Insights: FCA considers new regulated activity for firms providing ESG ratings
By Harry Barnes (IQEQ) -- As the regulation of environmental, social and governance (ESG) investments continues to mature, HM Treasury has announced a consultation on the creation of a new regulated activity covering the provision of ESG ratings. Here, we highlight the key details of the proposed activity and how firms may be impacted.
ESG front and centre for investors and regulators alike
ESG ratings are becoming increasingly influential in investment decision-making. Institutional investors are considering ESG ratings more frequently, and they are becoming embedded into the investment process. This growth has put a spotlight on the provision of ESG ratings, the methodologies used, the lack of transparency and how providers manage conflicts between themselves and the rated entity.
Regulators have been increasingly focused on ESG investments and claims made by firms about the ESG characteristics of investments. With new climate disclosures and anti-greenwashing rules coming into effect at the end of next month, it is clear that all firms need to consider the ESG aspects of their business.
Regulation of ESG ratings providers
The new regulated activity would monitor the provision of ESG ratings to be used by UK-based persons in relation to specified investments in the Regulated Activities Order.
The intention of HM Treasury is to capture ESG ratings across different markets, potentially with a broad territorial scope. This means that ratings providers will have to understand how the ratings they provide are used and who they are used by – possibly even including indirect users.
The scope of the new activity captures a wide range of products too, including those currently considered by market participants to be data products. ESG ratings produced by algorithms will also be in scope, as in the eyes of the regulator there is an assessment in the creation of the algorithm, in terms of determining what factors the algorithm will consider and how those factors are weighted
Exclusions may apply
HM Treasury is consulting on a large number of potential exclusions to the new regulated activity:
- ESG data providers – The provision of raw ESG data without any assessment will not be in scope of the new regulated activity
- Not-for-profit entities – Registered charities and their overseas equivalents will potentially be exempt from requiring the new permission (although the consultation notes that charities whose main activity is the provision of ESG ratings may not be given an exclusion)
- Entities producing ratings for internal purposes – In order to ensure proportionality, entities producing their own ESG ratings used only for internal decision-making purposes might be excluded. No decision has been taken as to whether intra-group ratings fall within scope
- Credit reports considering ESG factors (as these are already regulated under the Credit Ratings Agencies Regulation)
- Investment reports considering ESG factors (as HM Treasury considers these to be different to the ratings of only ESG matters)
- External reviews, including second party opinions, verifications and certifications of ESG labelled bonds
- Proxy advisor services e.g. voting or recommendations to shareholders – Even if these recommendations relate to ESG matters they are provided for a specific purpose and should not fall within the scope of the new regulated activity
- Consulting services – Even if specific to ESG matters, they are generally ad hoc and bespoke, meaning they would fall within the exclusion. However, in some situations, such as where an ad hoc ESG rating is provided in a circumstance where it might significantly influence capital allocation (for example in an IPO), then this would not fall within the exclusion
There is the possibility that smaller providers of ESG ratings might be excluded from the requirement to seek authorisation, although no definition as to what would be considered small is given. In this situation, there would be an opt-in system allowing smaller providers to opt into the full requirements and seek authorisation.
The requirement to seek authorisation to provide services under the Financial Services and Markets Act (FSMA) only applies where the rating activity is carried out in the United Kingdom. Determining what counts as "in the United Kingdom" in the context of ESG ratings is not as clear as for other activities.
At a minimum, HM Treasury intends for all direct provision of ESG ratings to UK users to require authorisation. This would include domestic and overseas rating firms and apply to the direct provision of ESG ratings to both institutional and retail investors.
Direct provision would only cover situations where a UK user has paid for a rating, either on its own or as part of another service or bundle of services. It does not cover where ESG ratings are accessed for free.
HM Treasury does not rule out including some indirect provision in the scope of the new activity. Examples given on what could be included are where ESG ratings are provided to UK users by intermediaries, or where an entity outside of the UK pays for an ESG rating and then makes that rating available to UK users.
What needs to be done?
At the time of writing, we cannot say with certainty what the exact form and scope of the new permission will look like. Firms should consider whether they will potentially be in scope based on the current consultation. Firms should also note the seriousness with which regulators are taking ESG, particularly in the context of transparency and marketing – and especially in light of the new anti-greenwashing rules coming into force this year.