Regulating the Raters

UK set to regulate ESG ratings providers

Environmental, social and governance (ESG) continues to be at the top of regulatory agendas in the capital markets industry in 2024. The European Union has become the trailblazer for setting a comprehensive ESG regulatory framework, with the deployment of comprehensive frameworks such as the Sustainable Finance Disclosure Regulation (SFDR), the Corporate Sustainability Directive (CSRD) and the EU Taxonomy.

ESG regulations can be split into general ESG regulation, which targets all companies regardless of industry, and ESG financial regulation, which specifically targets investment products and financial services firms. Generally, financial firms must adhere to both sets of regulations; for example, EU-based financial firms must adhere to the EU-wide EU Taxonomy, and the financial industry-specific SFDR. More details about the EU’s ESG regulatory framework can be found in our Trends in ESG 2024 report.

However, tighter and more complex ESG requirements and competition for increasingly ESG-focussed investors have prompted some financial firms to engage in greenwashing, where firms make spurious claims about the degree to which their statements, declarations, actions, or communications reflect their actual levels of sustainability. Greenwashing incidents increased by roughly 70%, globally, in 2023, in comparison to the previous year. Studies have shown that companies with strong ESG performance tend to outperform their peers on a number of financial metrics, including return on equity, total shareholder returns and risk-adjusted returns. As such, purporting to have strong ESG credentials can attract higher levels of investor interest, so it is hardly surprising that greenwashing is prevalent.

As a consequence, in order to protect investors and ensure compliance, ESG ratings providers are taking on an increasingly important role in the ESG regulatory landscape. ESG ratings provide assessments of companies‘ ESG performance and are widely used to inform investment decisions. An example is the MSCI ESG Score - one of the most commercially successful ESG ratings - which considers several key ESG-related aspects, such as carbon emissions, privacy and data security, and business ethics. Gauging these factors, from an investor standpoint, could give some idea into a firm’s overall health and long-term investment potential. Other ESG ratings providers include Morningstar, Bloomberg and the London Stock Exchange Group.

As such, the EU has also made further ESG regulatory progress, announcing its first ever rules for ESG ratings providers in February 2024. Under the rules, ratings providers will have to explicitly disclose how far a company’s operations consider environmental, social and governance factors and not just the impact of ESG on a company’s revenues. ESG ratings providers in the EU will have to be authorised and supervised by the European Securities and Markets Authority. Ratings providers based outside the EU but conducting business in the EU will need to have their ratings endorsed by a ratings provider regulated in the EU. EU states and European Parliament still need to give formal approval to the deal, which will likely come into force in 2025. In many ways, the regulations will ensure transparency, quality and reliability of ESG ratings.

In addition, the European Securities and Markets Authority (ESMA) published its final guidelines for how asset managers can use words like ‘sustainability’ and ‘ESG’ in fund names in May 2024. Specifically, it has scrapped the distinction between funds using sustainability-related terms in their titles, and those using ESG-related terms. In the final guidelines, funds are required to have 80 per cent of their assets allocated to investments aligned with the sustainability objectives of SFDR.

The UK is comparatively further behind the EU in its ESG regulatory journey, but is progressing nonetheless. The UK’s ESG regulation is centred around two pieces of legislation - the UK Sustainable Disclosure Regulation (SDR) and the Taskforce on Climate Related Financial Disclosure (TCFD). The SDR, which is phasing in from May 2024, will mandate companies and financial firms to disclose their wider sustainability impact. TCFD requires UK firms to report their firm-wide and product level consideration of climate-related risks and opportunities, both qualitatively and quantitatively. The first disclosures, for the largest asset managers, have already taken place. The second round, which captures smaller firms, took place on 30 June, 2024. Disclosures are centred around four key themes, including governance, strategy and risk management.

In fact, last week the UK government confirmed it is to introduce new legislation to regulate ESG rating providers next year. The legislation is part of a global regulatory drive to increase transparency of the sector. In doing so, the UK will seek to follow the EU’s ratings agency regulations outlined above and improve its competitiveness from an ESG standpoint.

The announcement comes as a relief for financial firms seeking to improve their ESG credentials, removing the ambiguities around ESG data and ESG scores that are prevalent across the capital markets industry. This is especially the case within third-party ESG vendors and ratings providers, who have their own iterations of scoring ESG credentials of in-scope firms. Regulatory clarity in this instance should help to provide standardised ESG benchmarks and remove some grey areas that have plagued the ESG industry for several years.

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