The appetite for environmental, social and governance (ESG) focused financial products and services gathers pace. At the same time, financial services firms are under increasing scrutiny for "greenwashing", which refers to false claims of how "green" or socially-focused a financial product or service may be.

Many firms are making their ESG claims heavily reliant on the use of unregulated ESG data and ratings providers. This is particularly problematic as data availability and ESG resources can be challenging. There is often frustration from financial services firms at some ESG data and ratings providers' lack of transparency on their methodology in assessing and scoring how green or socially impactful an investment prospect may be, and in the accountability the providers have for their services.

Financial services firms are themselves in the firing line for greenwashing, and while they try to meet customer demand for ESG-related products and services, they also need to be able to depend on accurate ESG claims. The Financial Conduct Authority (FCA) has been monitoring this evolving picture and has now made a significant step in increasing the scrutiny and expectations of the ESG data and ratings providers. It has established a working group of industry experts to develop a voluntary code of conduct for ESG data and ratings providers.

ESG data and ratings providers as a potential "source of harm"

The use of ESG data and ratings covers a broad spectrum of financial products and services. The services supplied by the ESG data and ratings providers can include ranking or scoring how green a company is. They will analyse the company's commitment to and its reporting on the net zero greenhouse gas emissions target of 2050, alongside other environmental metrics and measures.

The company then relies on that assessment to help it make an investment decision. This might be in an environmentally focused fund where there is a commitment to make investments in companies with strong climate change commitments.

Such reliance on the services provided by ESG ratings and data providers is not inherently a source of harm, according to the FCA; however, the regulator says this view is on the basis that the providers are transparent about the methodologies they use and have in place proper systems and controls around the use of the data, they identify and manage any conflicts of interests between different parties and have good governance.

This is an extensive wish list. The FCA's advisory group and the code of conduct are intended to help firms achieve it.

Global standards as the baseline for the code of conduct

A "globally consistent voluntary code" is the primary objective set by the FCA for the code. Indeed, the FCA intends the structure of the code to be grounded in the International Organization of Securities Commissions (IOSCO) recommendations on the following four outcomes:

1.transparency – on methodologies, data and procedures;

2.good governance – management of the conflicts of interests between parties, ensuring methodologies stay consistent and that there are sufficient resources and competent personnel;

3.sound management of conflicts of interests– to identify, mitigate, manage and disclose conflicts of interests – for example where an entity they are rating is also paying them for consultancy services on ESG-related matters;

4.robust systems and controls – including policies and precures around methodologies, processes for reporting complaints and misconduct, and for engagement with rated entities.

The financial services industry will generally welcome this approach in the hope that it will lead to a globally coordinated approach, and to a greater standardisation of ESG-related information flowing through investment chains and in the market more widely. Divergence of UK standards with competing other codes around the world could otherwise be a hurdle for the UK code's take-up for many of those ESG data and ratings providers with an international footprint.

This global approach is not unexpected from the FCA in an ESG-focused announcement. It is in line with its own ESG Strategy - in which its first core principle is for "global solutions to global problems".

Proportionality a key consideration

The briefing paper the FCA gave to the working group of industry experts emphasises the need to develop the code in a proportionate manner. The FCA asks the working group to have regard to the different sizes and capabilities of ESG data and ratings providers, as well as to consider the size and capabilities of the entities that are rated.

As the code is developed and published in draft, it will be interesting to see whether this proportionate policy means that some of its requirements are therefore not advised to be applicable to some of the smallest ESG data and ratings providers. Equally, there is a core group of data and ratings providers that are dominant in the market, (many financial services firms that rely on their services will be much smaller than they are) and the code's application may reflect this imbalance too.

Stepping stone to regulating ESG data and ratings providers

Even after the development of the voluntary code, that is unlikely to be the end of the regulatory road for ESG data and ratings providers. The FCA has described its announcement of the code as an "important step" towards addressing the concerns of those sourcing and relying on ESG data providers and ratings. The FCA refers to it as part of "building trust" between the parties, but notably does not claim that trust will be complete.

The code could also "inform potential future regulation", according to the FCA. This heavy hint is in line with FCA's earlier warning that it saw a "clear rationale for regulatory oversight of certain ESG data and rating providers." In a sign of future developments, the government has committed to considering expansion of the FCA's regulatory scope to include ESG data and ratings providers.

In the paper published by the FCA to the working group, the three target outcomes of the voluntary code are: i) help build trust in the market; ii) protect market integrity; and iii) promote effective competition.

All three outcomes are aligned with the FCA's own strategic operational objectives. The working group will have carried out the groundwork of analysing how the code links to the FCA's wider objectives, and there seems to be a clear indication that the voluntary code will become compulsory in future. It is noteworthy that under the terms of the Financial Services and Markets Bill the entire legislative architecture for financial services is under review and set for change.

Next steps

The working group is required to deliver the code for ESG data and rankings providers across the first half of 2023. If there is takeup of this code, whether initially while voluntary or later when it may become mandatory, this development should result in a more streamlined, objective, and consistent approach to the ESG scoring and rankings.

This process may require an uplift in scrutiny and requirements for ESG data and rankings providers but will also provide greater comfort for the users so heavily reliant on them.

This article was first published in Thomson Reuters on 25 November 2022.