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FIND OUT MOREPartner Kate Gee and Senior Associate Tom Crawford explore how the implementation of a new regulatory framework for ESG ratings agencies will inevitably lead to corresponding litigation risk for the industry. Kate and Tom’s article was published in Environmental Finance on 7 October 2024, and can be found here.
Ratings produced by ESG ratings agencies are widely used to assess a company's handling of environmental, social, and governance risks. In August, in one of her first actions since being appointed Chancellor, Rachel Reeves called for HM Treasury to respond to the consultation opened in March 2023 and to establish a UK regulatory regime for ESG ratings providers by 2025.
The driving force for this is the need to regulate the sustainable ratings industry, which exerts significant influence over the multi-billion-pound investment sector by, for example, rating stocks and bonds held by investment funds that are designated ‘sustainable’.
Companies are increasingly aware of the risk of litigation arising out of misleading or inaccurate ESG ratings; and, notwithstanding the good intentions behind the proposed regulation, it seems inevitable that the corresponding litigation risk will increase once implemented.
As part of the Chancellor’s drive to develop the UK’s sustainable finance sector, Reeves is aiming to increase transparency in the ESG sector by bringing legislation in line with other leading economies. Last year, the European Commission proposed new EU rules for ESG ratings providers; by contrast, how ratings agencies create ESG criteria and benchmark companies against those criteria is largely unregulated in the UK. But, nevertheless, the ratings awarded to certain investments directly affect whether they can be marketed as ‘sustainable’.
The proposals include that the Financial Conduct Authority will determine rules for the new regime, potentially supported by a new watchdog for administration and enforcement of the same.
At present, under English law, certain companies are currently required to have certain ESG ratings: for example, listed companies and large private companies/LLPs are subject to strict regulatory requirements including material disclosures in annual reports on climate-related risks and opportunities based on the four-pillar framework established by the Task Force on Climate-Related Financial Disclosures.
How important is a robust ESG strategy?
ESG is already shaping corporate strategy, particularly in the US. A recent survey of US General Counsels revealed that more than half of their organisations had changed their strategic business decisions in the past year due to ESG considerations.
On the other side of the coin, 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.
When ratings agencies become regulated, there will be greater scrutiny around their ESG ratings methodology – and a risk that if such methodology is found to have been inconsistent, incorrect or based on inaccurate data, the results, and the related companies or investments – will be downgraded or overturned, as part of a public process.
What could be the impact of a misleading ESG rating?
To put the above in context, it is useful to consider the Institute for Energy Economics and Financial Analysis’s (IEEFA) examination of specific ESG-rated funds, which concluded that certain ESG data can be flawed.
Where ESG ratings or labels have been awarded erroneously, relevant investors who learn that they have invested in something that was less sustainable than they were led to believe be inclined to take action.
From this fact pattern, potential claims for misrepresentation or breach of warranty may arise, including in the form of M&A/securities litigation.
Companies must continue to prioritise their ESG strategy and take steps proactively to assess and verify their ESG credentials, testing ESG ratings agencies where it is practicable to do so, and taking care not to overstate their position. Should any inaccuracies or overstated credentials be identified, a company ought to take immediate action to correct the position, seeking advice in relation to the same.
What is the outlook for ESG litigation?
ESG litigation is already a “hot topic” – and with the introduction of new ESG rating-focused legislation, we can expect increased regulatory scrutiny and an increase in the volume of ESG-related litigation, in the first instance at least.
