UK’s Financial Conduct Authority says it’s ready to regulate ESG ratings firms to stop greenwashing

In the absence of regulations on methodologies, defining and measuring ESG is often described as a 'wild west'

The FCA made the statement in a new paper on ‘ESG integration in UK capital markets’, published this week after a consultation on “potential harms that may require further policy intervention” as ESG investing becomes more mainstream.

One of the potential harms addressed in the consultation was ensuring that investors are able to access comparable and credible information about the environmental, social and ethical impacts of the firms they invest in. Getting this information, the FCA has concluded, may require more regulatory requirements to be placed on organisations providing ESG ratings.

In the absence of a formal, nationally universal definition of ESG, the FCA heard, ratings agencies are using their own methodologies and are routinely seeing them criticized. Businesses to have received support from ESG funds and then faced controversies relating to human rights include fast-fashion brand Boohoo and care home provider Orpea. Observers have asked whether some methodologies account for the most material impacts to and of a business, particularly after S&P’s 500 ESG Index removed Tesla but kept companies which have historically impeded the low-carbon transition, like Exxon.

More broadly, on the ‘E’ in ESG, an August 2021 analysis from InfluenceMap found that 71% of equity funds with climate themes are supporting activities consistent with the Paris Agreement on emissions.

Summarising the key concerns heard by members, the FCA’s paper highlights poor governance controls and potential conflicts of interest as factors which have skewed ESG data and ratings in the past. It also flags that providers may not be required to adequately engage with company, using poor-quality data and failing to apply “appropriate due diligence”. Some providers, the FCA heard, may be shying away from this due to the cost of data requests.

The FCA’s paper states that it would welcome the Government’s proposals to bring ESG data and ratings providers “within its regulatory perimeter”, which were first made last autumn through the Treasury’s Roadmap to Sustainable Investing.

This change could be made fairly swiftly, but designing and implementing any new regulation would take time. The FCA remains at the proposal stages and will need to craft more specific requirements to ensure that data and rankings firms, including third-party organisations, are delivering instruments and products that can be trusted. At this stage, it has indicated that mandates may differ for firms of different sizes.

It has stated that it will follow the recommendations of the International Organisation of Securities Commissions (IOSCO) when developing any potential mandate. This should make it easier for the UK to share its approach in this field with other nations.

“Given the potential lead time before any such regime could come into force, we would – in the interim – work with the Treasury to convene, support and encourage industry participants to develop and follow a voluntary Code of Conduct addressing matters similar to those listed above [ – transparency, good governance, management of conflicts of interest, and systems and controls],” states the FCA’s document. “Such a voluntary Code could potentially continue to apply for ESG data and rating providers that fall outside the scope of any future regulatory regime.”

Finance Watch

In related news, Finance Watch has released a new report arguing that, without stronger regulation, net-zero targets set by firms within and beyond the financial sector could continue to be largely uncredible for years to come, undermining the ability of the private sector to make the emissions cuts required to avert the worst of the climate crisis.

Net-Zero Tracker’s latest stocktake concluded earlier this month that just one-third of large publicly traded companies have net-zero targets which meet the minimum requirements of the UN’s Race to Zero Initiative. Many of the other two-thirds of firms have no credible plans to reduce emissions this decade, to address their indirect emissions footprint or to adequately finance mid and long-term plans, the stocktake found.

Finance Watch is calling for European nations to create a unified definition of what constitutes a net-zero approach, so that firms will need to adopt best-practice approaches to claim they are aligned with a net-zero future.

For the finance sector specifically, Finance Watch is proposing a regulatory system in the UK and EU whereby institutions cannot claim net-zero status unless they sell either taxonomy-aligned investment products, investment funds engaging with companies on their net-zero transition plans, or transition-linked financial products with climate-related covenants.

The Government is set to introduce a net-zero transition plan mandate for some large firms from next year and will expand its perimeter in the years to come. Finance watch is arguing that transition plans should have to cover indirect emissions, which account for the majority of the total footprint of most large multinationals. It also wants the Government to prevent businesses from using offsetting and avoided emissions outside of their value chain, or from relying heavily in man-made carbon capture technology.

Join the conversation during edie’s Green Finance Focus Week

Readers interested in ESG investing and net-zero finance are encouraged to mark edie’s upcoming Green Finance Focus Week (18-22 July) in their diaries.

Throughout the week, the edie editorial team will be publishing a range of features, interviews, reports and more to inform and inspire readers around making sense of the ESG landscape and scaling up finance to accelerate the transition to a sustainable future. We will also be hosting a series of online Inspiration Sessions on the afternoon of Thursday 21 July, sponsored by Inspired Energy and featuring expert speakers from organisations including Natwest, Standard Chartered and the We Mean Business Coalition. Click here for details and to register.

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