The consultation considers what a potential regulatory regime would look like, and its proposed scope.
The government announced as part of the Edinburgh Reforms last year that HM Treasury would consult on a potential regulatory regime for ESG ratings providers. Now HM Treasury is seeking views on whether such a regime should be introduced, and what its potential scope should be. The government is not proposing to regulate ESG data providers for the time being. The consultation is open until 30 June 2023; no further timetable has been set at this stage but it could take a couple of years for any new regime to be finalised and take effect.
What Are ESG Ratings?
The consultation paper describes ESG ratings as “assessments of the ESG characteristics of entities, such as companies and sovereigns; or of products, like financial instruments”. ESG ratings can cover a wide range of areas, such as a company’s exposure to and management of ESG risks and opportunities, as well as a company’s ESG impact.
As ESG criteria become more important, market participants need a way of assessing and measuring these criteria. Consequently, they have increasingly started to rely on ESG ratings when deciding how best to allocate capital and when making investment decisions.
Why Regulate ESG Ratings Providers?
Given the importance of ESG ratings and their ever-increasing influence, it is seen as critical that they are reliable, and that the methodologies used to produce such ratings are sound and transparent. The FCA confirmed last year that it sees a clear rationale for regulating ESG ratings providers (please see this Latham blog post). Although the ESG Data and Ratings Code of Conduct Working Group is developing a voluntary Code of Conduct, the UK government feels that mandatory rules are necessary in this area.
Whilst the regulation of ESG data providers alongside ratings providers has been discussed, HM Treasury is not proposing to regulate data providers at this juncture. According to HM Treasury, the key risk of harm stems from the assessment or judgement made by ratings providers, which investors and other market participants then rely on. Therefore, HM Treasury considers that providers of raw or unprocessed data, and data that is only minimally processed (for example by formatting or summarising) should fall outside the scope of regulation, provided there is no separate assessment. HM Treasury states that it will keep this under review, and in the meantime encourages ESG data providers to follow the voluntary Code of Conduct when finalised.
What Would Regulation Look Like?
HM Treasury intends to capture a wide range of ESG ratings used in financial markets, regardless of whether or not they are labelled as ratings, or how they are marketed. To bring ESG ratings providers within the regulatory perimeter, HM Treasury would need to make changes to legislation, and the FCA would then need to consult on relevant changes and additions to its rules.
HM Treasury is proposing to amend the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) to include 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, as a regulated activity. This would include provision of ratings to both institutional and retail users in the UK, but HM Treasury only intends to capture paid-for ratings. HM Treasury also notes that it would intend to include ESG ratings that are directly produced by analysts, as well as ratings that are generated through an algorithm.
Notably, this formulation would require the ratings provider to know that the rating would be used in relation to a specified investment. However, capturing only paid-for ratings could reduce this burden. HM Treasury specifically asks for feedback as to whether ratings providers would know what their ratings would be used for.
Anyone performing this new regulated activity would be required to gain FCA authorisation, and to comply with relevant FCA rules. The FCA would need to devise appropriate rules and a supervisory strategy for ESG ratings providers. The FCA has indicated that it anticipates using the main elements of the International Organization of Securities Commissions’ (IOSCO) recommendations for the regulation of ESG ratings and data providers as a starting point for its rules (for more information on the IOSCO proposal, please see this Latham blog post).
How Would the Regime Apply Proportionality?
Since the market currently contains a few large providers of ESG ratings and numerous smaller providers, HM Treasury is considering two options to keep the regime proportionate:
- All providers would require authorisation, but only larger providers would be subject to detailed FCA rules.
- Only providers over a certain size threshold would face authorisation requirements. There could be an opt-in mechanism so that smaller providers could choose to be regulated if they felt this to be beneficial. Unauthorised providers could also be subject to some regulatory requirements through, for example, the forthcoming Designated Activities Regime, which will allow the FCA to impose regulatory requirements on unregulated entities performing activities designated by HM Treasury.
HM Treasury is seeking views in particular on where it should draw the line between small and large providers, and the best way to measure size. It also asks whether any factors other than size should be considered when applying proportionality.
Would Third Country Ratings Providers Be Captured?
HM Treasury intends to capture the provision of ratings to users in the UK by firms anywhere in the world. Although (as the consultation notes) there is precedent for this approach, it is a major and important departure from the UK’s predominant approach, which treats an activity is being “in” the UK where the characteristic of the activity being performed (which would be the provision of the rating, not the receipt) is here. The potentially extraterritorial effect is likely to receive significant scrutiny as part of the consultation process.
The paper also acknowledges that other scenarios require some careful thought and consideration, for example whether the indirect provision of ESG ratings to UK users should be captured. HM Treasury emphasises that the FCA would need to consider whether overseas firms would need a UK presence in order to obtain authorisation. However, it does not rule out the possibility of recognising equivalent overseas regimes in future.
What Would Be Excluded From Regulation?
HM Treasury sets out some potential exclusions in the consultation paper. Notably, these include ratings created by an entity solely for use by that entity, such as asset managers that create their own internal ratings. However, HM Treasury seems undecided on whether ratings used more widely intra-group should be caught and asks for views on this issue.
HM Treasury also proposes to exclude:
- Investment research products
- Recommendations by proxy advisors
- External reviews of ESG-labelled bonds
- Credit ratings that consider the impact of ESG factors on creditworthiness
- Consulting services, except activities that could impact capital allocation, such as provision of an ESG rating for the purpose of an IPO
- Academic research and journalism
HM Treasury aims to introduce a “proportionate but effective” regulatory regime, and is asking in particular for feedback in relation to any practical challenges associated with introducing regulation of ESG ratings providers, and any potential overlap with existing areas of regulation (such as benchmark regulation). HM Treasury highlights that being one of the first jurisdictions to introduce regulation in this area creates an opportunity for the UK to be a global standard-setter, and it clearly hopes that other jurisdictions would replicate any future regime.
Whilst regulation is likely required in this area, formulating a regime with an appropriate scope will be challenging. As with the regulation of benchmarks, these sorts of activities can be difficult to define, often leading to a much broader scope than was intended. Any entities potentially caught by a new regime should consider HM Treasury’s proposals in detail, especially whether it would capture the right activities and whether the proposed exemptions would suffice. Latham & Watkins will continue to monitor developments in this area.