As part of a consultation on climate-related disclosures, the FCA has sought views on ESG topics in capital markets, raising questions on the nature of this fast-evolving market. The consultation raises a number of important areas of regulatory consideration, including the nature of the transaction documents on sustainable finance transactions, the use of Second Party Opinion (SPO) providers and ESG data and ratings. The importance of the consultation should not be under-estimated, as it is an indication that the UK Regulator is seeking to potentially increase supervisory scrutiny in this market, which is important given its current growth.
On 22 June 2021, the FCA published a consultation paper on enhancing climate-related disclosures by standard listed companies, which included a detailed look at the functioning of green, social and sustainable (GSS) debt instruments and ESG rating and data providers.
The market for GSS finance has seen an explosion in growth over the past 18 months. From being a niche asset class just a few years ago, it is growing to become a common choice for many issuers in financing their business. As the sustainable finance market has expanded, so too have the number of firms providing services to it, such as SPOs, ESG ratings and data. However, with this growth comes the need for clarity in the regulatory approach as the pace of innovation introduces new and emerging practices.
This blog focuses on the ESG capital markets topics discussed in the consultation, looking at GSS labelled debt instruments, the role of verifiers and SPOs, and ESG data and rating providers. Whilst there are no specific regulatory rule changes proposed in relation to these topics, the FCA poses a number of open questions and there is a clear intention to highlight concerns in current practices. The fact that the FCA has highlighted areas of concern may point to an appetite to provide additional guidance or potentially increased intervention in the future.
The FCA invites feedback from market participants by 10th September.
Green, Social and Sustainability labelled debt instruments
The FCA comments on the proliferation of ESG-related financing. Notably, reference is made to Use of Proceeds bonds (the more conventional type of sustainable finance where the proceeds from the loan or bond will be channelled into projects or assets which will have a positive ESG impact) and sustainability linked products (a more recent introduction, featuring Key Performance Indicators linked to potential reductions in interest payments).
The range of different options open to issuers (e.g. the nature of the financing, the ESG framework it follows, how an issuer will approach the sustainability aspects of it financing) demonstrates the current breadth of innovation in this market.
The FCA has examined transactions and found issues (e.g. the commitment to use of proceeds is often on a “best endeavours” basis). This may be expected in such a fast-growing sector, where defining and measuring sustainable activities can be difficult. The consultation raises the potential that the FCA will incorporate amendments to the Prospectus Regulation to require additional information relating to sustainability aspects so issuers will need to consider the potential implications of such a move (e.g. increased legal liability).
The FCA poses a number of open questions relating to the sustainable finance market, for instance, how to recognise existing standards such as the ICMA Principles and whether the UK should establish a Green Bond Standard similar to the EU.
Role of verifiers and SPOs
SPOs have emerged as an integral part of ESG financing, designed to provide an independent assessment of an issuer’s alignment with a defined set of principles, such as the ICMA Green Bond Principles or EU Green Bond Standard. It’s noted in the consultation paper that SPOs generally fall outside of any formal specific regulation, both in terms of their provision and their methodology, suggesting that the FCA could subject them to greater scrutiny. This could be similar to the EU’s proposals to have ESMA oversight and supervision of External Reviewers as part of its proposed European Green Bond Regulation.
Sustainability linked products, which will often feature a step-down in interest payments if a company achieves certain KPI targets, subject to verification, are also highlighted as another area for potential reform.
Given the importance of reporting by the issuer for both Use of Proceeds bonds and sustainability-linked products, assurance or verification of reporting will be an important consideration for market confidence, but the FCA notes that is subject to a number of challenges:
- a potential conflict of interest given it is an “issuer pays” model, which could be further complicated where perceived or actual conflicts may exist (e.g. if the assurance provider or verifier is providing related services such as ESG ratings or consultancy),
- a lack of transparency on the methodology used to support the SPO,
- the complexity of analysing the performance of sustainability-linked KPIs, which can require specialist skillsets, and,
- a reliance on information and data provided by the issuer.
ESG data and rating providers
Coinciding with the growth of ESG financing markets, there has been an increase in the providers and use of ESG ratings and data. The FCA references research by Opimas which suggests the market for ESG data was worth approximately $600m in 2019 and could approach $1bn in 2021, and SustainAbility research, showing there to be over 600 ESG ratings and rankings existing in 2018.
In a similar way in which the credit rating industry experienced radical changes following the 2008 financial crisis, the FCA notes a number of potential issues in the provision of ESG ratings.
The FCA notes what it considers to be a number of issues in the ESG ratings market currently, including:
- interpretation of the ratings can be challenging, ESG is, by its very nature, more subjective than financial information. Ratings providers will construct ratings using different metrics, weightings and methodologies, which can make them difficult to translate and compare;
- ESG ratings can be subject to data gaps, based on public data or based on an ‘arm’s length’ understanding of a company;
- an ESG rating can be hardwired into the process, common in the case of sustainability-linked transactions, which can create ‘cliff-edges’ in the system;
- users of ESG ratings should be able to be confident that the rating is subject to sound governance and avoids any potential conflicts of interest and the lack of any current regulation or supervision of this sector may call this into question, and;
- ESG ratings are often based on issuers completing questionnaires which can be inefficient, inconsistent and open to potential misinterpretation.
The similarities between the current market for ESG ratings and the shortfalls exposed in credit ratings around the time of the financial crisis in 2008 are a clear prompt for the FCA to consider closer regulatory supervision in the development of this market.
The consultation is a positive step forward in the development of sustainable finance. The UK government has emphasised the importance of transforming the UK financial system for a greener future and for that to be achieved, issuers and investors will need to have the same confidence in ESG-related financing as any other financial transactions, requiring the market to be efficient, robust, well-disciplined and operate within a clear and transparent framework.
The consultation points to a range of different options for the FCA to address these areas of concern, many of which suggest international co-ordination will be important. There are parallels with the European Commission’s Strategy for Financing the Transition for a Sustainable Economy and IOSCOS’s recent recommendations on sustainability-related practices in asset management. The policy options open to the FCA range from sharing voluntary best practice guidance, through to bringing activities such as ESG ratings and data within the FCA’s regulatory perimeter. Either way, it’s clear we can expect there will be enhanced expectations and greater scrutiny for the sector which will have an influence across all market participants, including issuers, investors, rating agencies, data and SPO providers.
ESG-related finance in the UK is at a pivotal moment. This is a welcome step by the FCA and could be an indication of greater regulatory scrutiny over this rapidly developing market.
 CP 21/18 available at https://www.fca.org.uk/publication/consultation/cp21-18.pdf
 See Deloitte’s blog on the topic of the EU Green Bond Standard at; https://ukfinancialservicesinsights.deloitte.com/post/102h2ih/the-eu-puts-its-stamp-on-a-new-european-green-bond-framework
 See Deloitte’s blog on this topic of the European Commission’s Strategy on Transitioning to a Sustainable Economy at; https://ukfinancialservicesinsights.deloitte.com/post/102h2ii/the-eu-sets-out-its-new-sustainable-finance-strategy
The UK government has emphasised the importance of transforming the UK financial system for a greener future and for that to be achieved, issuers and investors will need to have the same confidence in ESG-related financing as any other financial transactions, requiring the market to be efficient, robust, well-disciplined and operate within a clear and transparent framework.