With increased demand for “ESG friendly” investments (in an ESG investment market on track to exceed US $53 trillion globally by 2025), asset managers, funds management companies, superannuation funds and other investors are actively turning to ESG ratings agencies to guide their decisions.

As it currently stands, there is significant potential for discrepancy in the ratings being produced. This is confusing and potentially misleading for investors and may also divert capital away from its intended direction. 

Regulation can improve standards of quality, reliability and comparability of ESG ratings and on 7 November 2022, the International Organisation of Securities Commissions (IOSCO) published a call for action to ensure investors have access to internationally consistent and comparable sustainability-related information from ESG ratings providers.

The United Kingdom and the European Union are currently considering the introduction of mandatory regulations for ESG ratings providers.

The proposed UK model, which is the subject of a consultation paper issued by HM Treasury, would bring ESG ratings provided in connection with UK investments within the scope of the existing financial services and markets regime. Ratings providers would need to be authorised by the Financial Conduct Authority (FCA) and meet minimum threshold conditions to be set by the FCA. While those conditions have not yet been specified, HM Treasury indicates in the consultation paper that they should be aligned with the IOSCO “key regulatory outcomes” concerning:

• transparency (e.g. disclosure of methodologies, data and information sources);

• good governance (e.g. consistent use of methodology and adequate resources and expertise);

• management of conflicts of interest (e.g. where a ratings agency also advises an entity that is being rated); and

• robust internal systems and controls.

It is intended that there will be certain carve-outs to avoid an excessive compliance burden – so that smaller ESG ratings agencies (to be defined based on turnover, balance sheet and number of employees) may be excluded from mandatory regulation.

The UK consultation period closed on 30 June. Given any mandatory regulations could take some time to be drafted, in the interim the FCA is in the process of developing an industry voluntary code of conduct for ESG ratings providers, also centred on the IOSCO key regulatory outcomes.

Under the proposed EU model, EU ESG ratings providers that issue public ESG ratings would be required to apply for authorisation from the European Securities and Markets Authority and comply with minimum obligations, including:

• the independence of ratings activities from political and economic influences;

• the adoption of ESG ratings methodologies that are rigorous, systematic, objective and capable of validation and that are publicly disclosed; and

• having appropriate knowledge and expertise to produce the relevant ESG ratings.

The EU Commission will now engage in discussions with the European Parliament and the European Council to advance the regulatory framework.

The call for similar regulation is gathering pace in Australia as the scale of ESG investment increases. Such regulation could complement impending new climate risk disclosure standards and increased scrutiny of greenwashing by ASIC and the ACCC.