As ESG and sustainability generally are becoming more prominent factors in the context of corporate metrics and investments, the Financial Conduct Authority (FCA), the UK's financial services industry's regulator, has recently completed a review of Environmental, Social and Governance (ESG) benchmarks in March 2023.
The FCA issued a warning to ESG benchmark administrators highlighting the need for improvement across "poor" ESG benchmarks, stating that "ESG matters are high on our regulatory agenda".
ESG benchmarks are used to systematically evaluate the ESG capability and performance of entities with a view to understanding existing deficiencies and ultimately improving their overall environmental, social and governance impact.
The need for improvement in benchmarking highlighted by the FCA is particularly important not only because ESG metrics have increasingly been introduced to the dealmaking environment to the extent that they are becoming a considerable factor in M&A decision making, but also because ESG benchmarking is viewed as an area characterised by a lack of certainty.
After publishing its ESG strategy in November 2021, in September 2022 the FCA sent a portfolio letter to benchmark administrators identifying that high quality ESG benchmarks are crucial to support trust in the market for ESG products and noting the risk of poor disclosures for benchmarks. The letter noted that ESG matters are high on the regulator's agenda as "for the financial sector to help support the transition to a more sustainable future, market participants and financial services firms need high-quality information, a well-functioning ecosystem, and clear standards".
In March 2023 the regulator completed its preliminary review of ESG benchmarks and concluded in its "Dear CEO" letter that, in general, the overall quality of ESG disclosures made by benchmark administrators was "poor". The FCA summarised the issues identified in a subsequent letter as follows:
- Not enough detail on the ESG factors considered in benchmark methodologies;
- Not ensuring that the underlying methodologies for ESG data and ratings products used in benchmarks are accessible, clearly presented and explained to users;
- Not fully implementing ESG disclosure requirements; and
- Benchmark administrators failing to implement their ESG benchmarks’ methodologies correctly – for example, using outdated data and ratings or failing to apply ESG exclusion criteria.
The regulator noted that benchmark administrators may be subject to "the FCA's full range of…tools" (which likely includes enforcement action and/or legal action or claims) if they fail to have strategies to address the issues identified in the review. The FCA is working closely with the government, which is consulting with stakeholders on whether to extend the FCA's perimeter to capture ESG ratings providers (this consultation closes on 30 June 2023). The FCA also encourages the development of a voluntary code of conduct for ESG data and rating providers.
It is clear that whilst ESG metrics play an increasingly important role in promoting corporate sustainability, the methodologies currently used can in some respects be vague and unclear. It will be interesting to see how this relatively new sector is going to respond to the FCA's warnings and recommendations and whether it will become fully regulated, whether by the FCA or another regulator.
We will watch the consultation with interest and in particular how benchmarkers, funders and the industry respond to any recommendations made as part of the consultation.
