Introduction

ESG ratings and data markets have grown exponentially over the last few years as a result of growing sustainability markets and investors needing to understand the climate risk and sustainability impacts of companies and investments.  ESG ratings and data providers have thus become increasingly influential in the capital markets.  But a lack of availability of credible sustainability data, “black box” methodologies and potential conflicts of interest have challenged the credibility of ESG ratings and prompted the International Organization of Securities Commissioners (IOSCO) to take action. 

IOSCO published a set of principles for securities regulators and ESG ratings and data providers in November 2021 (the Final Recommendations) and a number of voluntary codes of conduct have been modelled on these Final Recommendations.  Codes have been (or are being) developed in Japan, Singapore, India, South Korea, Taiwan and Hong Kong. The European Union has published a draft text on the regulation on the transparency and integrity of ESG rating activities and the UK has confirmed that ESG ratings providers will be brought within the regulatory perimeter of the UK Financial Conduct Authority (FCA) where they assess ESG factors for the purposes of investment decisions and to influence capital allocation.

Following a launch event for theUK Code at the London Stock Exchange on 31 January 2024, we share some of the insights garnered from the UK, Japanese and Singaporean regulators.

United Kingdom

On 14 December 2023, the Code of Conduct for ESG Ratings and Data Products Providers was launched. The Code was commissioned by the FCA and developed by the International Capital Market Association (ICMA) and the International Regulatory Strategy Group (ISRG) for use in the UK and internationally.  See our article here for more information.

Japan

The Japanese Financial Services Agency (Japanese FSA) was the first regulator to release its Code of Conduct for ESG Evaluation and Data Providers on 15 December 2022. One of the reasons it was quick to release its Code was that its Chief Sustainable Finance Officer was Co-chair of the IOSCO workstream which developed the Final Recommendations.

Singapore

The Monetary Authority of Singapore (MAS) launched its Code of Conduct for ESG Rating and Data Product Providers on 6 December 2023.  ICMA has been asked to host the Code of Conduct as well as the list of providers who have adopted the Singapore Code of Conduct.  One of the ways the MAS Code of Conduct differs from the Japanese and UK Codes is that it recommends third party assurance of the checklists confirming attestation (in line with the IOSCO Call for Action paper). 

Promoting interoperability between Codes

Many ESG rating agencies and data providers are international organisations.  Thus interoperability of Codes in different jurisdictions is essential for the functioning of the market.  Hence the Japanese, UK and Singapore Codes of Conduct have implemented IOSCO’s Final Recommendations as appropriate in their jurisdictions.  They have also collaborated with each other and other regulators to achieve maximum interoperability between Codes. 

Compliance with the Codes in Japan, the UK and Singapore is voluntary. ESG rating agencies and data providers are required to make annual attestations confirming the extent of their compliance.  The UK and Japan do not prescribe a form for the attestation.  MAS has provided a checklist for entities to complete which separately identifies the good practices set out in the IOSCO Call for Action paper and additional Singapore specific best practices to promote interoperability with codes of conduct in other jurisdictions. 

ICMA is also performing the Secretariat role for the development of the Hong Kong ESG Ratings and Data Code of Conduct Working Group and this is likely to enhance the interoperability of the Hong Kong Code being developed. We expect to see a draft of the Hong Kong ESG Ratings and Data Code of Conduct in Q1 2024, approximately three months after the first meeting.

ESG ratings users need to do their due diligence

None of the UK, Singapore or Japanese regulators will monitor compliance with the relevant Codes of Conduct.  ESG rating agencies or data providers will need to upload their attestations annually to the ICMA website (in the case of the UK and Singapore) or the Japanese FSA website (in the case of Japan).  The Japanese FSA has performed some analytical checks on the Japan attestations which have already been uploaded and the quality of the attestations varied greatly. 

Users of ESG ratings need to ensure that they perform due diligence on the ESG ratings providers.  Their engagement with ESG ratings and data providers is essential to understand where data is sourced, the objective of the ESG ratings being provided and the methodology. Only by asking questions of providers will users know what products they are buying and if they suit their purpose. It is also worth users checking attestations to ensure that they are up to date and that they are happy with the quality and content of the responses. 

What is next? More voluntary codes and regulation?

Mandatory compliance with regulation is also on the horizon for ESG rating agencies.

In the EU, the compromise text on the proposed Regulation on the transparency and integrity of environmental, social and governance (ESG) rating activities (2023/0177(COD)) (dated 9 February 2024) was published on 14 February 2024.  The text reflects the outcome of the provisional political agreement reached by the Council with the European Parliament on 5 February 2024.

These regulations are more far ranging than the voluntary codes of conduct and will require ESG rating agencies to be authorised by the European Securities and Markets Authority (ESMA).  Rating agencies will need to comply with transparency requirements (such as publishing their rating methodologies and data sources) and will need to separate business activities to avoid conflicts of interest (unless an exemption applies). 

If a composite ESG rating is being provided, the weighting of the E, S and G factors should be explicit.  Separate E, S and G ratings are also possible.  See here for more detail on the proposals.  The provisional political agreement is subject to approval by the Council and the Parliament before going through the formal adoption procedure. The regulation will start applying 18 months after its entry into force.

In the UK, HM Treasury's consultation consulted on a future regulatory regime for ESG ratings providers ended on 30 June 2023.  On 6 March 2024, HM Treasury confirmed that it will regulate ESG ratings where assessments of ESG factors are used for investment decisions and influence capital allocation. A full consultation response and legislative timeline will follow later this year.  It may be that this topic is also considered in the Transition Finance Market Review which is due to report back to the government by July 2024. 

Our Sustainable Finance & Investment practice brings together a multidisciplinary global team to support our clients in this mission-critical area. We will be keeping a close eye on ESG ratings developments so please get in touch if you would like to discuss further. 

This note is intended to be a general guide and covers questions of law and practice.  It does not constitute legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.

Authored by Emily Julier and Rita Hunter.

^{Hogan Lovells (Luxembourg) LLP is registered with the Luxembourg bar.}