Will ratings shake-up build trust in ESG?

Tough new regulation being drawn up by the Financial Conduct Authority intends to tackle potential conflicts of interest amongst ESG ratings providers.

The measures have been drafted to bring greater transparency, consistency and objectivity to the way that the growing number of providers rate publicly-traded companies based on various ESG criteria.

But they also plan to address criticism over conflict of interest because, as City AM put it, “some agencies also have ties to ESG consultancy services with a client base that overlaps with the pool of firms they are responsible for rating”.

The Financial Times covered how the proposal was the first time that the FCA had mooted regulating such ratings providers for ESG purposes, and that the plan was to “clean up” conflicts in the sector.

Announcing a consultation process on the draft regulation — but also being clear that the vast majority of parties involved were wholly in favour of it — the FCA said that “'our proposals will give those who use ESG ratings greater trust and confidence – supporting our goal of increasing trust and transparency in sustainable finance”.

The risk for batting for both sides is what has captured most of the imagination around the story though. Reuters reported that the clampdown was targeted at scenarios when ratings providers could both score companies on ESG performance and advise them on improvements.

Calling it a “crackdown on ethical investing”, the Daily Telegraph reported that “The FCA’s investigation of the market found it to be something of a Wild West”.

Regardless of political stance or views on the wisdom of ESG investing, the overall point here is that ratings agencies being able to rate credentials without sufficient scrutiny over their methods is clearly a weak spot in the whole sustainable finance ecosystem. Proportionate measures to put that right should lead to both more trust around rated ESG factors and the rigour applied in the sector.

For companies with ESG goals that are reporting on their progress, if the proposals are passed then they should increase the level of fairness and reduce the element of guesswork required in trying to understand how different raters will come to their ‘scores’. They may also help to build greater trust in ESG overall.

But the changes will also place a premium around the more objective and consistent methods that are used, meaning that companies will need to do more to get to grips with both how the FCA regulates the market
and how the criteria for assessment become standardised.