The UK Considers How to Regulate ESG Rating Agencies: Finding the Balance

The UK, as a result of its decision to leave the EU, does not have to implement the Union’s Sustainable Finance Disclosure Regulations (amongst others) and, therefore, has the option to find equivalence in its own way (as it seeks to do). However, with sustainability massively on the agenda on both sides of the Atlantic (and further afield), the UK and the US are now pushing to catch up. One question, however, is how to handle the ESG rating problem? The Financial Conduct Authority is currently responding to a roundtable they held on the issue and are making statements regarding what the options are moving forward. Yet, is it all talk? Is there even anything that can truly be done?

 

The problems with the ESG rating agencies are that they are, as a group, relatively new and extremely inconsistent. We have already examined this in the blog and have introduced the ‘Aggregate Confusion Project’ that is developing at MIT, and has shown emphatically that there are serious issues within the act of rating on an ESG-basis. Furthermore, in my most recent book I examined these deficiencies in detail, and came to the conclusion that they are inherent, and that regulation needs to be carefully designed based on reality, rather than a desired dynamic that does not exist. Those issues range from a substantial lack of consistency between agencies, within agencies, a lack of certification of training, and a conflicted industry that offers both advisory and rating services (as the credit rating agencies also do).

 

To that end, the FCA have stated that they have a number of aims when it comes to designing a regulatory framework for ESG rating agencies, particularly as part of disclosure regulations that are being designed to be equivalent to the EU’s leadership in this regard. Interestingly, and correctly, the FCA is focusing on fund managers, not necessarily the ESG rating agencies themselves. For example, it has been noted that one of the aims is to ‘steer fund managers away from greenwashing (where environmental credentials are significantly overstated, whether intentionally or unintentionally), which risks the misallocation of capital and erodes trust’. In addition to this, they are keen to install the principle that fund managers must attach certain pieces of information to their own disclosures, including how they come to their conclusions and how they have designed their sustainability-related objectives; if an ESG rating agency has been used, this must be declared.

 

However, the FCA also want investors to fully understand the methodologies of the agencies before they use the respective agencies’ services. This essentially puts the onus on both the agencies to fully disclose their methodological processes, and then on the investor to demonstrate that they have understood those methodological processes. The FCA has stated the importance of getting this right, as the UK seeks to make the most of its departure from the EU and take the lead on financial sustainability-related practices. Yet, there are issues that anybody who understands the ‘rating’ industries will know. The first is to what level the ESG rating agencies can disclose their methodological processes because, just like their credit rating brethren but perhaps even more, their rating processes are increasingly subjective in nature. How can an asset manager understand that from the outside? Research has shown that the ESG rating process is particularly exposed to outside influence and also particularly inconsistent. A cynic may suggest that as the ESG rating industry is currently in a nascent period but facing exponential growth if sustainable investing continues to move towards the mainstream, the potential for conflicts-of-interest to take hold are extremely prevalent. Additionally, one of the most important roles of a rating agency is to signal to somebody else on behalf of another. This signalling theory is central to understanding a rating industry, but for the asset managers, the new proposed regulations put them between a rock and a hard place. On one hand the need to be sustainable and also demonstrate this is becoming increasingly important, but the way to demonstrate that in a palatable form is simply not trusted. Even the regulator, before developing a regulatory framework, has cast serious doubts on the usefulness of the industry that the asset managers will need to use.

 

It is a delicate balance to find in this increasingly important environment. However, the ESG rating agencies are, unfortunately, not close to meeting the demand for a signaller as I have argued in the recent book. They are primed to be devoured by the credit rating agencies, whom themselves are massively conflicted and will not bring a progressive solution to the problem, merely a practical one. Their oligopolistic model and their history, when compared to the ESG rating agencies, makes them a practical alternative in a game with no real progressive alternatives. The FCA are keen to develop trust in the concept of sustainable business, but the level of trust has not been defined. It is arguable that only just enough trust to keep the system progressing is enough at this stage, and perhaps in that understanding the ESG rating agencies can find a role for themselves.

 

Keywords – ESG, ESG Rating Agencies, FCA, Regulation, @C_R_R_I