Insurers have widely adopted environmental, social and governance (ESG) ratings to implement ESG strategies and tilt investment portfolios to meet shareholders’ and policyholders’ deepening ESG expectations. But while moving your portfolio to investments with higher ESG scores is an action aimed at meeting your stakeholders’ needs, in practice ESG scores can represent something of a ‘black box’.
The data which providers use to generate ESG ratings or scores (the terms are interchangeable) is not always transparent. ESG rating methodologies are also not harmonized across providers. The ESG ratings industry, central to providing information that directs the flow of trillions worth of capital, currently has a relatively low level of regulatory oversight.
Growing disquiet over ESG ratings was underscored by the 2023 collapse of Silicon Valley Bank (SVB). Despite its financial failures, SVB had nevertheless received a good overall ESG rating and an upper-end ESG score for governance from a leading data provider.
The U.K. government has responded to concerns, announcing plans for a regulatory regime for ESG ratings providers. In this Q&A, we examine the proposals and the implications of ESG ratings regulation. We also consider the proactive stance you can adopt now to unpack the ESG data black box and position your insurance organization for competitive advantage in this developing space.
Below, we cover:
What is the government’s rationale for regulating ESG ratings agencies?
The U.K. government recently published an updated Green Finance Strategy. This has reinforced the U.K.’s ambition to be a global leader in green finance and to regulate accordingly. HM Treasury’s stated view is that the “importance of reliable ESG information is critical and growing". It launched a consultation in March 2023, following on from the Financial Conduct Authority (FCA) consultation in June 2022.
The FCA consultation paper on climate-related disclosures and ESG in capital markets asked market participants about the case for regulatory oversight of ESG ratings and ESG data providers. Respondents highlighted several areas the FCA recognised as posing potential harm, including a lack of transparency, poor governance and systems and controls and poor management of conflicts of interest. The FCA also identified potential conflicts where an ESG ratings provider is renumerated for providing advice to the rated entity on how to improve its ESG rating.
HM Treasury’s consultation points to concerns over ESG ratings providers’ methodologies and objectives, which can be “opaque and lead to confusion about what a rating implies”, affecting market confidence.
What do the proposed ESG ratings regulations cover?
The proposals aim to cover ratings in relation to regulated investment activities in the U.K., irrespective of the location of the ratings providers and would apply to any ratings service providing ESG assessments.
The proposed rules focus on the transparency of ESG ratings methodologies, ESG data sources and the procedures when there are gaps in data. It’s also proposed the regime covers ESG ratings’ governance in terms of:
The planned framework also includes plans for robust systems and controls, specifically:
What is the timing around the proposed ESG ratings regulation?
The government first announced proposals to bring ESG ratings providers under the scope of regulation as part of the Edinburgh reforms in December 2022. The government issued its consultation in March 2023, setting out potential proposals for a regulatory framework, with formal proposals expected in early 2024.
What are the implications of ESG data regulation for insurers?
In the short-term, the consultation highlights some potential issues. For example, amongst the issues highlighted by HM Treasury’s consultation is the subjectivity in ratings methodology, which can lead to contrasting ratings between different providers.
An absence of objectivity can also create opportunities for allegations of greenwashing. For example, an entity may have enjoyed a ratings upgrade by a provider but without impactful activity that materially improves the organization’s ESG credentials or diverts from significant failures, as the case of SVB proved.
However, in the longer term, once it is implemented, a robust regulatory framework could lead to greater objectivity and confidence in ESG ratings, providing greater reassurance on the credibility of ESG investment products and wider sustainable investments market.
Such positive change could deliver enhanced sustainability outcomes, more positive outcomes for investors and support you in defining credible transition plans to meet your net zero targets.
What action can insurers take now to prepare for ESG ratings provider regulation?
The good rating SVB received ahead of its failure demonstrates the potential limitations of relying too much on single sources of outsourced, off-the-shelf ESG data. You can address the vulnerabilities by taking greater ownership of the data you rely on for setting sustainable investment strategies. You need to consider the overall reliability of the ESG data you use, in particular, the emissions data.
To be assured of the answers, you should perform due diligence on external rating providers. This is about understanding, and being able to demonstrate the credibility of the ESG data and ratings you use to make decisions.
Ahead of any regulation, you should focus on setting and embedding responsible investment strategies underpinned by moves to overcome the known limitations of ESG scores and ratings. Your insurance organization should also be ready to interrogate alternative approaches to validating how ESG ratings providers are using ESG data. This will give you a full and meaningful picture of the ESG risks and opportunities facing external counterparties and the corporates within your investment portfolios.
A curious and proactive approach that calls on multiple ESG data sources to ‘kick the tyres’ of ESG scores with sufficient vigour will lend itself to more strategic stances on ESG scores. Showing leadership in the push for ESG ratings transparency now could act as a differentiator ahead of regulation being introduced, putting you in greater control.
For expert support on validating your ESG data and approach to developing your journey to net zero, get in touch.