UK Sustainable finance: regulating ESG ratings providers

Following a consultation on implementing a regulatory regime for ESG ratings providers in the UK which closed in June 2023, the government has published a Consultation Response, together with its proposals for the new regime and draft legislation implementing ESG ratings regulatory proposals.

The main features of the proposal are set out below.

ESG ratings providers will require FCA authorisation

The UK’s regulatory perimeter will be expanded to include a new regulated activity of providing ESG ratings.  As a result, any person based in the UK or overseas in certain circumstances who provides ESG ratings will need to be FCA authorised.

Scope of the new regulated activity

The proposed definition for the new activity is as follows:

"(1) Providing an ESG rating is a [regulated activity], where that rating is— 

(a) produced using an established methodology and a defined ranking system of rating categories, 

(b) made available by an ESG rating provider in accordance with paragraph (2), and 

(c) likely to influence a decision to make a specified investment, unless the ESG rating provider could not reasonably have expected the ESG rating to influence a decision to make a specified investment. 

(2) This paragraph applies where— 

(a) a rating is made available by an ESG rating provider located in the UK by any means; 

(b) a rating is made available by an ESG rating provider not located in the UK by way of a business relationship, including but not limited to a subscription or any other contractual relationship, with a person located in the UK."

The following defined terms are relevant to this definition:

• “ESG opinion” means an ESG rating involving substantial analytical input from an analyst, whether or not it is characterised as an ESG opinion.
• “ESG rating” 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 rating provider” means an entity that produces and makes available ESG ratings.
• “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.

ESG data

As expected, the government does not propose at this stage to include the provision of ESG data within the new regulated activity.  Only when ESG data undergoes an assessment will it be subject to the new regime. This approach is aligned with the EU’s proposed approach to ESG data.

The government will continue to monitor the ESG data market and international developments to assess whether further regulatory action is required.

Exclusions

There is an exclusion from the definition of the regulated activity when a person is providing an ESG rating in the course of carrying on another regulated activity.  This is known as the “regulated products and services exemption”.

The intention behind the “regulated products and services” exemption is that firms who are already authorised by the FCA will not need to apply for a separate permission to provide ESG ratings, provided that the ESG ratings it provides are not also provided as a stand-alone product or service. 

This exemption raises the question of whether there would be a different regulatory regime for authorised firms who can benefit from this exemption and other persons who cannot.  The government says that it supports the FCA reviewing its rules and guidance to ensure a level playing field between all firms producing ESG ratings.  This is likely to mean that, even if authorised persons can rely on this exemption, the rules that apply to them when they are producing ESG ratings in the course of their other regulated activities are likely to be the same as those that apply firms to that have to obtain authorisation.

There are also exemptions in respect of:

• ESG ratings provided for use within the ratings provider’s group (provided that the ratings provider reasonably expects that the ESG rating will not be made available to a third party outside that group);
• “private use” – i.e. where the ESG ratings provider is providing the rating pursuant to a contract with, and exclusively about, the person that the ESG rating relates to (provided that the ratings provider reasonably expects that the ESG rating will not be made available to a third party outside that person’s group);
• ancillary non-commercial provision of ESG ratings – specifically as part of the activities of a journalist, academic or charity;
• ratings provided by public bodies, central banks or international organisations; and
• ESG ratings that are developed exclusively for accreditation or certification processes (provided that the purpose of the accreditation or certification is not to influence a decision to make a specified investment).

Territorial scope

The new regime is designed to capture not only UK-based ratings providers, but also any overseas firms who are providing ESG ratings to UK users by way of a “business relationship”.  This is intended to create a level playing field between UK and overseas providers.

An overseas ESG rating provider who makes their rating available to a UK user via a third party located outside the UK will also be in scope of the regulation.  This is in order to close a loophole whereby an overseas ESG ratings provider could seek to avoid regulation by producing an ESG rating that they then make available to a user in the UK via a separate distributor outside the UK. However, the overseas ESG rating provider in this scenario is only captured where they could reasonably have expected the ESG rating to be made available to a person located in the UK, whether via that separate distributor or another third party.  

As noted further below, the government is considering an alternative approach under which overseas ratings providers may be able to avoid the need for authorisation if, for example, the UK has put market access arrangements in place with the ratings provider’s home country.

Overseas firms may also be able to benefit from the “regulated products and services” exemption if they are authorised in the UK.  The Consultation Response also notes that there are situations in which overseas credit ratings agencies and overseas benchmark providers may be permitted to access the UK without the need for authorisation on the basis of them being subject to equivalent regimes in their home country.  The government is still considering its approach in relation to this issue.

The Consultation Response says that the FCA is considering its approach to overseas ESG ratings providers applying for UK authorisation.  This includes exploring whether, according to size, significance, or market impact in the UK, an overseas ratings provider would be expected to be incorporated in the UK – that is, to establish a separate legal entity in the UK and apply for that entity to be authorised, instead of being able to apply for authorisation for the overseas ratings provider itself.  

The Consultation Response also says that the FCA is continuing to reflect on the most appropriate approach for overseas ESG ratings provision, including whether the best means of achieving this would be via the existing Threshold Conditions guidance, or some other means and will engage with firms to inform its policy thinking.  This will form part of the FCA’s consultation on the firm-facing rules under the ESG ratings regime.

International alignment

The Consultation Response reported that the overwhelming majority of responses were in favour of international alignment.  The government has incorporated this into the UK’s regulatory regime by aligning definitions broadly with IOSCO’s definition of ESG ratings provision.

The FCA also intends to develop a regulatory regime that is informed by the IOSCO recommendations, aligning territorial approach with that of the EU where appropriate.

The role of the FCA

Once the legislation necessary to implement the new regime has come into effect, ESG ratings providers will need to apply to the FCA for authorisation (unless they can benefit from an exclusion).  

Prior to the FCA’s authorisation gateway opening, and following their policy development processes, the FCA will consult on draft rules and guidance for ESG ratings providers.  This will include additional rules for those existing authorised firms who wish to benefit from the regulated products and services exclusion.  While these firms will not require a separate permission to provide ESG ratings as part of an existing regulated product or service, the FCA will assess whether existing standards need to be enhanced, to help ensure a level playing field between all firms producing ESG ratings. The consultation will include a cost benefit analysis to assess their impact before being finalised.

Authored by Dominic Hill, Emily Julier, and Rita Hunter.