Consultation response: Future regulatory regime for Environmental, Social, and Governance (ESG) ratings providers
Sylvera is a provider of carbon credit ratings (a “Carbon Credit Ratings Agency” or “CCRA”), and therefore is commenting from that perspective.
We support regulatory oversight of CCRAs to build trust in a nascent market. However, we are somewhat concerned that if CCRAs were subject to regulation designed for a different kind of ratings agency (ESG Ratings Agencies), this could have adverse consequences both for CCRAs and the wider market.
In particular, we recommend that any regulation, and approach to supervision, is broad and understanding enough to capture the very different business models of CCRAs and ESGRAs. Furthermore, we expect that only regulating the activity of CCRAs as it relates to specified investments will create uncertainty for both CCRAs and ratings users. We therefore outline three possible approaches to overcome this issue (question 7).
1 - Introduction
1. Do you agree that regulation should be introduced for ESG ratings providers?
Yes, we believe that CCRAs should be subject to some form of regulatory oversight to ensure that stakeholders have sufficient understanding of, and confidence in, their approach and governance. We see huge benefits both for the market, and for CCRAs themselves, of building the trust placed in CCRAs. However, all existing CCRAs are relatively young businesses and VCM activity hasn’t yet settled into the established patterns of other financial / commodities markets, so the worst outcomes for CCRAs would be (a) uncertainty as to whether licensing is required, (b) a heavy, international regulatory burden, and/or (c ) regulation built for ESGRAs but with CCRAs required to comply. We address each limb in the relevant section below.
2. (For ESG ratings providers) If your firm were subject to regulation in line with IOSCO’s recommendations, and aimed at delivering the four key regulatory outcomes in Figure 1.A, how would this impact your business? Please provide information on the size of your business when answering this question.
We are supportive of keeping regulation in line with IOSCO’s recommendations. We are above the UK CA06 small business threshold, but only on two limbs and not by much. We currently have a voluntary governance framework (here) that was inspired by IOSCO’s recommendations for credit ratings agencies and aligns with IOSCO’s recommendations for ESG Ratings Agencies, so it wouldn’t be a drastic leap to regulation on these lines. However, the main overhead change would be in enforcement. Currently, we permit deviation from our policies where there is a clear business need and with oversight from the Ratings Oversight Committee, so would need to move to an approach requiring stricter compliance. This would have overhead (i.e., hiring a compliance / internal audit lead) and output (i.e., lower throughput of ratings) impacts that are difficult to quantify at this stage.
We would primarily want to ensure the drafting of any regulation, and approach to supervision, is broad and understanding enough to capture the very different business models of the CCRAs and ESG Ratings Agencies. E.g., we’re not paid by the project developer, so developer engagement is a different (and much more complex) art to a company-pays model.
3. Are there any practical challenges arising from overlap between potential regulation for ESG ratings providers and existing regulation?
N/A. We are not aware of pre-existing regulation that applies to CCRAs.
4. Are there any other practical challenges to introducing such regulation?
We would be very interested to understand how the FCA would approach authorisation and supervision. We expect there would be a large reliance on reporting and internal audit, but the nature of the supervision will naturally influence the burden for CCRAs.
2 - Description of ESG ratings and their provision
5. Do you agree with the proposed description of an ESG rating?
We don’t have specific concerns with it, subject to the wider point here about giving certainty to the position of CCRAs.
6. Do you agree that ESG data, where no assessment is present, should be excluded from regulation?
Yes, in general we agree that ratings are much higher risk than data and that data without an assessment should be excluded.
It would be good to give clarity on services that sit between the two. For example, our Carbon Credit Analytics product uses our project ratings and applies them to portfolios of credits held by businesses, meaning a business’ portfolio or a sector’s portfolio can be given an average rating. This may appear to be a rating of the business or sector, but is arguably just a combination of different ratings of projects. Ensuring that CCRAs can continue to innovate in how their data is deployed without tripping regulation would be very welcomed, not least given the urgency of the net zero imperative.
7. Do you agree with the proposal to regulate the activity of providing ESG ratings to be used in relation to RAO specified investments?
We think that only regulating the activity of CCRAs as it relates to specified investments will create uncertainty that is bad for ratings / data users and CCRAs.
We fully understand why HMT has proposed this approach. However, the trading of carbon credits is much, much more nascent than the trading of debt, equity and other ESG-rated assets. Typical market activity is not yet established for the voluntary carbon markets, and we regularly hear of new carbon credit-related products or trading strategies being launched. For example, Foresight Sustainable Forestry Company PLC was the first Voluntary Carbon Market designated fund, a category that launched recently to distribute carbon credits as dividends. It is a UK domiciled investment trust trading on the LSE’s Main Market, Premium Segment. If our ratings / data were somehow applied to its securities, could they be deemed units in a collective investment scheme (Art 81, RAO) and therefore bring us into the perimeter on that use case only? Equally, if certain voluntary carbon credits are accepted for use in the UK or EU Emissions Trading Scheme and used by customers as part of such a scheme, would they be deemed greenhouse gas emissions allowances (Art 82B, RAO) and therefore our ratings regulated only insofar as they applied to those credits?
If CCRAs are only regulated so far as their activity relates to specified investments, they would either need to (a) contractually limit the use of their products by customers, or (b) seek regulatory approval to avoid this. The former would be a significant commercial impediment, at a time where there are already enough impediments in the form of carbon market uncertainty, whilst the latter would seem disproportionate and a regulator may not prioritise such applications given the potential perceived harm.
To ensure CCRAs can operate with certainty, we think there are a few options:
- Bring CCRAs clearly within the perimeter – e.g., by adding voluntary carbon credits to the list specified investments alongside compliance units, and the act of rating / assessing them to the specified activities. However, thought would need to be given to the unintended consequences of this, not least for those buying / selling voluntary carbon credits.
- Specifically exclude CCRAs from the perimeter, subject them to the FCA’s Voluntary Code of Conduct until market activity becomes more predictable, and then bring them within the perimeter subsequently.
- Provide the certainty that if a CCRA wants to be regulated, even if it’s not immediately clear that its products will be used in relation to specified investments today, the FCA will take them through the authorisation process with the same commitment as ESG Rating Agencies, so that CCRAs aren’t required to turn away commercial opportunities.
Whilst we firmly believe in the importance of regulating CCRAs, if (a) is too complicated and (c ) deemed not an appropriate use of oversight resources, then we would suggest (b) as the next best solution to providing short term certainty for CCRAs.
- (For ESG ratings providers) Do you know when an ESG rating you provide will be used in relation to a specified investment?
As above, we have limited visibility of how our ratings/data is or will be used, and often our customers don’t have medium term visibility when first agreeing to purchase our ratings/data.
- Are there ESG ratings used in relation to anything other than an RAO specified investment which also should be included in regulation?
3 - Exclusions
8. Do you agree that each of the eight scenarios listed above (in paragraphs 3.2, 3.3, and 3.5) should be excluded from regulation?
We understand the approach taken, but exempting all not-for-profits might lead to some perverse outcomes, given some are huge players in the climate space that might extend their roles in future years (e.g., SBTi, CDP, etc.). Equally, a deep-pocketed funder might set up a not-for-profit foundation to act as a CCRA (e.g., Microsoft deciding to set up a foundation to do this). However, not excluding not-for-profits may beg the question as to whether the IC-VCM should be subject to regulation, as they will be providing confirmations that certain projects are compliant with their Core Carbon Principles (i.e., a form of assessment). So, thought could be given to how to include prominent, deep-pocketed not-for-profits that could influence the market if not subject to the same oversight.
9. Are there any other exclusions which should be provided for?
4 - Territorial scope
10. Do you agree with the proposal to regulate the direct provision of ratings to users in the UK, regardless of the location of the provider?
Our primary concern with any jurisdictional approach to regulation is not disproportionately increasing the regulatory burden. Since IOSCO has done such an impressive job of distilling the core principles of regulation here, we would hope that IOSCO and the FCA can push hard for an internationally equivalent set of regulatory regimes here, provided they substantially follow the proposals of IOSCO.
The customers of CCRAs are highly global in their nature, meaning that allowing a regulatory landscape to develop where CCRAs require permission in each jurisdiction that they have a customer would create a disproportionate regulatory burden for CCRAs, whilst creating the risk of lower quality, less reliable players setting up to service the needs of customers in markets that leading CCRAs have determined against seeking authorisation in.
We would therefore strongly recommend that HMT advocates for internationally equivalent regimes from the outset.
11. For UK users of ESG ratings) Are you concerned that this proposal would hamper the choice of ESG ratings available to you?
12. Should any instances of direct provision of ESG ratings to users in the UK be excluded from regulation (for example, the provision of ESG ratings to UK branches of overseas firms, or to retail users who are temporarily physically located in the UK)?
13. Are there any scenarios of indirect provision of ESG ratings to UK users which should also be regulated?
The approach to this should be determined by the need to create a level regulatory playing field. If CCRAs provide data to UK users, but one is direct and one is via a Bloomberg terminal, it would be unfair for the activity of the former to be regulated if not the latter.
14. How would the territorial scope proposed in this chapter interact with initiatives related to ESG ratings in other jurisdictions, such as proposals for regulation or codes of conduct?
5 - Proportionality
15. Should smaller ESG ratings providers be subject to fewer or less burdensome requirements?
We think this is fair and reflects the approach of other regulated activities (e.g., EMI / PI licences).
16. (For ESG ratings providers) What impact would an authorisation requirement have on your business? Please provide information on the size of your business when answering this question.
We are above the small business threshold, but only on two limbs and not by much. We currently have a voluntary governance framework (here) that was inspired by IOSCO’s recommendations for credit ratings agencies and aligns with IOSCO’s recommendations for ESG Ratings Agencies, so it wouldn’t be a drastic leap to regulation on these lines. However, the main overhead change would be in enforcement. Currently, we permit deviation from our policies where there is a clear business need and with oversight from the Ratings Oversight Committee, so would need to move to an approach requiring stricter compliance. This would have overhead (i.e., hiring a compliance / internal audit lead) and output (i.e., lower throughput of ratings) impacts that are difficult to quantify at this stage.
17. Do you have any views on an opt-in mechanism for smaller providers?
More regulated CCRAs is a good thing for the market from our perspective, so we are supportive of providers being able to opt-in if under any relevant threshold.
18. What criteria should be used when evaluating the size of ESG ratings providers?
We think the small companies CA06 approach makes sense, however relying on just one (and not two) condition(s). This is because there are plausible scenarios where new CCRAs set up, keep low employee numbers due to a reliance on technology, raise a large amount of money (so crossing the balance sheet threshold) and start deploying it aggressively but take time to reach £10m revenue as they take a market-share-first approach to growth. Significant damage could be done by a CCRA taking this approach before they are subject to the same regulatory oversight as their competitors.
19. What level could the criteria for small ratings providers be set at (i.e., how could ‘small ratings provider’ be defined)?
Is there anything else you think HM Treasury should consider in potential legislation to regulate ESG rating providers? When proposing regulation to manage conflicts of interest, we would caution to not be too heavy-handed around advice to the rated entity. Consulting and rating is, of course, a dangerous mix, but in the voluntary carbon markets being able to provide feedback to project developers on their projects (likely without payment) is absolutely critical to improving climate outcomes. Whilst we don’t do this at the moment, latitude to do so (with proper governance in place) in the future would drive better climate outcomes.
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