UK regulator to increase scrutiny of ESG ratings providers

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The market for ESG investing in the UK will come under greater scrutiny from the Financial Conduct Authority (FCA), according to a new business plan published by the regulator.

In its ‘Business Plan 2021/22’, the FCA outlined a strategy to “promote integrity” in the sustainable investing market by extending regulatory oversight to ESG service providers, including data and ratings providers.

“We will gather market intelligence to gauge how well firms are supported by service providers, such as ESG rating providers,” writes the FCA.

This follows last month’s recommendation from International Organisation of Securities Commissions (IOSCO), that regulators target ESG data providers as a means to tackling misleading sustainability claims by asset managers.

The FCA has also set out further requirements for asset managers marketing ESG investment products. This includes a proposal to bring forward mandatory TCFD reporting rules for asset managers, life insurers, and pension schemes, from 1 January 2022.

The regulator will also apply scrutiny to investment stewardship. “We will monitor the exercise of investor stewardship by institutional investors, including voting at Annual General Meetings,” says the FCA. 

“If there is insufficient evidence of active stewardship to advance environmental and social goals, we will consider further regulatory action.”

The FCA’s chief executive, Nikhil Rathi, says these developments form part of a larger “step-change” in the regulator’s approach over the next year.

This year, the regulator intends to be “even more innovative, led by data and technology… even more assertive to ensure consumer protection and market integrity… and even more adaptive to meet the challenges we know about and prepare for those that will come,” according to Rathi.

The FCA says it intends to curb greenwashing in the asset management industry, which has become a concern as the market for sustainable and ESG investment funds has skyrocketed.

By the end of 2020, sustainable funds held almost USD1.7 trillion in assets, up 50 per cent over the year, according to Morningstar.

The UK Sustainable Investment and Finance Association (UKSIF), a members’ organisation for sustainable and responsible finance in the UK, is “very supportive” of the FCA’s plans to oversee ESG investing.

“We think that it is really important that the regulator is taking a close view of what's going on in ESG, and we're very pleased to see both the FCA and the Bank of England get a net zero component added to their mandate last budget, which is absolutely essential for the work we’re doing,” says James Alexander, chief executive of UKSIF.

In March, the UK government expanded the FCA’s remit to include the transition to net zero, meaning that financial institutions may be mandated to produce transition plans in the coming years.

Alexander believes that the FCA’s focus on data providers will be important in allowing market participants to “feel comfortable using” ESG ratings.

This will require accurate self-reporting by companies, as well as a transparent method for building ESG ‘ratings’.

“The challenge that we have with data is the amount of data that we're trying to talk about. If you talk about ESG, it fundamentally means everything non-financial, in its full entirety,” says Alexander.

The full gamut of ESG data ranges from information on company carbon emissions and water use, through to workforce diversity and corporate governance structures.

Alexander notes that amalgamating all of this information requires ratings providers to make a “judgment call” on which data matter the most, and tiny tweaks to the weightings can drastically alter a company’s overall ESG score.

“I think that what we need is to have greater transparency on how the numbers are amalgamated together to create ESG scores,” says Alexander. 

He adds that many of UKSIFs members are now building their own assessments based on raw company data.

Research from SquareWell Partners shows that more than half of the world’s 50 largest asset managers have developed their own proprietary internal ratings system. At the same time, 40 per cent use data from at least four different ESG ratings agencies, such as MSCI and Sustainalytics. 

“What we what we definitely do know is that the role and importance of the data industry in achieving our ESG goals is absolutely paramount to success,” says Alexander.

Alexander also notes the FCA’s focus on investment stewardship as a crucial area where public confidence must be built.

As shareholders of large companies, investors have huge sway over the way the real economy operates. 

“If we just take a divestment approach to hitting net zero, we're not going to make the change in the real economy that we as a country need to see,” he says. 

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