Synergy Crucial for UK ESG Ratings Regulation
New legislation looks to improve sector transparency, with “considerable benefits” to be derived from a harmonised approach.
The UK’s project to introduce new rules for ESG ratings early next year has been widely welcomed by industry, but experts have underscored the importance of international alignment to avoid fragmentation.
The regulation announced by UK Chancellor Rachel Reeves last week is part of an attempt to heighten transparency in the sector, which has long faced criticism for its opaqueness. The chancellor flagged concerns around lack of transparency in the ratings process, suggesting more clarity over ESG ratings would bolster the UK’s efforts to develop sustainable finance.
Issues around the misalignment between jurisdictions on ESG ratings have previously been raised. Many now see the creation of these rules as a perfect occasion to restate the message, insisting on the need to ensure effectiveness and avoid market confusion.
“Avoiding fragmentation is an important part of this challenge, for which the Financial Conduct Authority (FCA) will need to closely collaborate with international standard-setters (such as the International Organization of Securities Commissions’ (IOSCO) and European Securities and Markets Authority) and regulatory authorities,” Oscar Warwick Thompson, Head of Policy at the UK Sustainable Investment and Finance Association (UKSIF), told ESG Investor.
“Greater international alignment has the potential to enhance innovation in the market, reduce barriers for UK-based investors in accessing ESG products and ratings, promote investor protection, and support new and smaller players in the market.”
UKSIF anticipates considerable benefits from a more harmonised approach due to the highly global nature of ESG ratings, with a higher degree of interoperability likely to help reduce compliance costs and complexity for providers – while keeping costs for end users reasonable.
Enhancing transparency
Reeves’ announcement built on a statement from former UK chancellor – and now Shadow Chancellor – Jeremy Hunt, in which he said the government would regulate the provision of ESG ratings used in investment decisions as part of the 2024 Spring Budget in March.
The government consulted on a potential regulatory regime last year, having previously announced its intentions as part of the Edinburgh reforms unveiled in December 2022.
Reeves has selected the country’s industry watchdog, the FCA, to set the rules of the new regime.
“This law is expected to focus largely on the future scope of the regulatory framework,” Warwick Thompson explained. “We would like to see the FCA focus on enhancing transparency in the market and improving governance arrangements while addressing the risk of conflicts of interest.”
To enhance transparency, the rules should require clearer disclosure of methodologies used to calculate ESG metrics and ratings and help avoid the issue of ‘black box’ methodologies, Warwick Thompson suggested.
“It is in the interest of the industry at large to have greater clarity of process when it comes to these ratings, and for clients to have transparent documentation,” he added. “This should all help to avoid confusion.”
ESG data and ratings providers generated revenues of almost €1 billion (US$1.1 billion) in 2021 alone, which have risen since. Publicly listed companies spend between €200,000-450,000 per year on ESG ratings-related costs on average, while institutional investors paid an estimated €1 million for collecting, analysing, and reporting ESG metrics.
“We are keen to see a drive to increase transparency that will help consumers get clearer and accurate information,” said Paris Jordan, Head of Responsible Investment at UK wealth manager Charles Stanley. “The focus on ensuring users are well-informed and understand the criteria used in the ratings process is a key area that needs improving.”
Regulatory fragmentation risk
The FCA had previously commissioned the International Capital Market Association (ICMA) and the International Regulatory Strategy Group to create a code of conduct for ESG ratings and data providers, published last December.
The code aimed to improve the availability and quality of information provided to investors at product and entity-levels, promote good governance, enhance competition through better comparability of products and providers – as well as translate the IOSCO recommendations to a UK setting.
At the time, industry participants told ESG Investor the code could help to harmonise regulation around practices globally. Market participants flagged concerns around fragmentation risks and highlighted the importance of interoperability between domestic and international standards.
“The key word is synergy: there is no doubt that regulation is the next step for this growing market, but policymakers should avoid fragmentation at all costs to preserve much-needed competition, innovation and investments in the space,” Arthur Carabia, Director of ESG Policy Research at Morningstar Sustainalytics, told ESG Investor. “Any major differences and add-ons require additional compliance efforts, with often little benefit to investors and market concentration implications.”
Other jurisdictions have also been developing rules and regulations on ESG ratings. In February, the European Parliament and Council signed off a proposal to regulate such activities, aiming to boost investor confidence in sustainable products and improve comparability and reliability between providers by increasing transparency and restricting potential conflicts of interest.
When the regulatory framework was initially proposed, expects once again sounded the alarm bells of regulatory fragmentation.
The Economic and Monetary Affairs Committee (ECON) has since made significant changes to the draft EU ESG Ratings Regulation proposed by the commission last December – including disaggregating the consideration of E, S and G factors to prevent obscuring poor performance on individual metrics.
In January, the committee proposed amendments that meant an entity seeking to obtain more than one ESG rating would need to choose at least one ratings provider with a market share below 15%.
Elsewhere in the world, the Monetary Authority of Singapore (MAS) finalised its own code of conduct for ESG ratings and data products providers last December.
ICMA has hosted the MAS’ voluntary code of conduct on its website since October 2022, and has also worked with the Hong Kong Securities and Futures Commission to assess whether the code could work as a baseline for a similar initiative in Hong Kong.
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