Kate Gee and Tom Crawford discuss the impact of regulating ESG ratings agencies in The Law Society Gazette

Managing environmental, social and governance (ESG) risks is an increasing challenge for many companies. Next year, the UK government intends to introduce legislation that is designed to regulate ratings agencies which evaluate ESG corporate performance. Following plans devised by her predecessor, Jeremy Hunt, for a new ESG regulatory regime to supervise these agencies, Chancellor Rachel Reeves has requested HM Treasury to respond to the consultation that began in March 2023 and to establish a regulatory regime for ESG rating providers in 2025.

Ratings awarded by these agencies concern – for example – the sustainability of a financial product or investment, and can influence significantly the investment sector.  The ratings are widely used by the companies who receive them, including to assess their ESG-risk profile and to inform the way in which they conduct their business and label their financial products.  However, even though ratings awarded to certain investments directly affect whether they can be marketed as ‘sustainable’, the methodology currently used by agencies to create ESG criteria and benchmark companies against them is opaque, and largely unregulated in the UK.

The primary driver for the proposed new legislation is a perceived lack of clarity around some ESG ratings, perhaps generated by the widely divergent ratings that are produced for the same business or attributed to similar investment products. The resulting lack of transparency has become ever more acute as investors integrate ESG considerations into their investment processes. The International Organization of Securities Commissions (IOSCO) has urged regulators to improve transparency in ESG ratings and apply regulatory oversight. Several jurisdictions have already done just that. For example, the European Parliament recently adopted the Regulation on the transparency and integrity of ESG rating activities (ESGR). After formal approval by the Council, ESG ratings agencies will be brought under the authority of ESMA, the European markets regulator.

In the UK, the Financial Conduct Authority looks set to determine rules for the new regulatory regime, potentially supported by a new supervisory watchdog.  However, the introduction of legislation in this space could inadvertently increase the risk of litigation – of which companies are already keenly aware - arising from misleading or inaccurate ESG ratings.

A robust ESG strategy

At present in the UK, certain companies are required by English law to have some ESG ratings, including a requirement to make material disclosures in their annual reports relating to climate-related risks, in addition to opportunities based on the four-pillar framework established by the Task Force on Climate-Related Financial Disclosures.

Looking to the US, it is apparent that - in response to widespread ESG concerns - US companies are re-shaping their strategic decisions. A recent survey of US general counsels revealed that, as a direct result of ESG consequences, 52% of respondent companies had made changes to their strategic business decisions in the past year. This is happening against a background of ESG ratings – the very regime currently being scrutinised.

The Institute for Energy Economics and Financial Analysis (IEFFA) found that ESG ratings can be subjective, inconsistent or inflated, and that the absence of standard criteria across the ratings industry and a degree of transparency in methodologies would inevitably lead to a mispricing of stocks, bonds or funds – with the consequences that would flow from that decision.

At the same time, across the global financial market, investors are increasingly considering a company’s ESG strategy when deciding on their financial investments.  In doing so, investors may take into account ESG ratings awarded by ESG ratings agencies, and any corresponding statements or marketing materials which reflect those ratings.  For example, in an M&A context, institutional investors may rely on ESG credentials when acquiring a company, as part of the usual diligence process.

Potentially, this could lead to companies being under scrutiny or claims being brought: for example, with investors alleging liability for misrepresentation in M&A or securities litigation.

Outlook

More ESG regulation is a welcome development for the sector.  However, the short term consequence could be an increase in ESG-focused litigation – already a “hot topic”. We can expect that the introduction of new ESG rating focused legislation will continue to drive the volume of ESG-related litigation upwards in the UK, mirroring developments in the US.

In taking proactive steps to mitigate potential litigation risk, companies must prioritise their ESG strategy, ensuring that they assess and verify their ESG credentials, evaluating the ESG rating agencies wherever possible, and taking care not to overstate their ESG credentials. Should any inaccuracies or overstated credentials be identified, a company should take immediate action to rectify the position and seek advice in relation to the same.