ESG ratings providers consultation

The Financial Inclusion Centre submitted a response to the consultation on the future regulatory regime for Environmental, Social, and Governance (ESG) ratings providers. We very much support the government’s intention to give the FCA powers to regulate ESG ratings providers.

However, we do have concerns about elements of the government’s proposed approach. We also raised concerns about the FCA’s approach to developing an interim voluntary code of conduct on ESG ratings intended to be used until the FCA has the powers to regulate ESG ratings.

The submission can be found here: HMT ESG ratings consultation FIC submission final

As we explained in The Devil is in the policy detail – will financial regulation support a move to a net zero financial system?[1] the approach to climate finance regulation adopted by policymakers and regulators has hitherto focused on the impact of climate change on the financial system and institutions rather than the impact of finance on the environment. In other words, the focus has been on the consequences of climate change, not the causes.

This also applies to ESG data, ratings, and ratings providers. According to the FCA, MSCI is the most widely used ratings agency.[2] Yet, its ratings measure the impact of external events on a company’s prospects not a company’s impact on the environment.[3]

The approach adopted by financial policymakers and regulators needs to change to focus on the role finance plays in causing climate change.

The case for regulation ESG ratings and ratings providers

There is a clear case for regulating ESG ratings and ratings providers. Parallels can be drawn with credit rating agencies who were criticised for the role in the financial crisis of 2008.[4] One of the main criticisms related to the inherent conflicts of interest in the credit ratings system which contributed to concealing the nature and scale of market risk in the financial system.

Similar conflicts of interest exist in the ESG ratings market. There is a strong incentive for financial institutions to select a ratings provider that produces inflated ESG ratings. The old adage ‘follow the money’ has particular application in financial markets. As the level of interest and investment in ESG grows, there is a strong incentive for financial institutions to misrepresent the compliance of the firm and its funds/products/ activities with climate goals. This threatens to understate the amount of climate related risk in the financial system.

So, it is important to regulate the ratings (including methodologies), and ratings providers through the application of robust conduct standards to deal with inherent conflicts of interest and competition dynamics in the market. But, as we explain below, it is also important to regulate the underlying input data used in ratings.

The need to regulate the underlying ESG data as well as ratings

The key building blocks of any ESG ratings system (whether rating, ranking, scoring, marking, or benchmarking) are the:

  • input data relating to the ESG performance of specific economic entities (corporate or sovereign); and
  • the models and methodologies used to compare the ESG performance of the economic entity, financial institution (which provides finance to economic entities), or collective vehicles (which can be in the form of loan books, insurance, pension, and investment funds and so on).

It is self-evident that the integrity of a rating system will very much depend on the quality, reliability, and integrity of the foundational input data used in models and the methodologies. If that input data is flawed or  misleading then the output ratings will also be flawed or misleading.[5] This increases the risk of greenwashing and misallocation of ESG related financial resources. Unless the underlying data is addressed, we fear that ratings systems will be ‘built on sand’.

Concerns about the interim voluntary Code of Conduct

In advance of being given powers to regulate ESG ratings, the FCA has announced a working group to develop a voluntary Code of Conduct for Environmental Social and Governance (ESG) data and ratings providers. The group is to be known as the ESG Data and Ratings Code of Conduct Working Group (DRWG).[6] The objectives of the DRWG are to develop (i) a comprehensive, proportionate and globally consistent voluntary Code of Conduct for ESG data and ratings providers, and (ii) a recommendation on ownership of the Code.

We are particularly concerned that the voluntary code working group is dominated by industry representatives.[7] The Terms of Reference of the DRWG[8] state that two industry groups, the International Capital Market Association (ICMA) and the International Regulatory Strategy Group (IRSG), will serve as the Secretariat. This Secretariat will appoint the members of the DRWG.

The FCA envisages that the group will consist of between 16-18 members. Yet only three of the positions are to be reserved for academics and civil society representatives. The FCA, HM Treasury, the Bank of England, the Financial Reporting Council, and other relevant financial regulators and government departments will be in the FCA’s words ‘active observers, offering their views, where deemed appropriate’.

We agree that developing a meaningful code of practice on ESG ratings while we wait for statutory regulation is critical. Yet we are very concerned about the ability of a DRWG, so heavily dominated by industry representatives, to deliver a meaningful Code of Conduct.

The terms of reference of the DRWG are too weak. And it is unacceptable that such a group is dominated to such an extent by industry vested interests. The whole set up comes across as all a little too cosy and could even furnish ministers with an excuse not to require full regulation.

We urge HMT to use its influence to ensure that the working group has proper civil society representation to generate trust and confidence in any interim code of conduct and prepare the ground for regulation. The FCA should chair this group. If not, it should ensure that it is chaired by an independent person not industry representatives. The FCA should appoint the members and also ensure that half of the DRWG members is made up of independent civil society representatives. Moreover, the FCA cannot allow this DRWG, as constituted, to determine ownership of the Code. At the very least, the regulator must approve the recommendation of Code ownership.

ESG ratings inconsistencies

The FCA does not seem to think that the low correlation between the ESG ratings provided by different agencies is a problem.[9] Yet, surely there is a risk that, if different agencies reach very different conclusions about the ESG rating of the same asset, this will cause confusion and make it harder for investors to make effective, informed choices. It also makes it easier for financial institutions and underlying economic entities to select the most favourable rating.

The low correlation could be something that is addressed as the broad regulatory architecture and taxonomies become better established. But, the inconsistencies in the methodologies will undermine the efficacy of the forthcoming regulation of ESG ratings. We urge the FCA to:

  • Investigate urgently why there is such a low correlation between ESG ratings and publish the results of that analysis.
  • Identify the potential detrimental impacts on investor decision making created by the low correlation between ESG ratings.
  • Assess the potential for conflicts of interest created by users being able to select favourable ESG ratings methodologies.
  • Promote consistent methodologies for ESG ratings.

[1] The Devil is the policy detail – will financial regulation support a move to a net zero financial system? | The Financial Inclusion Centre

[2] See ESG integration in UK capital markets: Feedback to CP21/18 (, Fig 3

[3] ESG Ratings: A Compass without Direction (

[4] See for example: Credit rating agency reform is incomplete (

[5] Garbage in, garbage out (GIGO)

[6] Code of Conduct for ESG data and ratings providers | FCA

[7] A full critique of the FCA’s approach can be found in The Devil is the policy detail – will financial regulation support a move to a net zero financial system? | The Financial Inclusion Centre, p82

[8] ESG Data and Ratings Code of Conduct Working Group: Terms of Reference (

[9] ESG integration in UK capital markets: Feedback to CP21/18 ( Risk of harm, p13