The concept of environmental, social and governance (ESG) is nothing new to the City of London, and ESG has become a favourite acronym of boards, bankers and asset managers alike in recent years. In the UK, almost half of the £10tn worth of assets under management have now integrated ESG into the investment process.
But the rise of ESG investing is nothing unique to the UK, with global ESG assets projected to reach $50tn by 2025.
In response to investors’ increased demand for ESG data and its assessment, ESG ratings and data products have exploded onto the market: recent analysis suggests that 94% of investors use ESG ratings and data products at least once a month, and it’s estimated that there now are more than 40 ESG ratings, 150 ESG rankings and 450 ESG indices available to draw from.
The providers of these products and tools wield substantial influence, and with great power comes great responsibility. Now, this responsibility is being met with regulatory scrutiny here in the UK.
After much – and ongoing – debate on the role and impact of ESG ratings and data products providers, the UK Financial Conduct Authority (FCA) is consulting on a voluntary code of conduct for data and ratings providers, while HM Treasury has just concluded a consultation on whether to give the regulator the power to crack down more formally on ESG ratings.
The UK can take pride in being one of the fastest movers in this space, and it presents an opportunity to demonstrate global leadership, bringing rules and regulation together in a more consistent way.
the UK must refine its approach to ensure it is thinking and acting as part of a global market
However, while the FCA has stated that it favours a “globally coherent” approach and “to do it internationally”, the proposal from HM Treasury, released for public consultation this summer, suggests that the UK may take a different approach in several aspects, including its territorial scope. This may lead to regulatory fragmentation, which presents major risks to both the users and providers of ESG services and ultimately could undermine the very reason for regulation.
This week, CDP outlined these risks in our latest report, ‘Data for Public Good: Steering the Role of ESG Ratings and Data Products Providers’, the first comprehensive analysis of the fraught ESG ratings regulatory landscape.
The findings make it clear: if regulation is to be impactful and ensure that data is used for public good, then the UK must refine its approach to ensure it is thinking and acting as part of a global market, working collaboratively towards a global baseline of regulatory scope and definitions. A failure to do so risks market chaos.
How can it do so? Well, definitions matter. A shared understanding and language are imperative to regulation aimed at an interconnected, global market. The UK and other jurisdictions must communicate and collaborate in a global effort to adopt a common baseline of definitions around ESG ratings.
Current initiatives proposed or already implemented by the EU, Japan, India and the UK diverge on definitions, which risks market confusion.
The definition of ‘ESG ratings’ proposed by HM Treasury has called the attention of market participants for being broader than other regulators’. The definition also diverges significantly from the one recommended by the International Organization of Securities Commissions in its milestone report, which is generally considered as best practice.
If HM Treasury decides to proceed with the definition as is, it may lead to significant fragmentation and even create market confusion, as an ESG rating in the UK may be many more things than elsewhere. However, I prefer to think that HM Treasury has deliberately chosen to consult on ampler definition to gather a diverse range of perspectives on how to solve the main issue regulators currently face: properly defining such an innovative, fast-paced and diverse range of ESG data-derived products.
The territorial scope of UK regulation is also critical: its current approach is out of sync with other regulators moving forward in this area, leaving the UK at risk of driving regulatory fragmentation. A regulatory approach that is based on the location of a wide range of users may pose significant challenges for providers.
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Under these circumstances, providers would have to know the actual uses of their ESG ratings by all customers. Further, providers would also have to know the location of every customer, and whether such location is based on, for example, headquarters, subsidiaries’ addresses, on the actual place of decision-making – which would be close to impossible. Compliance complexities would increase significantly – especially given the jurisdictional fragmentation that would exist should the UK pursue this approach.
Ultimately, ESG ratings will be regulated in the UK and most global economies. What we must focus on now is ensuring policies are developed and can drive sustainable investment in a way that does not create even more market confusion than already exists.
Following the steps outlined above will be essential if the UK is to seize this opportunity to demonstrate leadership, work collaboratively and take another step towards being the “net-zero financial centre” it claims it will soon be.
Pietro Bertazzi is the global director for policy engagement and external Affairs at CDP.
CDP is a not-for-profit charity that runs the global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts.
