The UK is pioneering mechanisms to make the environmental, social and governance (ESG) funds market more credible and transparent. These include a new code of conduct that stands to become a global resource. It will help economies worldwide adopt clear, comprehensive and proportionate guidance for ESG data and ratings.

As more money floods into ESG funds, driven by increasing concerns about sustainability and climate change, the market for providing advice to investors on how potential investments help support firms’ climate goals is booming.

These services, including data and ratings provision, can reduce research efforts by individual fund managers and help investors to find worthwhile potential investments and flag problematic issues, essentially helping them to identify and understand financially material ESG risks to a business.

But these ratings and data services are most commonly delivered by third parties and are not presently regulated, leading to an overall lack of consistency in the field. There is little consensus on methodology, meaning that often one service can suggest a product scores highly in terms of ESG issues, and another might disagree. Data is often self-reported, open to error and unverified or unaudited.

Julianne Flesher is co-founder and CEO of Nossa Data, a platform that aims to help companies avoid ESG survey fatigue by streamlining their disclosure. Having worked with many UK listed businesses directly on their relationship with rating agencies, she shared:

Lack of rating agency consistency is a huge problem for companies in the UK and globally. Without one common methodology, companies are left needing to respond to hundreds of different questions or risk the brand reputation of a poor rating. This time spent managing rating agencies' information requests is time lost focusing on the core objective of ESG: improving on fundamental performance of key environmental and social topics.

Julianne Flesher, CEO, Nossa Data

According to a November 2021 report from the International Organization of Securities Commissions (IOSCO), there are several key problems with the system as it currently stands.

First, there is a lack of clarity and alignment on definitions, including on what metrics ratings or data products take into account, it said.

The report also found limited transparency regarding methodologies, and uneven coverage of products offered, causing gaps for investors.

It raised concerns about the management of conflicts of interests between ESG ratings and data providers and products, and suggested the sector needs to communicate better with companies subject to ESG ratings and data products – including further attention to ensure validity of ESG ratings and data product information.

Work has already been done in the UK to try and address these challenges affecting the global market.

The Financial Conduct Authority (FCA) consulted last year on whether there should be voluntary best practice guidance for ESG ratings agencies or binding regulation, for example, and other bodies have sought to make the case for a more consistent, and more transparent, approach.

A joint report by Accenture UK and the International Regulatory Strategy Group (IRSG) published in February of this year, said that by the end of 2021, investors with over $120 trillion in combined assets had signed an agreement to integrate ESG information into their investment decisions.

It is within this context that ESG ratings provide an increasingly popular and powerful tool in helping market practitioners to assess ESG or sustainability risks and opportunities,” the report said. “While ESG ratings provide just one interpretation of the many sources of ESG data available to portfolio managers, the growing significance of ESG ratings products across both equity and fixed income (debt) markets cannot be understated.

ESG Ratings and ESG Data in Financial Services

The report suggested that the only way to tackle this is with a global approach, with the UK well placed to take a leading role in developing regulatory frameworks:

“We believe that there is the potential for a regulatory first-mover advantage: the first jurisdiction(s) to create a statutory approach to address environmental disclosure coverage and quality issues will provide a template for others to follow, moving quickly to adopt the global standards established by ISSB once released.”

The UK is already seen as leading on climate risk disclosures, and is at the forefront of a new set of standards to overhaul the ESG ratings system, bringing it in line with other yardsticks for performance, such as credit ratings.

Ultimately, the government might deem it necessary to implement a formal regulatory regime, although the Treasury is yet to give the mandate to the FCA for this. The IRSG are delighted that the Government will consult in Q1 2023 on bringing ESG ratings providers into the FCA’s regulatory perimeter. As set out in the above report, the IRSG sees a strong rationale for regulating these firms, in line with IOSCO’s recommendations. The Code of Conduct has a vital role to play in raising standards now.

In the meantime, the FCA has asked the IRSG, which is jointly run by the City of London Corporation and TheCityUK, to work with the International Capital Market Association (ICMA) to set up an industry-led working group to develop a voluntary code of conduct for ESG ratings that might  provide a glidepath to future regulation.

When complete, this code of conduct will address four key areas: transparency, good governance, the management of conflict of interests, and robust systems and controls.

It will ultimately set out clear, comprehensive and proportionate guidance for ESG data and rating providers, while taking into account the needs of all key stakeholder groups within the ESG data ecosystem.

The working group met for the first time earlier this month and is aiming to publish a draft of the code for consultation in around six months’ time, with the finished version finalised by the end of 2023.

This work will mean the UK becomes only the second country in the world to develop a code of conduct for ESG ratings and data, after Japan. The ambition is that the new code will become a global resource, serving as a template to use in other jurisdictions.

A comprehensive, proportionate and globally consistent voluntary code of conduct for ESG ratings and data will help ensure this market is fit for purpose, in turn supporting market practitioners to assess the risks more accurately.

Kay Swinburne, Chair, IRSG

According to the FCA, this industry-led solution will help support the aims of its ESG strategy, by helping to promote more rapid development of best practice. The code will seek to be internationally consistent, by taking into account not only IOSCO’s recommendations but also developments in jurisdictions such as Japan and the EU. This will help encourage the development of consistent global standards, it said.

A comprehensive, coherent ESG ratings system should enable investors to more confidently embed sustainable decisions into their businesses, and the work currently being carried out in the UK could have global implications to that end.