Policymakers are turning their attention to the regulation of players in the wholesale capital markets. Calls for ESG data and rating providers to be regulated have increased, standards for bond issuers are being debated and developments in the carbon market are being monitored closely.

Asset owners (including insurance companies, pension funds and collective investment funds) and asset managers have been grappling for some time with new ESG-related regulation on disclosures and company processes, the detail of which continues to grow. And banks and insurers have been embedding ESG factors (especially climate change) into their risk management frameworks and stress tests. Now the spotlight is turning on players in the wholesale capital markets. Regulation will inevitably follow.

In addition to the three topics covered below, other areas are under review. For example, as well as increased reporting by listed companies, ESMA's annual work programme (PDF 589 KB) includes consideration of amendments that might be needed to the EU Securitisation Regulation, the UK Benchmarks Regulation is being revised (PDF 245 KB) to improve disclosures and refer to the Paris-aligned benchmarks, and an EU Social Bond Standard is expected.

Wholesale firms need to respond to the demands of regulators and customers. They need to integrate ESG considerations into their business strategies, processes and product offerings, improve transparency and be prepared for greater regulatory scrutiny.

Calls for regulation of ESG ratings and data

The variations observed in ESG1 ratings of issuers by different credit rating agencies (CRAs) are much greater than the usual spreads in ratings. This has led to concerns among both issuers and users about the methodologies used by CRAs and data providers. Calls for them to be regulated - to address the conflicts of interest in them both collecting and selling data, and to improve transparency about their methodologies - have increased. A new report (PDF 609 KB) from IOSCO2 has lent weight to these calls.

IOSCO notes that the role and influence of ESG ratings and data products providers in financial markets, and in the sustainable finance ecosystem more specifically, have grown significantly. However, it found little clarity and alignment on definitions, lack of transparency about methodologies used, uneven coverage, concerns about the management of conflicts of interest and a need for improved communication with rated companies.

The report, therefore, sets out a number of recommendations, starting with a proposal that regulators could consider focusing greater attention on the use and activities of ESG ratings and data products in their jurisdictions. Recommendations addressed to ESG ratings and data products providers suggest that they consider a number of factors related to issuing high-quality ratings and data products. This includes publicly-disclosed data sources, defined methodologies, management of conflicts of interest, high levels of transparency and handling confidential information. IOSCO also suggests that users of ESG ratings and data products could consider conducting due diligence on the providers they use within their internal processes. The last set of recommendations focuses on improved information-gathering processes, disclosures and communication between providers and entities subject to assessment.

In the EU, as part of its direct supervision of CRAs, ESMA will assess the way they incorporate ESG factors into their methodologies for credit ratings and outlooks, how they ensure the robustness of their methodologies and their disclosure of ESG factors in credit ratings.

In the UK, the FCA has also noted similar emerging issues and potential harm from the increasingly prominent role of ESG ratings and data. The provision of ESG ratings and data is currently an unregulated activity in the UK, but the FCA is engaging (PDF 1.30 MB) with HM Treasury on potential regulation of this area.

The challenges that regulators have identified in this area are similar to those that were found in the credit rating and benchmarks sectors. So, potential international principles and regulation could be modelled on the IOSCO Principles for Financial Benchmarks (PDF 388 KB) and EU Benchmarks and Credit Rating Agency Regulations.

An EU Green Bond Standard (GBS)

The EU GBS Regulation proposed by the Commission, which is now being debated by the European Parliament and the Council, aims to address concerns about “greenwashing” and protect market integrity, to ensure that legitimate environmental projects are financed. It will be a voluntary standard available to all issuers, both private and sovereign, and to non-EU as well as EU issuers.

The four key requirements under the proposed framework are:

  1. Funds raised by the bond must be allocated fully to projects aligned with the EU Taxonomy.
  2. Full transparency on how bond proceeds are allocated, through detailed reporting requirements.
  3. Checking by an external reviewer to ensure compliance with the Regulation and that funded projects are aligned with the EU Taxonomy (with specific, limited flexibility for sovereign issuers).
  4. External reviewers must be registered with and supervised by ESMA, to ensure the quality and reliability of their services and reviews (again, with specific, limited flexibility for sovereign issuers).

For those issuers that choose to (or for which market forces necessitate that they) follow the GBS, the mandatory requirement for external review is a new feature for ESG regulation in the financial markets. It may be a sign of things to come in the expected Social Bond Standard and EU Eco-label for retail investment products. If any such reviewers are part of groups that also provide ESG ratings or data, the question of management of conflicts of interest will likely be at the forefront of regulators' minds.

ESMA monitors the EU carbon market 

ESMA has published a preliminary report (PDF 1 MB) on the EU carbon market, in response to a request by the European Commission for an analysis of European emission allowances (EUAs) and derivatives on EUAs. The report notes that:

  • The number of counterparties holding a position on EUA futures has tended to increase since 2018 in all categories of counterparties, in line with the observed expansion of the EU Emissions Trading System market.
  • Open positions are to a large extent, and almost evenly, held by investment firms and credit institutions on the one hand and by non-financial counterparties on the other hand. The remaining percentage of open positions, held by investment funds and other financial counterparties, remains relatively low.
  • The breakdown of open positions between the various categories of counterparties does not appear to have significantly changed since 2018. It is broadly in line with the expected functioning of the market, where non-financial entities buy EUA futures to hedge their carbon price exposure, while financial counterparties act as intermediaries to facilitate trading and provide liquidity to the market.

The report also provides an overview of the regulatory environment for the EU carbon market under financial regulations such as MiFID II/MiFIR, MAR3  and EMIR4, which covers over-the-counter derivatives. Since 2018, EUAs have been classified as financial instruments and have been subject to a series of requirements aimed at ensuring the transparency and the integrity of the market. In particular, entities trading in EUAs and their derivatives must provide data to their national regulators.

ESMA will deliver its final report to the Commission in early 2022. The Commission will then assess whether there is a need for targeted actions in the EU carbon market. Meanwhile, the financial services industry is calling for scaling up of the carbon markets and emission trading schemes, and inter-operability between different types of markets and jurisdictions.

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1 Environmental, social, governance

2 International Organization of Securities Commissions

EU Market Abuse Regulation

4 European Market Infrastructure Regulation