Hong Kong continues to drive standards in relation to the integration of environment, social and governance (ESG) factors into financial services, market integrity and consumer protection goals. Hong Kong regulators have long recognised the pivotal interaction between financial markets and climate change. They also have a keen eye on where things can go wrong.
In this alert we look at what is driving sustainable investment, summarise the current ESG framework in Hong Kong and the risks rapidly appearing on the horizon for those companies that fail to take ESG properly into account. In particular, we examine the regulatory requirements that apply. We also consider risks arising from:
1. What is driving sustainable investment?
Before examining Hong Kong’s regulatory framework, it is important to remember the “why?”. There are many benefits of incorporating ESG into business models and investment decisions, these are summarised below.
Brand awareness
To attract new customers and retain existing supporters, businesses must not only address customer needs but customer values. This means aligning with customers’ ESG priorities.
Reduced risk
Risk managers must identify and mitigate ESG exposures. If they do not, regulatory risk can arise from breach of requirements and reputational risk can arise where the business is found to have invested in, or been in a supply chain with, a company that harms the environment, is involved in human rights abuses or fails to prevent overseas corruption, by way of examples.
Lower capital costs
Studies have found that companies with high ESG scores experienced lower costs of capital, lower equity costs, and lower debt costs compared to companies with poor ESG scores. Experts at McKinsey have concluded better ESG scores translate to about a 10% lower cost of capital. This correlates to lower regulatory, environmental, and litigation risks associated with high ESG-scoring companies.
Broader investor base
The higher reporting standards and wide class of products and the higher ethical standards will attract a broader base of investors looking to invest in products that are reliable, ethical and transparent. ESG also could further develop investor loyalty.
Broader range of financial products
ESG spans multiple asset classes. There are “green bonds” and “social bonds,” ESG money market funds, “green” mortgage-backed securities, “green loans” and “sustainability-linked” loans.
Competitive advantage
Companies that understand the need of adapting to changing environmental and socioeconomic conditions are better positioned to spot strategic opportunities and meet competitive challenges.
2. Hong Kong’s ESG regulatory framework
Hong Kong’s regulators are particularly focused on the “E” in ESG at this stage, as is common among the vast majority of leading markets. A large part of this stems from the dual drivers of systemic risks identified by multiple transnational bodies in connection with the climate crisis, plus strong levels of corporate and consumer interest in the “greening” of the global economy.
2.1 Cross-agency steering group
Hong Kong has established a Green and Sustainable Finance Cross-Agency Steering Group (“ESG Steering Group”). This is a multi-regulator steering group co-lead by the Hong Kong Monetary Authority (“HKMA”) and the Securities and Futures Commission (“SFC”).
The ESG Steering Group aims to position Hong Kong as a leader in green and sustainable finance and help the financial ecosystem transition towards carbon neutrality. The ESG Steering Group has developed the Centre for Green and Sustainable Finance, working groups under which have issued recommendations regarding capacity building and green and sustainable finance data, as summarised below.
| Capacity building | Data |
|---|---|
|
|
The ESG Steering Group is also exploring the development of a green classification framework for adoption in the local market which facilitates alignment with the Common Ground Taxonomy (i.e. areas of commonality between the ESG taxonomies of Mainland China’s and the European Union). This work will be guided by the principles of interoperability, comparability and inclusiveness.
The ESG Steering Group has announced the ambition to have mandatory climate-related disclosures aligned with the Task Force on Climate-related Financial Disclosures (“TCFD”) framework by 2025 across all relevant sectors.
In addition, an assessment of carbon market opportunities for Hong Kong has been conducted and the following next steps have been announced to develop Hong Kong’s carbon market opportunities:
Developing Hong Kong’s carbon market opportunities
For an in-depth dive into carbon markets see our previous alerts: Carbon trading - practical insights; Understanding Carbon Markets in China and ESG - Voluntary Carbon Markets.
2.2 HKMA
“Climate change is a source of financial risk impacting the entire financial sector.” - HKMA Chief Executive, May 2020
The HKMA introduced a new module to its Supervisory Policy Manual in December 2021 (“GS-1”) to provide guidance on the HKMA’s expectations for banks to develop risk management frameworks in relation to climate risk. The requirements are summarised below.
Banks are required to implement the requirements by 30 December 2022.
The expecations in GS-1 are in some respects detailed, setting out expectations for scenario analysis and stress testing. Guidance on this can also be drawn from HKMA consultations and publications on this area over the last few years. The disclosures requirements are also relatively detailed with banks expected to make their first disclosures by 2023, drafted to align with TCFD recommendations. However, in other areas the requirements are also very principle based with little around the “how” the banks are expected to achieve the HKMA’s expectations. This is where risk starts to appear, with somewhat vague and new requirements, banks may struggle to properly implement what the HKMA will deem to be an adequate approach to risk management. See further, Part 2 – ESG enforcement and litigation risks and trends.
2.3 SFC
“Hong Kong’s capital markets are especially important, because of its business with Mainland China which has a critical role to play in reducing carbon dioxide emissions.”- SFC Chief Executive, Dec 2021
The SFC does not yet impose general obligations on Licensed Corporations or Registered Institutions in the same way that the HKMA has introduced through GS-1. The SFC has however introduced obligations on fund managers of collective investment schemes requiring them to take climate related risks into consideration in their investment and risk management processes and make appropriate disclosures. The requirements are implemented through amendment to the Fund Manager Code of Conduct and they are to come into effect on a staggered basis:
| Baseline requirements | Enhanced requirements | |
|---|---|---|
| Large Fund Managers [1] | 20 August 2022 | 20 November 2022 |
| Other Fund Managers | 20 November 2022 | Do not apply |
The requirements are only about climate related risks, not wider ESG considerations. Whether the requirements apply is determined by whether the fund manager has discretion over the investment management process and whether climate related risks are relevant and material to the fund. Where this is the case, the requirements cover four key elements:
Governance
Fund managers must involve the board and management and clearly assign roles for climate risk management. Policies and procedures will need to be reviewed and updated.
Investment management
Fund managers need to decide how they are going to recognise and measure climate related risks, there is flexibility on how this is achieved but it should include examining physical and transition risks. This requires examining how climate related risks impact each investment and then aggregating the impact of all investments to determine the overall level of relevance and materiality. Climate related risks will not be relevant to certain funds, as recognised by the SFC. Namely, quantitative, macro strategy, index tracking, forex and managed futures funds will not be in scope.
Risk management
Risk management processes need to incorporate steps to ensure that climate-related risks can be identified, assessed, monitored and managed on an ongoing basis. Risk can be managed through reallocation of assets, exercising stewardship and proxy voting. If this cannot be done, for example because of a passive strategy, then the SFC encourages engagement.
Disclosures
Can be through the website, newsletters or reports to investors so long as they are in writing and drawn to the attention of investors.
In addition, there are also enhanced disclosure obligations imposed on SFC-authorised funds which incorporate ESG factors as a key investment focus (“ESG Funds”). In summary:
| Disclosure | Requirement |
|---|---|
| ESG focus | A description of the ESG focus through a clear description of the aim and a list of ESG criteria (e.g. filters, third party ratings) used to measure the attainment of the ESG focus. |
| ESG investment strategy | A description of the investment strategy adopted by the ESG fund, the binding elements and significance of that strategy in the investment process, and how the strategy is implemented in the investment process on a continuous basis. A summary of the process of consideration of ESG criteria which may include methodologies in measuring ESG criteria and sequencing those criteria in order of importance. A description of whether an exclusion policy is adopted and the types of exclusion. |
| Asset allocation | The expected or minimum proportion of securities that are commensurate with the fund’s ESG focus. |
| Reference benchmark | Where a fund is tracking an ESG benchmark (e.g. an index fund) for the purpose of attaining the ESG focus, details of the benchmark and an explanation of how the designated reference benchmark is relevant to the fund. |
| Additional information | An indication of where investors can find additional information about the ESG Fund. |
| Risks | A description of the risks or limitations associated with the ESG focus must be disclosed. |
In addition to the above, the SFC requires ESG fund managers to disclose on their website:
- How the ESG focus and performance is measured and monitored throughout the lifecycle of the ESG Fund.
- ESG due diligence procedures in respect of the fund’s underlying assets.
- The engagement approach, including proxy voting.
- The ESG data sources and processing or relevant assumptions where data is not available.
An ESG Fund should conduct a periodic assessment, at least annually, to assess how the fund has attained its ESG focus. The assessment results must be disclosed at least annually.
Fund managers must regularly monitor and evaluate underlying investments to ensure the ESG focus continues to be met. If ESG is no longer the focus of a fund, investors and the SFC must be informed as soon as reasonably practicable.
The obligations are further detailed in our alert SFC Guidance on Enhanced Disclosures for ESG Funds.
In addition to the above, the SFC requires fund managers of collective investment funds to ensure that advertisements must not be false, biased, misleading or deceptive. As such, fund managers must ensure they do not falsely advertise a funds’ ESG credentials.
Even for those fund managers not currently required to incorporate ESG factors, there are compelling reasons to do so. Namely, ESG funds outperform:
- In the first half of 2021, ESG-linked funds outperformed the S&P 500.
- The data shows that from 31 December 2020 to 17 May 2021, 16 of 27 of ESG exchange-traded funds and mutual funds performed better than the S&P 500.
- Those outperformers rose between 11% and 29.3% over this period, in comparison the S&P500 increased 10.8%.[2]
2.4 HKEX
Since 1 July 2020, mandatory ESG reporting obligations that apply to listed companies have incorporated the TCFD Recommendations. Listed companies are required to make disclosures in annual ESG reports, which can be part of their annual report or separate.
The Main Board Listing Rules include an ESG Reporting Guide. In preparing the ESG report, issuers should conform to the four reporting principles of:
- Materiality: The ESG report should include matters of sufficient importance to investors.
- Quantitative: Key performance indicators should be measurable.
- Balance: The report must be unbiased.
- Consistency: Consistent methodologies should be used to allow meaningful comparisons of data over time.
It is mandatory for an ESG report to include a statement from the Board containing:
There are then “comply or explain” provisions under the ESG Reporting Guide, meaning each listed company must make a disclosure or explain why one has not been made on each specified area. The purpose of the “comply or explain” approach adopted by the HKEX is to allow companies to only report on matters relevant to their business and operations whilst ensuring each key aspect is considered in preparing the ESG report. Areas to be covered, where relevant, are:
3. Risks of regulatory enforcement and litigation
3.1 Greenwashing and misselling
At its heart, “greenwashing” is misselling – that is, the provision of false or misleading information, or omitting material facts, that ultimately induce transactions in financial products such as shares, funds or derivatives.
Greenwashing is a significant risk for financial institutions and corporates alike. As investors and customers look for and support “green”, “sustainable” or broader “ESG” products, the risk of being accussed of greenwashing by regulators, investors or customers is significant.
There will be an increased level of scrutiny into whether processes and practices match disclosures and are in line with published ESG strategies. Where this is not the case, regulatory fines and litigation could arise. The risk could arise even where the overstating of a fund’s or product’s “greeness” or sustainability is not deliberate but has arisen because the ESG strategy is not fully implemented.
Companies may also find themselves facing action for false advertising from other sources.
The UK’s Advertising Standards Agency (“ASA”) earlier this year banned a drinks company from continuing to air an advertisement that contained animal characters singing about recycling and fixing the planet due to the fact the bottles were made of single-use plastic and because of the parent company’s significant plastic pollution contribution globally.
Similarly, the ASA banned an airline from advertising themselves to be the “Europe’s…lowest emissions airline” because it simply wasn’t true.
A UK bank is also facing greenwashing accusations from ASA. This is due to it being found to have promoted its green initiatives whilst excluding information about its financing of firms with substantial emissions. This demonstrates that greenwashing can arise from omissions as well as statements made.
Case studies have also arisen in other markets. See for example the cases in Australia covered in our alerts: "Fake Movers", "Greenwashing" on United Nations Radar: How to Respond and Greenwashing Hits Court Room.
3.2 Regulatory enforcement action and stress testing
There is risk of regulatory enforcement action by the HKMA if banks fail to implement the new GS-1 requirements by the end of 2022. Whilst the requirements are new, and in places hard to interpret and implement, this will not be considered a defence, or even a mitigating factor, if banks are found to not be complying. For example, the HKMA recently published disciplinary actions taken against four banks for AML/CTF failings that occurred immediately after the legislation imposing the requirements came into place in 2012.
In December 2021 the HKMA published the results of a “climate related stress test” it had conducted with 27 banks in Hong Kong. It concluded that vulnerabilities and gaps had been identified which the participating banks had developed plans to plug. If the HKMA later reviews measures put in place by any of these 27 banks and finds that they have not in fact plugged the identified gaps, enforcement action is even more likely. Repeated breaches are always looked upon more strictly by regulators.
3.3 Corporate accountability
Listed companies that fail to comply with Hong Kong listing rules on ESG reporting could be subject to disciplinary action from the HKEX, again particularly if there are repeated breaches of the listing rules. This could arise from failing to report on ESG or inaccurate or incomplete reporting.
For listed companies, there is also the very real risk of shareholder activism.
The ExxonMobil case in 2021 is a good example of how this risk can manifest. An activist investor, a small hedge fund called Engine No.1, took on ExxonMobil and won. Engine No.1 thought ExxonMobil’s climate efforts were slow and insufficient. It pushed to install three directors on the board with the goal of pushing the energy giant to reduce its carbon footprint. It was successful in doing so because it secured the support of some of ExxonMobil’s biggest institutional investors: Blackrock, Vanguard and State Street who also believed Exxon needed to do more. This shows the power of shareholder activism.
Climate change litigation is a key tool for climate activists. This is expected to continue and grow with NGOs likely being spurred on by the success in the case against Shell in 2021.
A Dutch court found that Shell’s decarbonisation plan was insufficient and ordered it to reduce its global carbon emissions (from its group company, suppliers and customers) by 45% by 2030 compared to its 2019 levels. The case was brought by Friends of the Earth (Milieudefensie) and over 17,000 citizens. Whilst Shell has filed an appeal, the case will no doubt inspire other NGOs to take action against corporates with large carbon footprints. It is the first time a corporate has been ordered to reduce its emissions by a set metric.
In addition to activist pressure, litigation between corporates is possible. For example, litigation against a competitor accused of greenwashing may be possible where false or misleading statements are made leading to an unfair competitive advantage. Such cases have already been seen in Europe.
Failing to conduct due diligence
Failing to conduct due diligence on supply chains also poses significant risks of litigation. For example, Ikea has advertised its sustainability credentials. Yet, in 2020 it was alleged by Earthright to be using illegally sourced wood from forests in Ukraine that are home to endangered species includes bears and wolves. This did not appear to be deliberate, but when these things happen products have to be pulled and significant financial cost and reputational damage can flow.
Failure by IPO sponsors to conduct ESG due diligence could also lead to significant fines from the SFC. It is important to remember the “S” and the “G” in ESG cover a broad range of topics. For example, anti-bribery, human rights and working conditions all come under the ESG umbrella. Failing to identify significant non-compliance with corruption laws or labour laws could well amount to a sponsor failure. For example, in 2019 the SFC reprimanded and fined UBS AG and UBS Securities Hong Kong Limited (UBS Securities Hong Kong) (collectively, UBS) a sum of HKD375 million for failing to discharge their obligations as one of the joint sponsors of three listing applications. This was on the basis of five key failings, including failing to verify compliance with laws and regulations.
Finally, parent companies may find themselves liable for damage by subsidiaries. For example, a number of recent cases in the UK have confirmed that parent companies can be liable to overseas operations of their non-UK subsidiaries.
In the Okpabi case claims were brought by more than 40,000 citizens of areas in the Niger Delta in the English courts against Royal Dutch Shell and its Nigerian subsidiaries, claiming that oil spills and pollution by the Nigerian subsidiary had caused substantial environmental damage leading to loss of livelihood and natural water sources.
The Supreme Court held that it was at least an arguable case to allow this to proceed in the English courts on the basis that the parent company owed a duty of care to the claimants.
This followed a similar ruling in the Vedanta case where 1,826 Zambian people have been permitted to bring claims in the English courts against the parent company of a Zambian subsidiary for pollution from a copper mine.
This case law is likely to be persuasive in Hong Kong courts.
4. Key takeaways
ESG concerns are now mainstream and a core focus for regulators, investors and consumers in Hong Kong and globally. New regulations have been imposed on banks and the SFC is requiring fund managers to implement ESG disclosure and strategy procedures. The HKEX has also imposed disclosure obligations on listed companies that must be complied with. Failing to implement proper ESG policies and procedures carries significant risks of regulatory enforcement or litigation action for compliance failings, greenwashing, misleading advertising or failed due diligence. This is in addition to reputational damage and loss of business.
All businesses, across all sectors and whether regulated or not must ensure they have properly implemented policies and procedures that allow them to:
*Any reference to "Hong Kong" or "Hong Kong SAR" shall be construed as a reference to "Hong Kong Special Administrative Region of the People's Republic of China".
[1] Assets under management of $8 billion or more
