As the role of ESG in markets becomes increasingly important, the question arises as to whether ESG regulation should be introduced in the UK and if so how?
As the debate continues, Adam Lyons, head of the Green Finance Unit at HM Treasury, has said there are plans to work with the Financial Conduct Authority (FCA), alongside ratings agencies, to better understand how ESG ratings affect the market and whether they should be regulated.
Would ESG Regulation help the UK?
Robust and commonly understood ratings, standards and frameworks are vital for ensuring transparency, measurability and tracking concrete progress.
Analysis of the impact of ESG ratings would be an important step in terms of market maturity, given the plethora of agencies, methodologies used, the range of data analysis and the metrics selected.
In terms of ratings and accreditations today, until there is a more unified ESG approach and a regulator, it remains difficult to judge the usefulness of different ratings. There is a degree of confusion with the markets and such action could prove instrumental in accelerating the market.
No current ESG regulation in the UK
As Mark Stewart, Edinburgh office head & corporate finance partner at accountants Johnstone Carmichael, puts it, “While ESG frameworks represent huge opportunities for businesses to articulate and differentiate themselves based upon their approach to people, planet and profit, there are also many challenges in the ESG landscape due to the number of differing frameworks that are applicable and a lack of standardised reporting requirements.
“There is currently no legislative framework to provide that consistency but there is no doubt that will come in due course.”
The market for ESG ratings and data has grown over the past few years, but has suffered from lack of consistent information disclosures at the entity level.
The ESG market does not typically fall within the remit of securities regulators, so a jurisdictional approach to the use of ESG ratings and data products, as well as the activities of data and product providers, could help increase trust.
In the last year both the UK’s FCA and the International Organisation of Securities Organisation (IOSCO) have called for regulation of the ESG market.
Regulation is already forcing change in the market. Karem Kobayshi says: “The SFDR is one example. It is driving financial market participants to make certain disclosures around sustainability risks and alignment with the EU taxonomy.
This is a major step and contribution in this area, which will allow investors to make more informed decisions when choosing sustainable financial products.”
Net zero top of the agenda for the UK
The UK is also pushing its market leadership in net zero and sustainable finance. In April 2022, mandatory climate risk disclosures in line with the recommendations of the TCFD came into force for over 1,300 companies, and such disclosure will be extended over the coming years.
In the UK’s Greening Finance roadmap, released at COP26 in 2021, the Chancellor committed to mandatory publication of transition plans. That is expected to see financial institutions and companies with shares listed on the London Stock Exchange publishing net-zero transition plans from 2023.
There is a significant investment opportunity here. Ben Caldecott, founding director of the Oxford Sustainable Finance Group and seconded to the UK Cabinet Office as the COP26 Strategy Adviser for Finance, said in 2021: “Net-zero transition plans will create demand for packages of new financial products and services, as well as create demand for new ways of measuring performance using the latest earth observation, AI and data science methods.”
Most importantly, however, it will ensure that companies are held to account regarding their net-zero targets and how to achieve them.
Vaughan Lindsay, chief executive of climate solutions provider Natural Capital Partners, says: “Transition planning is the next phase in climate action – and will be a fundamental requirement for showing what you plan. It’s easy enough to make a pledge, but the first step [to a net-zero future] is publishing plans that allow investors to benchmark performance.”
The Treasury’s Lyons said that the focus will not be on the regulation of ESG ratings agencies but rather in setting up the frameworks for trust and transparency within the market – and that itself would be transformational.
ESG regulation needs to start with consensus
The last couple of years have seen growing maturity in ESG reporting and sophistication amongst investors in how they use ESG data.
There is little point, however, in attempting to regulate market operators where the basic definitions have yet to be agreed and defined.
Any move towards alignment and transparency is a positive one but ultimately, until the divisions between those focused on materiality versus those focused on double materiality are resolved, there cannot be one on regulatory approach.
What governments and regulators can effectively do is demand effective ESG regulation frameworks where comparisons can be made, as the UK is suggesting and as the SEC is proposing with its reporting requirement on performance.
In this way stakeholders might just solve the problem themselves.