accountability, and certainty foster the conditions for investment and growth? The UK government’s stance on this question is revealed by the latest announcements on plans to regulate the ESG ratings industry.

On 14 November 2024, HM Treasury released the UK’s response to the consultation on the regulation of ESG ratings providers (‘the response’); where a notable 95% of respondents had shown support for regulation. The response was accompanied by draft legislation (The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) (No. 2) Order 2024) in respect of which technical comments are sought by 14 January 2025 (‘the draft legislation’).

Together the response and draft legislation build on Chancellor Rachel Reeves’ announcement made in Toronto on 8 August, before representatives of the energy and infrastructure industries, that the new government would move early to introduce legislation in 2025, with the Financial Conduct Authority (FCA) taking responsibility for setting rules for the new regime. Reeves had stressed that the government will seek to position the UK as a ‘clean energy superpower’ and with the establishment of a National Wealth Fund backed by £7.3 billion, the government hopes to attract further private investment in green and sustainable industries. ESG investment is thus seen as catalyst for economic growth.

In the foreword to the response, the important interplay between economic growth and ESG regulation is underlined. “Growth is the number one mission of this government… With the global ESG market predicted to surpass US$40 trillion by 2030, investors and markets are making increasing use of ESG ratings to inform investment decisions and capital allocation. Bringing ESG ratings providers into regulation will boost investor confidence, reduce greenwashing, and address the lack of transparency highlighted in responses to the government’s consultation.”

A question of terminology

The draft legislation itself contains few surprises. Currently a broad range of terminology being used; not all ESG ratings use the term ‘rating’, and instead may use the word score, mark, assessment, opinion, or solution. However, ESG products can be identified by the objective they serve, which is to make an assessment, an evaluation, or value judgment of the characteristics of an entity or product as related to ESG matters. As a result, the proposed definitions for the purposes of the regulatory regime seek to cover both form and substance:

An ESG rating being defined as “an assessment regarding one or more ESG factors, produced in the form of an ESG opinion, an ESG score or a combination of both, whether or not it is characterised as an ESG rating.”
An ESG opinion defined as “an ESG rating involving substantial analytical input from an analyst, whether or not it is characterised as an ESG opinion.”
An ESG score defined as “an ESG rating derived from data and a pre-established statistical or algorithmic system or model, without additional substantial analytical input from an analyst, whether or not it is characterised as an ESG score.”

In using the phrase “regarding one or more ESG factors”, the government intends to capture both general ESG ratings products (e.g. aggregate ESG ratings on corporates or funds) and specific ones (e.g. biodiversity or controversy scores).

International and EU standards

The UK government is seeking to ensure its ESG regulatory regime (and regulation of rating agencies) is not an outlier or one that seeks to set a ‘gold standard’. Instead, the UK is looking to align domestic ESG regulation with developing international standards. For example, the ESG rating definitions referred to above align with International Organization of Securities Commissions (IOSCO) standards. This echoes the fact that the proposed UK sustainability reporting standards and UK sustainability disclosure requirements are being aligned with the International Sustainability Standards Board (ISSB) whose standards in turn have been adopted by IOSCO.

The draft legislation also seeks to ensure that the UK is one step ahead of forthcoming EU legislation (the Regulation on Transparency and Integrity of ESG Rating Activities (ESGR)) which will come into force in 2026. It was interesting to note that when announcing that the FCA would be responsible for drafting the rules, Reeves made clear that these rules would look to align with the ESGR. Whether a more Eurosceptic government would have felt compelled to exploit the so-called ‘Brexit dividend’ and introduce its own rules is open to question, but the realpolitik of this announcement is that with the EU’s adoption of the ESGR, time is limited, and the UK needs to ensure that it has ‘equivalency’ prior to EU-wide market regulation.

The ESGR will similarly apply to a very broad range/most ESG rating agencies operating in the EU and encompass agencies that rate a single ESG criteria (e.g. net zero or supply chain) or who offer multiple rating. The ESGR will apply to non-EU entities that issue and distribute ratings in the EU.

ESG rating agencies will be authorised by European Securities and Markets Authority (ESMA) or equivalent. Providers must separate the ratings business from certain activities (e.g. providing consultancy services to investors) and be aware of conflict. To ensure transparency, providers will be required to detail methodologies, models, and assumptions (including use of AI) on their website. The rating agency must disclose whether the analysis is backward or forward looking, what the industry classification is, and the scope and overview of data sources. This will require rating agencies to give thought as to whether developing AI products can happily co-exist in a disclosable ‘fixed’ methodology, i.e. can the rating agency explain how the data arises, or check that the data is obtained through verifiable sources.

As ever the devil will be in the detail, and whether the eventual FCA rules will be as prescriptive as the ESGR remains to be seen. Potential divergence from the ESGR would reflect a strategic shift towards greater regulatory independence and flexibility, with the UK seeking to tailor its sector specific regulations to address domestic priorities and economic objectives more effectively.

Looking across the pond

However, both the UK and EU approach may conflict with the deregulatory agenda anticipated under the Trump administration in the United States. Trump’s policies emphasise extensive deregulation across various sectors, including energy, healthcare, and financial services, focusing on reducing federal oversight to stimulate economic growth and innovation. While at least initially the US Securities and Exchanges Commission may, like the FCA, look to follow international standards (it will not want the US market for sustainable investment to be uncompetitive) in due course the wider ‘America First’ and ‘Drill, Baby, Drill’ policies may push ESG regulation in the US to the margins.

In conclusion, while the US is likely to move towards broader and more aggressive deregulation as a means of promoting growth, the UK’s regulatory strategy is more measured and sector specific, seeking to promote growth through boosting investor confidence in ESG ratings. This divergence may lead to hugely different regulatory landscapes and economic dynamics in the two countries.

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