Regulation Of ESG Ratings Activities

Shepherd and Wedderburn LLP


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ESG data and ratings play a key role in investment decisions for pension funds. In this article, we consider what ESG data and ratings are and how they are used by pension funds...
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ESG data and ratings play a key role in investment decisions for pension funds. In this article, we consider what ESG data and ratings are and how they are used by pension funds, as well as the forthcoming regulation of ESG ratings activities in the UK and EU.

Investment products aligned with Environmental, Social and Governance (ESG) factors have enjoyed increased popularity in the UK and EU in recent years, offering what many consider a more sustainable or ethical way to invest.

When it comes to making an investment decision, ESG-aligned investors, including many pension funds, are keen to ensure these products match their descriptions. This is where ESG data and ratings come in.

What are ESG data and ratings?

ESG data are the metrics used to assess the performance of a company or product against various ESG parameters. They can include, for example, CO2 emissions, diversity and inclusion statistics, or arrangements for company board elections.

ESG ratings are opinions and assessments based on an analysis of underlying ESG data, often presented as a label or score. Commonly, ratings providers compile a company's or product's ESG datapoints, apply methodologies and value judgements, and come up with an ESG performance marker. Today, more than half a dozen major providers issue ESG ratings.

Why and how are they used by pension funds?

UK pension schemes are a key source of capital and investment, with over £2 trillion in capital invested across a range of asset types. The core focus of scheme trustees and pension providers is on member outcomes, and ESG ratings play a key role in investment decisions. For example, allowing members to choose ESG-focused funds for their defined contribution pension savings; or ensuring trustees can show they are taking account of ESG factors when making investment decisions.

What concerns have been expressed about ESG data and ratings?

As the demand for ESG data and ratings is increasing among pension funds and other investors, so too is the demand for greater regulatory oversight of the firms that provide those data and ratings in order to address concerns about consistency and reliability, in particular:

  1. Inconsistency: methodologies and assessments can vary across providers. The underlying ESG data can be subject to varying degrees of processing. Some providers attach greater prominence to certain aspects, leading to divergent ratings for the same company or product.
  2. Conflicts of interest: rating providers often provide consultancy services on top of their ESG assessments for instance, by advising companies on how to boost their ESG scores. This might be perceived as undermining the impartiality and credibility of their ratings.
  3. Lack of transparency: ratings providers usually do not disclose their methodologies and companies and investors sometimes report difficulties in communicating with providers to rectify issues with ratings.

The future regulatory framework for ESG rating and data product providers in the UK and EU

To address those concerns, a voluntary code of conduct for providers of ESG ratings and data products providers was launched last December by an industry-led working group convened by the International Capital Market Association (ICMA) and the International Regulatory Strategy Group (IRSG). The code of conduct introduces standards that aim to foster a trusted, efficient and transparent market for ESG ratings and data products.

In addition to the voluntary code of conduct, HM Treasury is poised to introduce mandatory regulation of ESG rating providers in the UK under the Financial Services and Markets Act 2000.

The regulatory framework for ESG ratings providers in the UK is expected to be administered by the Financial Conduct Authority (FCA), who would create a system of rules based on the following four pillars:

  1. Transparency: methodologies, metrics and performance indicators should be defined and publicly disclosed.
  2. Good governance: providers should have sufficiently robust corporate governance structures to prevent conflicts of interest, with adequate staffing and resources to ensure integrity of service.
  3. Management of conflicts of interest: any conflicts should be mitigated, identified and disclosed, with the adoption of policies to prevent political or economic interference.
  4. Robust systems and controls: providers should use high-quality data, basing ratings on transparent methodologies and, where possible, public data sources.

Data providers will likely not be covered by the UK regulatory framework. ESG data products are regarded as inherently more transparent and objective, with fewer concerns about their consistency and reliability compared to ratings.

The European Union is also set to introduce regulations for ESG ratings providers across the EU. A provisional agreement has been reached between the EU institutions for a proposed regulation on the transparency and integrity of ESG ratings activities, which would introduce a similar regime for clarity of rating fundamentals and avoiding conflicts of interest.

What would the proposed reforms mean for pension funds

The proposed reforms will be welcomed by the pension funds, as it will give greater confidence that the ESG ratings they rely upon are robust and accurate. A continuing challenge will be meeting member demands and expectations in the ESG data space, and greater transparency around ESG ratings will help ensure this.

This article was Co-authored by Trainee Matthew Ferguson.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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