ESG rating providers: time for regulation?

This article was authored by Aylish Power, Trainee Solicitor, Manchester.

As public interest in environmental, social and governance (ESG) issues continues to grow, commitment to ESG has become of increasing significance to companies. 

More than ever, investors are turning to consider the ESG profile of companies to inform their investment decisions, and the concept of ‘responsible investment’ has been on the rise.

While investors may seek to reflect public interest by making investment decisions that will influence environmental or social changes, there is also the notion that investing in companies that place value on ESG is a profitable long term strategy, as it is more likely to be a stable and reliable investment that will generate increased returns.

ESG ratings providers

Currently, the ESG profiles of companies are assessed by ESG ratings providers. However, the industry has been faced with criticism due to its lack of regulation and consistency, as ESG is a rapidly growing concern that ratings providers may be struggling to keep up with.

Although there are many organisations that provide ESG ratings, there is currently no one standard approach. ESG ratings providers use internal guidelines to inform their ratings, and therefore weight is placed on varying factors dependent on the provider, resulting in a lack of consistency across the board.

As these providers are also not regulated, there is a concern that there is a lack of transparency as to how ratings are assessed. This lack of transparency poses a risk of ‘greenwashing’, and calls into question the reliability of ESG ratings and how well they reflect the company’s commitment to ESG.

The issues within this industry create confusion in investors looking to assess a company’s commitment to ESG, but also within companies themselves, as it leads to difficulties in understanding the basis for ESG ratings and how companies can go about improving upon this.

Proposals for change

Within the UK, the question as to whether ESG ratings providers should be brought within the remit of the Financial Conduct Authority (FCA) has been a topic of consideration for the FCA, which shares concerns about the lack of transparency and consistency within the area.

The government has also confirmed within its October 2021 policy paper, ‘Greening Finance: A Roadmap to Sustainable Investing’, that it is considering whether to bring ESG ratings providers within the scope of the FCA. The government is of the view that requiring FCA authorisation and regulation, which would impose a requirement on providers to have strong governance and management of conflict of interest, would go some way to help mitigate some of the risks under the current system.

In February 2022, the International Regulatory Strategy Group (IRSG) and Accenture published a report considering ESG ratings and data providers and the global challenges that the industry faces.

The report sets out proposals for change that aim to address these issues. This included the recommendation that the industry clarifies definitions of ESG ratings terms to ensure consistency, and that the industry establishes transparent methodologies. IRSG was also of the view that an international approach to reform should be taken; a view that has been shared by the FCA, as ESG ratings providers often cover companies globally.

More recently, and on a European level, the European Commission has published a call for evidence on ESG ratings and sustainability risks in credit ratings, with a view to potentially introducing new guidelines and legislation in respect of ESG ratings providers.

The FCA announced in its 2022 to 2025 strategy that it continues to collaborate with the government and other UK regulators on the topic, and we understand that the government intends to make further announcements later this year in respect of the regulation of the industry.

Comment

Although there has clearly been extensive discussion on the topic, small steps have been taken in implementing change to address the concerns in this area. For companies and investors alike however, it is certainly a topic worth following on both a domestic and global scale.

While the current climate is that ESG ratings providers are subject to criticism, a commitment to ESG remains to be within a company’s interest and should not be overlooked. Companies should continue to ensure that all ESG risks are sufficiently disclosed, and that all disclosures align to the relevant regulatory frameworks.

We recommend that companies seek legal advice on all disclosures made in annual and ESG reports, in order to ensure that all ESG reporting standards have been met, and accordingly that any risk of litigation arising from this is minimised.

Kennedys commercial team has expertise on a number of ESG related topics, and can advise on the same, to help promote the ESG profile of your company.

Related item: Environmental, social and corporate governance – transparency and consistency at last?

Read other items in Commercial Brief - July 2022