For a rating to be caught by the new regime, it will have to meet each of the following criteria:

1. Does it come within the definition of “ESG rating”?

An “ESG rating” will be defined in the new legislation as:

an assessment regarding one or more ESG factors, which:

(a) is produced in the form of an opinion, a score or a combination of both, where:

(i) ‘score’ means a measure derived from data and a pre-established statistical or algorithmic system or model, without additional substantial analytical input from an analyst, and

(ii) ‘opinion’ means an assessment involving substantial analytical input from an analyst, and

(b) is prepared using an established methodology and a defined ranking system of rating categories’.

It makes no difference for these purposes whether the assessment is characterised as an ESG rating.

An “ESG factor” is defined in the legislation as “an environmental, social or governance factor”. An assessment regarding one or more environmental, social or governance factors is potentially within scope. It does not necessarily have to relate to questions of the environment or sustainability.

Firms should be aware of the possibility that assessments of only social or governance factors could equally be caught by the new regime.

2. Is the provider producing the rating?

The provider must both produce the rating and make it available. Mere distribution of someone else’s ESG rating is out of scope.

3. Is the rating likely to influence decision-making?

The rating must be likely to influence a decision to make a specified investment.

It is immaterial whether someone commissioned the ESG rating (it is solicited) or no-one commissioned the rating (it is unsolicited).

The CP says that a person will need FCA authorisation for the new regulated activity where that person:

• is located in the UK and provides an ESG rating to a person (irrespective of whether the recipient is located in the UK or overseas); or
• is not located in the UK but provides an ESG rating to a person in the UK for remuneration. (Overseas persons providing ESG ratings other than for remuneration are excluded from the new regime even if the recipient of the rating is in the UK.)

The new regime is, therefore, potentially capable of applying to persons outside the UK.

Overseas firms who are engaged in ESG ratings-related activities with UK customers should consider whether they will need FCA authorisation under the new regime.

There are several exemptions available in relation to the new regulated activity – including an intra-group exemption.

The exclusion that is likely to be of most interest to the financial sector is the “regulated products and services” exclusion. Certain firms who are already regulated in the UK will be excluded from the regime where they provide ESG ratings in the course of carrying on another regulated activity.

Examples given in the CP include:

• asset managers producing proprietary ESG ratings solely to use in their fund marketing materials;
• investment firms producing ESG ratings as an integral part of their investment research; and
• benchmark administrators developing ESG ratings that they use solely in their index methodologies.

However, the exclusion does not apply where the ESG rating is provided as a standalone product or service. Regulated firms who wish to provide this kind of service will need to apply for a new permission from the FCA.

Only a firm that, broadly speaking, is regulated in the UK will be able to benefit from this exclusion. An overseas firm that is authorised in its home country to do similar ESG rating activities will not be able to benefit from the exclusion and will potentially have to apply for authorisation.

Any person who can benefit from an exclusion will be outside the scope of the new rules that the FCA is consulting on. Read on to see what the new rules will require of ESG ratings providers.

The FCA says that the regime it proposes for ESG ratings providers will be a combination of:

• existing baseline rules that apply to most other FCA-regulated firms, taking a consistent approach; and
• tailored rules where existing requirements are either not appropriate or not proportionate to address the risks of harm.

The baseline requirements will include things like the FCA’s Principles for Business, general systems and controls requirements and the senior managers regime.

The tailored element of the rules will focus on:

• Transparency: Minimum disclosure requirements for methodologies, data sources and objectives, so users better understand the ESG ratings and rated entities understand how they are assessed. Additional disclosures will be required when dealing with direct users and rated entities, as they may have additional information needs.
• Systems and Controls: Requirements for robust arrangements to ensure the integrity of the ratings process, including quality control, data validation and methodology reviews.
• Governance: Requirements to maintain operational responsibility over the ratings process, including any outsourcings, to ensure appropriate oversight and compliance with the regime.
• Conflicts of interest: Requirements to identify, prevent, manage, and disclose conflicts of interest at the organisational and personnel level, to maintain the ratings’ independence and integrity.
• Stakeholder engagement: Requirements to notify rated entities in advance that they will be rated and to give them the opportunity to correct factual errors. There will also be procedures to allow other stakeholders to provide feedback, and a fair complaints handling procedure.

The FCA says that these tailored rules are informed by IOSCO standards.

The CP proposes that the FCA’s Consumer Duty will not apply to ESG ratings activity, but it reminds ESG ratings providers that other firms in the distribution chain for ESG products may be subject to the Consumer Duty and it encourages them to consider this when conducting their business. The FCA says that the detailed rules on transparency will also be calibrated to give retail consumers the information they need, which should help avoid the harms that the Consumer Duty is normally there to prevent.

The FCA is proposing that the jurisdiction of the Financial Ombudsman Service (FOS) should not extend to complaints about ESG ratings, and that coverage under the Financial Services Compensation Scheme (FSCS) should not be extended to ESG ratings providers.

The new FCA rules will apply only to firms who are specifically authorised to carry on the new regulated activity of providing ESG ratings. They will not apply to existing regulated firms who benefit from the “regulated products and services” exclusion.

This creates the possibility of a dual regime, under which an ESG ratings provider will have to comply with detailed requirements under the new rules when producing an ESG rating, but a regulated firm that produces an ESG rating in the course of other regulated activities would not. This could mean, for example, that ESG ratings produced by an ESG ratings provider would have to comply with the detailed minimum disclosure requirements, but those produced by an asset manager would not.

In addition, some of the nuances regarding the regime for ESG ratings providers – for example, the particular types of issue that should be considered from a conflicts perspective – would not apply to an asset manager producing similar ESG ratings.

For regulated firms who rely on the exclusion, the FCA says that it plans to assess whether it needs to improve standards in existing regulatory regimes to address the risk of harm, and that if it considers there are significant gaps in standards between the new regime and the current regulatory framework for existing regulated products and services, then it will consult on any proposed changes to the existing regimes. There may, therefore, be further changes in this space.

It also remains to be seen whether the standards that apply to ESG ratings providers will become the market standard and followed even by firms who would benefit from an exclusion.

The CP contains a roadmap for implementation of the new regime. The key dates are as follows:

Authored by Dominic Hill and Emily Julier.