FCA sees ‘clear rationale’ for ESG rating regulation, hints at ESG debt crackdown

UK regulator investigating differences between sustainable debt frameworks and prospectuses will need Treasury intervention to regulate ESG ratings.

The UK’s Financial Conduct Authority (FCA) has said there is a “clear rationale” for the regulation of ESG data and rating providers, and that it will engage with the Treasury on introducing legislation to this effect.

In its response to a consultation on ESG integration in capital markets, the regulator said that 39 out of 44 respondents were supportive of either a voluntary best practice code for ratings providers or bringing them into its regulatory purview, with the majority preferring the latter option.

Given the potential harms of the ESG data and rating market, and “the benefit to wider market functioning” of an effective, trusted and transparent market, the FCA said it saw a clear rationale for regulatory oversight, and for a globally consistent regulatory approach based on recommendations put out by IOSCO.

Some of the respondents to the consultation also raised concerns about the depth of knowledge of analysts at ratings agencies, noting that some have to cover a “significant number” of entities due to cost constraints. Other concerns were related to market concentration and the high costs of data.

The regulatory regime proposed by the FCA follows IOSCO recommendations in focusing on the four areas: transparency, good governance, conflict of interest management, and systems and controls. Introducing such a regime would require the Treasury – which is currently considering the issue – to bring ESG ratings providers within the FCA’s regulatory sphere. Given the lead time on formal regulation, the FCA has outlined plans to establish a voluntary code of conduct in the interim.

The news comes as regulators across the globe consider intervention in the ESG data and ratings market. The European Commission launched consultations on a number of regulatory proposals in April, while the chair of the European pensions and insurance regulator has hinted at the need for regulation and ESMA this week released consultation results claiming reliability of ESG data products is hampered by low levels of transparency, poor coverage and poor responsiveness. Japan has also set up a regulatory advisory committee to develop a reference “code of conduct” for ESG data providers.

The FCA’s consultation also looked at the UK’s sustainable debt market, and put out a separate market bulletin summarising its findings and recommendations.

The regulator endorsed the use of ICMA’s principles for use-of-proceeds bonds and loans as “a suitable and appropriate starting point” for issuers, but raised several concerns around the ESG debt market.

In particular, the FCA noted that “occasionally, the language used in green, social and sustainability bond frameworks could be considered more definitive than the relevant sections in the prospectus, in particular on matters that are likely to be important to certain investors such as the use of proceeds”. It said it was “concerned” that investors might form expectations based on frameworks and marketing materials instead of relying on the contractual terms of issuance, pointing to the fact that some prospectuses clearly state that the issuer is not obliged to use the proceeds in a specific manner, while accompanying documents “imply” a stronger commitment.

The FCA said it would monitor the area and consider taking further action to understand how common the issue was and whether regulatory intervention was needed.

Looking at second-party opinion providers, the FCA warned that the market is currently unregulated, and that potential harm may arise from a lack of methodological transparency and “the potential conflicts of interest inherent to an ‘issuer pays’ model”. It recommended that investors engage SPO with providers to ensure they adhere to appropriate standards.