Written by Vernon Dennis, Partner and Head of Business Advisory at Howard Kennedy
Rachel Reeves first overseas trip as Chancellor to the US and Canada was an unashamed investment drive to showcase how ‘Britain is open for business’ and how the Government will seek to position the UK as a ‘clean energy superpower.’ The UK is already Europe’s leading market for sustainable investment, raising more capital than the next two highest European exchanges combined. With the establishment of a National Wealth Fund backed by £7.3 billion, the Government hopes to attract further private investment in green and sustainable industries, which it hopes will be a catalyst for economic growth.
On 8 August in Toronto, Rachel Reeves met representatives of the energy and infrastructure industries, and it was here that she announced plans to introduce a new law in 2025 to regulate agencies that evaluate ESG performance. She made clear that the FCA would be responsible for setting rules for the new regime and raised the possibility of a new watchdog to supervise rating agencies operating in the UK. These moves are welcomed, promoting transparency and accountability for those reporting on, assessing and rating ESG performance.
Increased ESG Reporting and Disclosure
The exponential growth of ESG rating agencies has met a business need where increasingly companies are called upon by legislation, regulation and investor demands to report on ESG criteria, disclose adverse impacts and outline ESG strategy.
For example, on 16 May, the Dept. for Business and Trade published a framework and terms of reference for UK Sustainability Reporting Standards. On the same day the Treasury, Dept. for Energy, Security and Net Zero, and Dept. for Environment published an implementation update for economy wide UK Sustainability Disclosure Requirements.
In the UK, Listed companies and large private companies/LLPs are already subject to strict regulatory requirements which include 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. The four pillars being an approach which embeds decision making into the core elements of how a business operates, namely governance, strategy, risk management, and metrics and targets.
These moves are in part a response to the Corporate Sustainability Reporting Directive which requires reporting on business model and strategy, transition plans, management and supervision of impact and risk, as well as the Corporate Sustainability Due Diligence Directive which will within 2 years require the largest companies operating in the EU to have due diligence policies; these will assess a wide variety of actual and potential social and environmental impacts, and impose an obligation to mitigate and remedy adverse impacts in operations and activities.
ESG Rating Agencies
Rating agencies have and will play a huge role in assisting on reporting and disclosure and are used to verify ESG claims. Currently, as an unregulated sector, there is concern as to the opaqueness of methodologies used in providing ratings/opinions, and difficulties in making informed comparisons. The proposed new law will seek to address these concerns.
The speed of introduction will ensure that the UK is ready for EU legislation, namely the Regulation on Transparency and Integrity of ESG Rating Activities (ESGR) which will come into force in 2026 and will impact all who seek access to the EU market. It is of note that Rachel Reeves made clear that the FCA would be responsible for drafting the rules and, crucially, legislation and regulation would mirror the requirements set out in the ESGR. Whether a more Eurosceptic Government would have felt compelled to exploit the so-called ‘Brexit dividend’ and introduce its own rules is open to question, but the realpolitik of this announcement is that the EU’s adoption of the ESGR means that time is limited, and the UK needs to ensure that it has ‘equivalency’ prior to EU wide market regulation.
The ESGR will apply to nearly all ESG rating agencies operating in the EU. The regulation encompasses agencies that rate a single ESG criteria, such as net zero or supply chain; and where a composite ESG rating is provided, the weighting must be clearly set out. The ESGR will apply to non-EU entities that issue and distribute ratings in the EU. ESGR exclusions include ratings developed internally or intra-group that are not intended for public distribution and where ratings are already regulated under EU legislation, such as the EU Sustainability Finance Disclosure Regulation and the EU Credit Rating Agencies Regulation.
ESGR defines an ESG rating as an opinion, score or combination of both, regarding either ESG profile, characteristics of the assessed company, or an ESG risk or impact based on an established methodology and defined ranking system of rating categories, irrespective of whether labelled as an ‘ESG’ rating, opinion or score.
ESG rating agencies will be authorised by the European Securities and Markets Authority (ESMA) or equivalent. ESMA will maintain a register of those authorised. Rachel Reeves’ announcement that the FCA will regulate the ESG rating agencies thus provides an equivalent authority.
Providers must separate ratings business from certain activities, for instance providing consultancy services to investors, and be aware of conflict. To ensure transparency, providers will be required to detail methodologies, models and assumptions used. Providers will also need to consider whether the rating is backward or forward looking, as well as the scope and overview of data sources. The need for transparent methodology is central to establishing investor trust and confidence in the ratings/opinions being provided. It allows for rating industry comparison and in time, the promotion of ‘best in class’ ratings.
It is of note that in the fast development of ESG rating much use has been made of AI modelling. AI has and will continue to play a role in providing dynamic data, due to its enhanced ability to check through public sources to determine the accuracy of ESG reporting, disclosure and claims being made. However, the ESGR will require rating agencies to give careful thought as to the use of AI and whether it can happily co-exist in a disclosable methodology i.e. can the rating agency explain the methodology of the AI model itself?
The Government has acted swiftly in picking up from the consultation commenced in 2023, ensuring readiness for changes to the European market. It has highlighted the connectivity between sustainable investment and the necessity for private sector trust and confidence in the assessment of ESG performance, and how this is seen as central to the Government’s plan to promote economic growth.
