HM Treasury introduces draft legislation for the regulation of ESG ratings

On 14 November 2024, HM Treasury (HMT) published a response to its consultation on proposed regulation of ESG ratings providers, which ran from March - June 2023. The initial consultation set out HMT's intention to introduce secondary legislation requiring providers of ESG ratings to be authorised by the Financial Conduct Authority (FCA). 

ESG ratings are assessments of ESG matters which may be used by investors and financial institutions to drive investment and lending decisions. Regulation of ESG rating providers aims to reduce the potential risks of greenwashing, enhance transparency in the rating process and improve investor confidence.

HMT's response found that there was strong industry support for the introduction of regulation concerning the provision of ESG ratings. Accordingly, along with the consultation response, HMT published a draft statutory instrument (Draft SI) which seeks to amend the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 so as to include the provision of ESG ratings as a specified activity regulated by the FCA under the Financial Services and Markets Act 2000.

The proposed regime comes in light of recommendations made by the International Organisation of Securities Commissions (IOSCO) urging regulators to focus on improving transparency in the ESG ratings and data space, and to begin to apply regulatory oversight. Similar regulation is being considered in other jurisdictions and has already been agreed in the EU (see our post on the EU ESG ratings regulation here).

Key takeaways from the consultation response and draft statutory instrument

Definitions of "ESG ratings"

The 2023 consultation sought feedback on how "ESG ratings" should be defined, given that the term is often applied loosely across the industry to refer to diverse activities which may include the analysis of raw ESG data for non-commercial purposes. Additionally, varying terms, such as "scores", "marks", "assessments", "opinions" or "solutions", are used across the industry to refer to activities which are effectively the same as providing "ratings".

The Draft SI includes the following definitions to set the scope of what will constitute providing an ESG rating:

• "ESG ratings" means an assessment regarding one or more ESG factors, produced in the form of an ESG opinion, an ESG score or a combination of both, whether or not it is characterised as an ESG rating; 
• "ESG opinion" means an ESG rating involving substantial analytical input from an analyst, whether or not it is characterised as an ESG opinion; and
• "ESG score" means an ESG rating derived from data and a pre-established statistical or algorithmic system or model, without additional substantial analytical input from an analyst, whether or not it is characterised as an ESG score.

The key aspect of the definition of "ESG rating" is that it an evaluation or value-judgment using an established methodology which includes systematically produced assessments that methodically draw comparisons between several entities or products to produce ESG ratings. It is irrelevant whether the assessment is characterised as an ESG rating or given alternative terminology.

Exclusions

Under the Draft SI, ESG rating providers are excluded from regulation where they conduct the following activities:

• Provision of regulated products and services: This exclusion is intended to avoid the need to apply for dual FCA regulation for providers which are already carrying out regulated activities such as credit ratings and investment research and in the provision of these activities provide ESG ratings. The exclusion does not apply where the ESG rating is provided as a standalone product or service. HMT considers that where providers benefit from this regulated products and services exclusion, the current regulations under which they provide regulated activities may not fully address the risks of harm associated with ESG ratings and firms may not have the relevant safeguards in place. HMT has therefore recommended that the FCA reviews existing rules and guidance relevant to other relevant regulated activities to assess whether standards need to be enhanced, to ensure a level playing field between all firms producing ESG ratings.
• Ancillary non-commercial purpose: ESG ratings which are ancillary to non-commercial activities undertaken as part of academia, journalism or charity are excluded unless the ESG rating is provided through a business relationship separate to the person's activities as a journalist, an academic or a charity.
• Internal use: ESG ratings are excluded where they are prepared about an entity's own business or product, either internally or through an external provider. These ratings may be shared intra-group, but the rating must not be reasonably expected to be made available to third parties.
• Accreditation or certification: ESG ratings developed exclusively for accreditation or certification processes where the purpose of that accreditation or certification is not to influence a decision to make a specified investment are excluded. An example given in the Consultation response is an Electrical Performance Certificate (EPC) rating to which the regime is not expected to apply.
• Public authorities: Public authorities, central banks and international organisations are excluded from the scope of the proposed regime. HMT's consultation response states that there is no evidence to suggest that such entities produce ESG ratings by way of a business relationship, nor with intent to influence investment decisions.

Territorial scope

The proposed regime aims to protect UK based investors from the greatest risks of harm and would apply to:

• UK and overseas firms providing ESG ratings to UK users; and
• UK firms providing ESG ratings to overseas users.

Responses to the 2023 consultation generally indicated support for a high degree of international alignment which has led the government to align definitions with IOSCO recommendations as far as possible. The FCA is also expected to consider IOSCO recommendations and align the approach with that of the EU ESG ratings regulations where it is without detriment to the intention of the Draft SI.

Next Steps

The overall process for designing, developing, and commencing the ESG ratings regulatory regime is expected to take four years with the Government currently accepting technical comments on the Draft SI until 15 January 2025. Secondary legislation is expected to be laid before Parliament in early 2025, followed by FCA consultations on the specific requirements of the policy.

The authors would like to thank Maariya Azhar for her contribution.