While the European Union has been leading on ESG initiatives – EU Taxonomy, Pillar 3, and Sustainable Finance Disclosure Regulation (SFDR) – the impact of climate change does not recognize borders, and so climate-risk assessment is becoming increasingly vital around the world. Enter Hong Kong, leading on the other side of the planet with its Prototype of a Green Classification Framework, a taxonomy that applies to all regulated banks under the Hong Kong Monetary Authority (HKMA).
The financial sector plays a particularly vital role in the transition to a low-carbon future. It can steer capital flows towards environmentally sustainable investments and away from high-emitting activities, thereby fostering green innovation and development. A green taxonomy is essential within each financial market as it defines a common language and criteria for assessing the environmental sustainability of financial products and investments. As with the EU Taxonomy and other similar initiatives, this framework enables investors to identify and invest in activities that contribute to environmental objectives while avoiding those that harm them.
To further demonstrate the interconnectedness of the global financial markets and the planet’s fate, Mainland China and the European Union have established the Common Ground Taxonomy (CGT) initiative under the International Platform on Sustainable Finance (IPSF). Any synergies – whether premeditated or accidental – across the avalanche of taxonomies swirling around the financial industry, would be a welcome respite for banks of all sizes and resources.
What is the regulatory framework and current context for Hong Kong’s ESG Taxonomy?
The Hong Kong Special Administrative Region (HKSAR) is committed to supporting global efforts to combat climate change and achieve the targets of the Paris Agreement. In 2021 it launched the Hong Kong’s Climate Action Plan 2050, which outlined four key strategies to decarbonize the economy and reach carbon neutrality by that time:
- Net-zero electricity generation
- Energy saving and green buildings
- Green transport
- Waste reduction
Today, the HKMA has requested feedback on the Prototype of a Green Classification Framework for Hong Kong by June 30, 2023. The prototype presents the structure and core elements of the proposed taxonomy framework that will form the backbone of Hong Kong’s ESG regulations.
The Regulatory Framework: Key ESG Reference Taxonomies
The prototype has synergies with some global initiatives:
- Mainland China and the European Union’s Common Ground Taxonomy initiative.
- EU Taxonomy, widely accepted as the foundation for the national taxonomical systems, comprises advanced technical-screening criteria, activity thresholds, and supplementary documents related to the issuance of financial instruments, disclosures, sectoral operational principles, etc.
- ASEAN Taxonomy, still a work in progress, includes the first batch of criteria published in March 2023. This multilayer “traffic-light” system allows ASEAN states to choose different decarbonization criteria baselines depending on their economic capabilities.
- Climate Bonds Taxonomy (CBT) is the oldest and one of the most developed taxonomies used as a reference for the prototype. At the heart of the CBT lies a suite of sector-specific eligibility criteria that set climate-change benchmarks for screening assets and capital projects.
Core to these taxonomies are principles around the alignment with the Paris Agreement, proof that there is no greenwashing, interoperability with other taxonomies, science-based criteria and thresholds, and the foundational “do no significant harm” (DNSH), and social safeguards.
A green taxonomy also helps to align investment decisions with climate goals and reduce the risk of stranded assets, supporting Hong Kong’s role as a bridge between the Mainland and the rest of the world, and reinforcing its position as an international green-finance hub.
Hong Kong would gain unique benefits from a green taxonomy including:
- It would be the first market to operationalize CGT and by so doing strengthen its position as a hub, positively contributing to the growing need for interoperability among standards within the green-finance space. An operationalized CGT also provides international issuers and investors with a tool for reporting and communicating sustainability impacts and meeting the global regulatory and investor requirements.
- A credible and scientifically robust taxonomy helps Hong Kong capitalize on opportunities presented by the Mainland to develop into a green finance center in the Guangdong-Hong Kong-Macao Greater Bay Area.
- A locally tailored green taxonomy supports Hong Kong’s goals for carbon neutrality by 2050.
What are some of the functional and technical challenges created by Hong Kong’s green framework?
Introduction of this taxonomy impacts functional, technical, and architectural areas in a financial institution; and not just because there are so many of them (ASEAN, EU, etc.). Functionally, the Climate Bonds Initiative covers regulatory classifications financial institutions will have to consider a global taxonomy architecture with local regulations embedded.
Climate Bonds Initiative Layering and Decision Tree Components
The Hong Kong Taxonomy proposes three layers of green definitions with varying degrees of preciseness depending on the complexity of the activities and applicability for Hong Kong.
The paper also mentions that the thought process was based on the decision tree below:
Technical challenges include:
- Data sourcing strategy/data collection
- Operating-model alignment
- Taxonomy design based on global regulations
- Need for a strategic data management and stress testing framework
What other initiatives are happening across Asia Pacific?
In addition to this discussion, HKMA is also preparing for the second round of Climate Risk Stress Testing.
Other Asia Pacific regulators are actively putting out updates including the following:
- Monetary Authority of Singapore: MAS Net Zero Action Plan.
- Bank Negara Malaysia issued a new policy document and supplemental guidance setting out new requirements for financial institutions on managing climate risk and conducting scenario analysis.
- Australian Sustainable Finance Taxonomy project led by ASFI. Phase 2 begins in July 2023.
- Mainland China regulators, according to Bloomberg, are working with advisory bodies and rating agencies to formulate a framework for mandatory ESG-related disclosures for companies listed in China.
- Thailand: Joint Press Release TBA launches ESG Declaration, a strong collective commitment to expediting sustainable development toward better and greener economy.
What’s next for banks in the region?
- Data collection and credibility top the list of ESG regulatory reporting challenges. Data required for calculations and reporting, such as ESG-risk ratings and greenhouse gas (GHG) emissions, is broadly unavailable, uncollected, and/or not measured by state or market-data institutions. This is a worldwide challenge as the demand for ESG data sources is relatively new.
- Technology and tools for measuring and evaluating risk factors are another key challenge for Brazilian banks. The requirement to report in a machine-readable format adds an extra layer of complexity to be addressed. Therefore, institutions need a system that easily links the infrastructure used to evaluate exposures and generates the final reports as an XML file.
- Risk reporting and reconciliation: To further demonstrate the interconnectedness of global financial markets, there is a growing recognition and trend towards aligning ESG and other risk reporting (e.g., DLO). A lot of source data aligns. Effectively reconciling the current set of risk reports with DRSAC would enable banks to have a more complete view of their underlying exposures.
- Climate-risk models: In addition to a lack of ESG data, the DRSAC does not provide a standard method or taxonomy for the assessment and definition of ESG risk ratings; it is up to financial institutions to define their own models. Therefore, banks must decide how to model their ESG risks, as well as estimate or create proxies for GHG calculations.
Given that the starting point for financial institutions in Hong Kong will be ESG taxonomy elements, data points and rules of global regulations, Adenza’s data-driven solutions are very well placed to help financial institutions in HK.