31 March 2023 Benjamin Maconick ESG - Sustainable finance - Financial Regulation

HM Treasury consults on regulating ESG ratings providers

HM Treasury has launched a consultation setting out proposals on the scope for a potential regulatory regime for ESG ratings providers. 

Proposed Regulated Activity

The core policy proposal is to bring into the scope of regulation: “the direct provision of an assessment of environmental, social, or governance factors to a user in the UK, where the assessment is used in relation to a specified investment in the RAO, unless an exclusion applies”. However, HM Treasury also note that other activities may also be brought into regulation, including some cases of indirect provision of these assessments, and where these assessments are used in relation to certain things other than RAO specified investments. A key clarification of the core proposal is that it does not matter how a product is labelled (i.e. whether it is presented as an ESG rating or not), and they have taken a deliberately broad approach to just saying it could be in relation to E, S or G. 

Whilst, in contrast to the IOSCO recommendations on the same topic, they are not proposing to regulate raw ESG data at the same time as ESG ratings, the proposal would include any “assessments” (i.e., whether they are called “ratings”, “scores”, “marks”, or anything else, including where they might be considered to be data products). So, the proposal could include certain things we might think of as “ESG data” even though that is not the primary focus of HM Treasury. The basic rationale given in the paper for drawing this distinction between “assessments” and raw data is that the content of data is “inherently more transparent than a rating which relies on a final evaluation”. In contrast ESG rating methodologies are more likely to be complex, potentially opaque, more subjective and vary more widely between providers. However, they have said HM Treasury and the FCA will continue to monitor the ESG data market and engage with market participants to understand whether further intervention may be necessary. 

HM Treasury’s proposed approach to capturing ESG ratings in regulation is by including a new regulated activity within the RAO. This new regulated activity would cover “providing an ESG rating to be used by persons in the UK in relation to an RAO specified investment”. However, they flag that there are ESG ratings of other things which may not be clearly in scope of specified investments, such as some voluntary carbon credits. So, HM Treasury will consider how these should be accounted for. 

HM Treasury is alive to the issues that could be raised by bringing very small ratings providers into the scope of RAO regulation, and proportionality is a consideration here. Hence, they discuss a couple of options, one being to only subject providers above a certain size threshold to authorisation requirements under the RAO (with smaller providers subject to requirements using other mechanisms not require authorisation). 

Exclusions

Given the broad scope of the proposed regulated activity, the consultation envisages a number of exclusions:

  • HM Treasury proposes that the regulated activity would not involve the provision of ESG ratings by not-for-profit entities.
  • ESG assessments where ratings are created by an entity solely for use by that entity (envisaging internal rating systems used by investment managers). However, this exclusion would not cover where a firm creates ratings for their own internal use as well as for external use. HM Treasury have asked for views on whether ratings produced by a firm for its use and its group’s use should be regulated.
  • Credit ratings which consider the impact of ESG factors on creditworthiness, given that these products are already subject to requirements under the Credit Ratings Agencies Regulation.
  • Investment research products, such as equity research reports.
  • External reviews, including second-party opinions, verifications, and certifications of ESG-labelled bonds. 
  • Proxy advisor services, such as voting or recommendations to shareholders of firms.
  • Consulting services, even where these relate to ESG matters. 
  • Academic research or journalism, even where that relates to ESG matters.
  • Raw ESG data (as noted above where this doesn’t amount to an “assessment”).

Territorial scope 

HM Treasury proposes to capture, at a minimum, the direct provision of ESG ratings to users in the UK, by both UK firms and overseas firms. This includes direct provision to both institutional and retail users in the UK. This would not capture the provision of ESG ratings by any UK or overseas firm to any user outside the UK.

  • “Direct provision” intends to capture where an ESG rating is provided to a UK user who has paid for that rating, either on its own or as part of another service or bundle of products. It does not intend to capture scenarios where a UK user accesses a free rating.
  • HM Treasury have indicated that there may be further scenarios that could be included in the scope of regulation, such as some instances of indirect provision of ESG ratings to UK users. For example, this could be where an ESG ratings provider does not have a contractual agreement with a UK user, but its ESG ratings become available to UK users anyway (for example via intermediaries). Or it could be where a UK investor uses an ESG rating which has been paid for by a rated entity located overseas (i.e., when an ESG ratings provider use an ‘issuer-pays’ model and that provider, or the rated firm who is the issuer, makes that rating available to UK investors).
  • HM Treasury does not express a view on whether firms carrying out these activities would be required to have a physical presence in the UK in order to obtain authorisation, and note it is for the FCA to determine. The detail of any such requirements would be subject to full FCA consultation.

Content of rules

It’s worth flagging that this consultation does not cover the potential content of regulatory rules that ESG rating providers would be subject to, as under the UK’s regulatory framework going forward this will fall within the remit of the FCA to determine. However, it does note that the FCA has indicated their regulatory approach would take the main elements of IOSCO’s recommendations as a starting point for any rules. 

Timing

The consultation will close on 30 June 2023.