Green Finance and Sustainability Study Guide PDF

CCCCCCCCCCCCCCCCCCCC GREEN FINANCE AND SUSTAINABILITY Published by: © The Hong Kong Institute of Bankers 3/F Guangdong Investment Tower, 148 Connaught Road Central, Hong Kong Telephone: (852) 2153-7800 Email: [email protected] Website: http://www.hkib.org All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, e.g. electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Disclaimer: This material is for educational purpose only and does not form any legal and/or expert opinion or advice in whatsoever form by The Hong Kong Institute of Bankers (“HKIB”) and/or its consultants and shall not be so relied upon. While every effort has been made to ensure its accuracy, the HKIB and/or its consultants give no warranties and/or representations in relation to any materials in and/or content of this study guide. 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Copyright © 2022 The Hong Kong Institute of Bankers Last updated: 6 July 2024 List of Chapter Chapter 1: Overview of Green Finance and ESG Chapter 2: Green Finance Instruments Chapter 3: ESG Investing Considerations Chapter 4: Green Finance Certification and ESG Rating Copyright © 2022 The Hong Kong Institute of Bankers Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Chapter 1 Overview of Green Finance and ESG Learning Outcomes Upon completion of this chapter, learners will be able to: Describe the ESG and ESG strategies Discuss the ESG equity and debt investment Discuss the relationship among ESG, green finance and sustainability List the influence and impact of climate risk on the banking industry Identify the ESG regulatory development Identify the guidance to issuers in relation to the climate transition finance Discuss the green loan principles, green bond principles, social bond principles and sustainability bonds guidelines Identify the green regulatory development Discuss the emergence of blue finance Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 1 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG List of Topics 1. Introduction to ESG 1.1 What is ESG 1.2 ESG Strategies 1.3 ESG Equity and Debt Investment 1.4 Relationship among ESG, Green Finance, and Sustainability 1.5 Influence and Impact of Climate Risk on the Banking Industry 1.6 ESG Regulatory Development 2. Climate Transition Finance 2.1 Company’s Climate Transition Strategy 2.2 Company’s Business Model Environmental Materiality 2.3 Company’s Climate Transition Strategy to be Science-based including Targets and Pathways 2.4 Company’s Implementation Transparency 3. Introduction to Green Loans and Green Bonds 3.1 Green Loan Principles 3.2 Green Bond Principles 3.3 Social Bond Principles 3.4 Sustainability Bonds Guidelines 3.5 Green Regulatory Development 3.6 Emergence of Blue Finance 4. Chapter Summary 5. References Summary 6. Review Questions 7. Further Reading Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 2 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG 1. Introduction to ESG 1.1 What is ESG In recent years, the term “ESG” has generally become synonymous with socially responsible investment. However, ESG should be seen as more of a risk management framework for evaluating companies and not as a stand-alone investment strategy. ESG measures the sustainability and societal impact of an investment on a company. These criteria help better determine the future financial performance of companies. Likewise, impact investing is more about the type of investments a manager is targeting, while ESG factors are part of an assessment process to apply non-financial factors to a manager’s analysis in identifying material risks and growth opportunities. Also, impact investing seeks to achieve a measurable, positive, environmental, or social synergy with the investments that a fund manager purchases, whereas ESG is a “means to an end,” serving to identify non-financial risks that may have a material impact on an asset’s value. Moreover, ESG is often incorrectly commingled with terms such as corporate sustainability and corporate social responsibility (CSR). While some overlap exists, these terms aren’t interchangeable. Corporate sustainability is an umbrella term used to describe the long-term creation of stakeholder value by encompassing opportunities and managing risks resulting from economic, environmental, and social developments. To many companies, corporate sustainability is about “doing good” and doesn’t require any set conditions. CSR is an embedded management concept where companies incorporate the concerns of key stakeholders into their operations and activities. In comparison, ESG assesses a company’s ESG practices, together with more traditional financial measures. Finally, ESG is also commonly intermingled with ethical investing. However, taking an ESG approach is effectively a precursor to the point of investing. It provides a framework that allows investors to consider ‘E,’ ‘S,’ and ‘G’ issues facing a company and to score them either individually or collectively to identify where they sit relative to each other. This leads investors to consider stocks that may be “best-in-class” from an ESG score perspective or exclude them entirely because, for example, their environmental score doesn’t reflect their values. Ethical investing involves selecting investments based on ethical or moral principles. Such investors Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 3 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG typically avoid “sin stocks,” such as those related to gambling, alcohol, or firearms, which can be implemented via an ESG exclusions strategy (where sin stocks are explicitly excluded from a portfolio). People are used to gauging financial ratios when investing in stocks, from the relative price- to-earnings (P/E) ratio to EBITDA margins. All of those ratios are still relevant, but now investors can view the same stocks through an additional lens. The sustainability evaluation of ratings firms is normally blended into a single ESG score, similar to the stock recommendations offered by investment banks and brokers. Like mainstream research analysts who calculate different recommendation valuations for the same companies by using largely the same information, ESG analysts also differ on their recommended scores. Unlike common financial ratios, there isn’t a common set of ratios that neatly define how a good ‘E,’ ‘S,’ or ‘G’ score looks like. And whether investors should aggregate the three scores together or investors should consider each one individually depends on their determination as to what issues they believe are most relevant from an ESG perspective. Indeed, some of the factors may be more material to some stocks than others. For example, the environmental risks associated with a bank will be less material than those facing a mining company, while such risks may be counterbalanced by other concerns over governance with a bank. Also, to what degree should investors be concerned, and what data or methodology will investors use to gauge that concern? ESG analysis brings an entirely new set of indicators that market participants need to consider, which can result in a complex analysis that isn’t reasonable for a layperson to undertake. 1.2 ESG Strategies ESG investment tends to conform to at least six distinct forms, depending on the comprehensiveness through which the asset manager seeks to utilise the ESG framework. Different bodies provide a categorisation of the sustainable investment strategies. On one hand, simplification is done through excluding certain firms categorically (e.g. moral considerations). On the other hand, full ESG integration is integral to the culture of investing, such that it becomes an essential part of the investment processes, governance and decisions. The approaches are not mutually exclusive and portfolios could simultaneously apply more than one approach at a time. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 4 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG The first form is “exclusion” or “avoidance” which signifies the exclusion of corporates and governments whose behaviours do not align with basic societal values. Causes for exclusion include, but are not limited to: manufacturing controversial weapons; activities that are not aligned with ethical standards, such as tobacco, alcohol and casinos; violation of global compact principles; companies with more than a certain percentage of revenues from coal extraction or activities with a negative impact on societal values. A second category is “norms-based” or “inclusionary screening” which pursues the inclusion or higher representation of issuers that are compliant with international norms, such as those by the OECD and UN. This can include “best in class” investing whereby firms achieving above certain ESG score thresholds are included. The third form, which in many cases is a step following inclusion, is the realignment of the remaining assets against ESG scores, with more tilt of portfolio exposures toward issuers with higher ESG and away from lower ESG scores. Funds can choose to align with an ESG-tilted index for passive investing, or engage in active investment through a selected approach relative to an index, or tilt more heavily towards where the portfolio manager believes to be creating additional value. This is particularly the case where the asset manager uses a proprietary ESG research approach and engages in additional quantitative and qualitative assessment that offers either different perspectives on the current ESG ranking of firms, or some insights into the momentum. The fourth form is the pursuit of ESG thematic focuses within at least one of the environmental, social or governance areas. Thematic strategies can be mostly financially-driven or values- driven These types of funds may or may not exclude or rebalance portfolios based only on ESG scores, but rather may focus on particular pillar scores and underlying metrics, such as with the E score and carbon footprint or intensity. Such thematic funds may be aligned with certain social standards. It is in this form that the financial and social investing objectives can be blurred, as the theme often serves a purpose that is distinct from maximising long-term financial value. Furthermore, funds could employ an impact focus. This category lends itself to ambiguity because impact investors often pursue social impact. While ESG impact investors may appear to be similar to the social impact investing, the key difference is that ESG impact funds should Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 5 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG seek to achieve outcomes for the benefit of financial returns, in the process of improving ESG practices. Improving financial performance of issuers could occur partially through active engagement by ESG impact investors that contribute to improvements in governance or climate risk management practices, or divesting from ethically undesirable subsidiaries, which in turn can improve market valuations and financial performance. In this regard, ESG investing could include investing in lower scoring ESG companies that show some propensity to transition to higher ESG, and/or where the fund engages in some form of shareholder activism through share voting or bilateral communications to change company behaviour and practices. This approach can be generalised across ESG, or could be thematic in focus, where fund managers may have expertise in one area of ESG, such as green finance or good governance. For example, ESG impact investing could seek to maximise financial returns through green finance bonds. Lastly, ESG integration, which refers to systematic and explicit inclusion of ESG risks and opportunities in all key aspects of an institutional investors’ investment process. Unlike the best-in-class method, ESG integration does not necessarily require peer group benchmarking or overweighting (underweighting) the leaders (laggards) because ESG factors are assessed during the asset selection, portfolio balancing and risk management processes. Signs of ESG integration often include dedicated governance to oversee ESG integration; substantial resources given to the assessment of ESG considerations within the portfolio management teams; explicit exclusion policies to avoid certain companies with very low scores and engagement policies to improve impact for those with relatively low scores but opportunities for improvement; and quantitative research and tools to assess performance. 1.3 ESG Equity and Debt Investment Equity investing has been given a powerful boost through the increasing effectiveness of ESG scoring for both screening and integration approaches, Ultimately, ESG scoring provides material information on risk and opportunity required for long-term investment decisions – something that is particularly importantly for active investment managers. Delivering specific, intentional and positive societal outcomes, above what would have been ordinarily taken place, is more difficult to prove when one buys stocks in the secondary market. However, there are certainly ways that impact investing can be applied in public equities, provided that careful analysis is conducted to identify and record the genuine and intentional impact outcomes. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 6 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Industries like low-carbon transport, and the supply chains around electric vehicles, for example, are likely to benefit from the increasing adoption rates in the coming years. Smart energy sectors represent another opportunity, as the digitisation of buildings and industries, and smart grid technology, is opening new possibilities for energy efficiency and renewable sources. In the agricultural sector, companies are exploring new ways to meet demands from the growing populations while limiting the use of scarce land. This creates opportunities to invest in companies that are developing food and agricultural technologies and solutions to address food waste. The scale of unmet social needs also creates opportunities for companies and investors to improve outcomes for underserved people in developing and developed countries, For instance, one can look for businesses which improve access to essential services, increasing inclusion for underserved populations and helping to address large unmet needs. Businesses looking to improve access to and affordability of healthcare, or that support medical innovation, represent another opportunity, as do companies which foster diversity, entrepreneurship and education. Such firms can create more opportunities for people around the world and sustain development within disadvantaged communities. Ultimately, public opinion is shifting and putting pressure on companies. Responsible asset managers have a duty to monitor and engage with companies whose shares they own. Fundamentally, if a corporation wants to be truly sustainable it needs to have robust governance structures in place, which proactively aim to tackle societal issues to deliver a better future for people and the planet. For example, businesses which mitigate environmental damage should yield large net gains to the global society. History shows that well-governed companies outperform others in the long term and are better positioned to take advantage of new opportunities. If they are not, it can display a potentially significant and negative impact. When it comes to fixed income, ESG investing issues contain material financial information which affects the credit quality of an issuer. ESG criteria effectively supply additional qualitative information. Fund managers can incorporate this information into their decisions, and after taking into account risks and opportunities, apply them to their fixed income portfolios. One of the most powerful demonstrations of ESG investing in the bond space has been the rapidly growing green bond market, which set a record of issuance of USD269.5 billion in 2020. The proceeds from green bonds are dedicated to financing new and existing projects which aim at exerting positive impact on the environment. When it comes to investing in green Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 7 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG bonds, there are two main approaches. One is to allocate green bonds into an existing fixed income portfolio and the other is to invest in dedicated green bond strategies. There are four key criteria on which investors should base their analysis of green bond: the ESG quality of the issuer, the merits of the project, the use of proceeds, and how the issuer will monitor and report on the project. Social bonds are very similar to green bonds concept-wise but are designed to finance social projects. These range from social housing, microfinance, access to education, improvements in gender equality, support for employment in underserved regions and more. In 2020, social bond issuance jumped sevenfold to USD147.7 billion, as businesses and governments borrowed for relief from the pandemic in the wake of significant investor demand. This growth is expected to continue. Social bonds should be measured against a set of principles like green bonds, including a clear definition of the issuer’s environmental strategy and commitments. Social bond issuers are also expected to apply relevant and robust criteria to define the target populations and areas that they aim at supporting through funded projects, and to provide reports on the use of the bond’s proceeds and its impact. This is very important to ensure that social bonds will be financed to make a difference. While green bonds are intended to finance environmentally-friendly projects, there is a significant gap where investors could step in and deliver real impact for companies which are not yet at this stage. There is an opportunity to provide finance to companies which are “brown” today but have the ambition to transition to “green” in the future, including firms that are not able to issue green bonds due to a lack of sufficiently green projects for which they can use the proceeds. Transition bonds are intended to provide financing for such companies i.e. most businesses in the world today. This new form of financing can play a potentially vital role in supporting the transition to a low-carbon society. But for investors their transparency is critical. For example, investors need to be comfortable that proceeds raised are used to finance projects within pre-defined climate transition-related activities. As such, transition bond issuers should give investors a clear description of the eligible assets, their eligibility criteria, and the asset selection process. Issuers should also have guarantees in place to ensure that the proceeds are effectively allocated to the eligible projects. In addition, alongside issuance-level components, there should be clear expectations for an issuer’s broader environmental strategy. 1.4 Relationship among ESG, Green Finance, and Sustainability Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 8 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Many people use the terms sustainability and ESG interchangeably, including business leaders and environmental experts. It makes sense, in a way, as both share the same goal of improving a company’s business practices in order to boost profits and win favour from investors, customers, and regulators. However, there are some key differences investors need to be aware of between these two initiatives. Although sustainability and ESG are similar, there's one main difference: sustainability is vague, whereas ESG is specific and measurable. While sustainability can mean different things to different companies, ESG provides a specific set of criteria - namely, environmental, social, and governance - that companies can measure and report against. In the recent years, sustainability has become synonymous with “going green” or “reducing carbon footprint”. Hence when most people think about sustainability, they think about things like reducing energy consumption and tracking water usage. However, it is a pretty narrow definition of sustainability. Sustainability is an umbrella term that encompasses all of a company’s efforts to reduce its impact on the world around it. For example, sustainability can also mean creating promising jobs or promoting gender equality - in addition to helping the environment. ESG, on the other hand, is much more specific and data-driven. It is focused on three dimensions (environmental, social, and governance) rather than just going green or being a responsible steward. The environmental dimension is most closely related to what most people think of with sustainability in mind. It focuses on improving the environmental performance of a company. That can include things like reducing carbon emissions, improving resource efficiency, reducing waste, and complying with environmental regulations. It can also include things like climate risk management. But ESG also involves other efforts that enhance a company’s overall performance and profitability; namely social and governance, which are not (always) included in sustainability. The social dimension focuses on a business’ impact on its employees, customers, and the community. This can include things inside like workplace safety, employee engagement, diversity and inclusion, customer satisfaction, and even data and privacy. The social dimension of ESG covers many more aspects than sustainability efforts normally would. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 9 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG The governance dimension focuses on a business’ leadership and structure. Issues like how much executives get paid, who is on the board, whether shareholders get to vote on important issues, and even how a company conducts audits and prevents bribery and corruption, all fall under the governance dimension. ESG also puts a heavy emphasis on risk management. Monitoring and mitigating risks across all three dimensions is an important priority for any company that is serious about ESG. 1.5 Influence and Impact of Climate Risk on the Banking Industry Climate-related risks are risks posed by climate change, such as damage caused by extreme weather events or a decline of asset value in carbon-intensive sectors. They are broadly classified into physical risk, transition risk and liability risk: Physical risk is categorised as acute when it arises from climate and weather-related events, such as droughts, floods, storms and sea-level rises, and as chronic when it arises from progressive shifts in climate and weather patterns, such as increasing temperatures. It comprises impacts resulting directly from such events and shifts, such as damage to property or reduced productivity, and also those that may arise indirectly through subsequent events, such as the disruption of global supply chains. Transition risk is a type of financial risk which can result from the process of adjustment towards a lower-carbon economy prompted by, for example, changes in climate policy, technological changes (such as energy-saving technologies and a sharp decline in renewable energy costs) or a change in market sentiment. Liability risk is associated with emerging legal cases related to climate change, including those seeking compensation from financial institutions which are held responsible for loss and damages resulting from the effects of climate change, or which finance companies with activities having negative environmental impacts. Assessing the risks posed by climate change to the banking industry would require an understanding of the various transmission channels. Below are some examples which outline how climate-related risks can develop into traditional risks faced by banks: Credit risk - Banks may be affected if the value of properties taken as collateral is hit by extreme weather events. Credit risk may also increase if banks are lending to customers whose businesses are adversely affected by drivers of climate change, climate policy, technology or market sentiment. Operational risk - Severe weather events such as floods and typhoons could compromise Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 10 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG a bank’s property and operation. Heatwaves may also disrupt power generation or transportation, which will in turn upset banking services, affect business continuity, reduce revenue and increase repair costs. A bank’s profitability may also be affected due to insurance costs being pushed up by higher risks stemming from extreme weather events. Market risk - Climate events may trigger extreme market movements such as volatility in commodity prices. Sudden policy changes, such as the imposition of a carbon tax or technological changes may cause the equity prices of companies in carbon-intensive sectors to fluctuate. Liquidity risk - Market sentiment towards carbon-intensive assets could change suddenly due to policy changes or technological breakthroughs, which may lead to a sudden decline in the value of assets held by banks, making it difficult to liquidate these assets. Furthermore, as credit rating agencies focus increasingly on ESG risks, poor management of climate-related risks could adversely impact the bank’s credit rating and consequently affect its ability to obtain liquidity from the market. Reputation risk - Market expectations of how adequately a bank responds to climate change are growing. A bank’s association with projects viewed as socially or environmentally damaging may create negative publicity that may hit the customer base or even revenue. Apart from risks, it is held that climate change would also bring opportunities. The TCFD identified several areas of opportunity including improvement in resource efficiency, adoption of low-emission energy sources, development of new low-emission products and services, access to new markets, and resilience building along the supply chain. The opportunities create demand for green funding. The Organisation for Economic Co-operation and Development (OECD) estimated that on average, USD 6.9 trillion a year would be required for green infrastructure investment from 2016 to 2030. The HKMA conducted a survey in April 2019 to understand AIs’ awareness of and progress in developing green and sustainable banking. On one question regarding the potential benefit of developing green and sustainable banking business, “corporate image and reputation benefits” was considered by most AIs as significant (68%), followed by “more business opportunities and new income sources” (66%), “meeting customers' demand” (62%) and “portfolio diversification” (52%). In fact, some surveyed AIs indicated that the development of green and sustainable banking had provided them opportunities to create positive environmental impacts and fulfil their duties to society and shareholders, and that they had observed increasing demand across different customer segments, from corporate clients Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 11 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG requesting green banking solutions, to high-net-worth clients asking for relevant investment solutions. Apart from green bonds, innovations in green and sustainable products have been observed. For example, in April 2019, a sustainability-linked loan was granted in Hong Kong, and the interest rate of which would be partially based on a third-party assessment of the borrower’s ESG performance. In November 2019, a sustainable deposit was launched for corporate and institutional clients, with funds raised being used to help finance activities that supported the UN SDGs. In December 2019, green retail certificates of deposit were issued in Hong Kong. The proceeds will go towards financing eligible businesses and projects that promote the transition to a low-carbon, climate-resilient and sustainable economy. 1.6 ESG Regulatory Development International Organization of Securities Commissions (IOSCO) The use of ESG ratings and data products has grown considerably in response to investors’ mounting interest in investing in companies that take into account sustainability in the way they are run. As a result, the role and influence of ESG ratings and data products providers in financial markets more generally, and in the sustainable finance ecosystem more specifically, have grown significantly. This has led some securities markets regulators to take a closer interest in the activities and business models of these providers. Given that this part of the market does not currently fall within the typical remit of securities regulators, IOSCO has sought to strengthen its knowledge by undertaking a fact-finding exercise with ESG ratings and data products providers, users of ESG ratings and data products, and the companies that are the subject of these ESG ratings or data products. The fact-finding exercise revealed that: there is little clarity and alignment on definitions, including on what ratings or data products intend to measure; there is a lack of transparency about the methodologies underpinning these ratings or data products; while there is wide divergence within the ESG ratings and data products industry, there is an uneven coverage of products offered, with certain industries or geographical areas benefitting from more coverage than others, thereby leading to gaps for investors seeking to follow certain investment strategies; Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 12 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG there may be concerns about the management of conflicts of interest where the ESG ratings and data products provider or an entity closely associated with the provider performs consulting services for companies that are the subject of these ESG ratings or data products; and better communication with companies that are the subject of ESG ratings or data products was identified as an area meriting further attention given the importance of ensuring the ESG ratings or other data products are based on sound information. IOSCO issued a Consultation Report on 26 July 2021 which explored these developments and challenges and sought to better understand the implications of the increasingly important role of ESG ratings and data products for financial markets. It did so by identifying potential areas for improvement within this part of the sustainable finance ecosystem, which in turn form the basis for a series of proposed recommendations for securities markets regulators as well as ESG ratings and data products providers, users of ESG ratings and data products and the companies that are the subject of these ratings or data products. ESG ratings and data products providers are broadly treated the same in this Report for efficiency. However, not everything stated to apply to ESG ratings providers may equally apply to ESG data products providers, and vice versa. IOSCO received a total of sixty-one (61) responses to the Consultation Report. Overall, respondents were supportive of IOSCO’s work and were broadly in agreement with the proposed recommendations set out in the Consultation Report. The IOSCO Board is grateful for the responses received and took them into consideration when preparing this Report. The Final Report provides an overview of the market for ESG ratings and data products, discusses the current practices of ESG ratings and data products providers, discusses observations in relation to users of ESG ratings and ESG data products, elaborates on the interactions between companies that are the subject of ESG ratings or data products and ESG ratings and data products providers, and discusses areas for improvement highlighted in the fact-finding exercise and sets out recommendations for securities markets regulators, ESG ratings and data products providers, users of these products and services, and companies subject to these providers’ review. The recommendations start with a proposal that regulators could consider focusing greater attention to the use of ESG ratings and data products and the activities of ESG rating and data products providers in their jurisdictions. This is followed by a set of recommendations addressed to ESG ratings and data products providers, setting out that they could consider a Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 13 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG number of factors related to issuing high quality ratings and data products, including publicly disclosed data sources, defined methodologies, management of conflicts of interest, high levels of transparency, and handling confidential information. The recommendations also suggest that users of ESG ratings and data products could consider conducting due diligence on the ESG ratings and data products that they use within their internal processes. The recommendations close with suggestions that ESG ratings and data products providers, and entities subject to assessment by ESG ratings and data products providers could consider to improve information gathering processes, disclosures and communication between providers and entities subject to assessment. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 14 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG 2. Climate Transition Finance 1. The concept of climate transition focuses principally on the credibility of an issuer’s climate change-related commitments and practices. Significant financing is needed to deal with the climate change. Capital markets have a critical role to play in enabling the climate transition by ensuring the efficient flow of financing from investors to issuers wishing to address climate change risk issues. To help facilitate these flows, the International Capital Market Association (“ICMA”) published the Climate Transition Finance Handbook - Guidance for Issuers in December 2020 to provide clear guidance and common expectations to capital markets participants on the practices, actions and disclosures to be made available when raising funds in debt markets for climate transition-related purposes. There are four key elements to the guidance: Issuer’s climate transition strategy and governance; Business model environmental materiality; Climate transition strategy to be ‘science-based’ including targets and pathways; and, Implementation transparency. 2.1 Company’s Climate Transition Strategy The financing purpose should be for enabling an issuer’s climate change strategy. A ‘transition’ label applied to a debt financing instrument should serve to communicate the implementation of an issuer’s corporate strategy to transform the business model in a way which effectively addresses climate-related risks and contributes to alignment with the goals of the Paris Agreement. The concept of climate transition focuses principally on the credibility of an issuer’s climate change-related commitments and practices. Climate transition finance is the extent to which an issuer’s financing program supports the implementation of its climate change strategy. This strategy should clearly communicate how the issuer intends to adapt its business model to make a positive contribution to the transition to a low carbon economy. In this framework, an issuer’s ability to identify eligible climate-related expenditures alone will not necessarily equate to a broader corporate strategic intention to address climate change risks and opportunities in the long-term. Corporate climate change strategies should respond to stakeholder expectations by purposefully and explicitly seeking to play a positive role in achieving the Paris Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 15 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Agreement. Establishment of a corporate strategy to address climate change-related risks is a pre-requisite to issuing a transition-labelled instrument. A range of climate change scenario providers exist in the market today to inform strategy design. The choice of relevant provider, or the decision to design an in-house scenario, are up to the issuer. However, regardless of the source, an issuer’s strategy should be guided by the objective of limiting global temperature increases ideally to 1.5°C and, at the very least, to well below 2°C. Disclosures regarding corporate strategies may be aligned with recognised reporting frameworks such as the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), or similar frameworks. These may be made according to the customary practices regarding corporate disclosures, e.g. via annual reporting, dedicated sustainability reporting, statutory filings and investor presentations. Suggested information and indicators: A long-term target to align with the goals of the Paris Agreement (e.g. the objective of limiting global warming ideally to 1.5°C and, at the very least, to well below 2°C); Relevant interim targets on the trajectory towards the long-term goal; Disclosure on the issuer’s levers towards decarbonisation, and strategic planning towards a long-term target to align with the goals of the Paris Agreement; Clear oversight and governance of transition strategy; and, Evidence of a broader sustainability strategy to mitigate relevant environmental and social externalities and contribute to the UN Sustainable Development Goals. 2.2 Company’s Business Model Environmental Materiality The planned climate transition trajectory should be relevant to the environmentally-material parts of the issuer’s business model, taking into account potential future scenarios which may impact on current determinations concerning materiality. Climate transition financing should be sought by the issuer for the funding needed in the strategic change over time to its ‘core’ business activities. These are the activities which are the main drivers of its current and future environmental impact. Climate transition finance is most relevant and required by those industries with high greenhouse gas emissions which face the most complex climate-related transition challenges. We note that the climate transition is not the only change faced by companies and that many are involved in various transformations across other business functions. The climate transition trajectory as far as it Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 16 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG relates to financing should also be a material factor to the future success of the business model, as opposed to being an incidental aspect. The trajectory should also consider the salience of an issuer’s climate impacts on the environment and society, and seek to mitigate negative externalities. Discussion of the materiality of the planned transition trajectory may be included in the disclosures referenced for the “Company’s Climate Transition Strategy” above. Existing market guidance regarding consideration of materiality may be applied in making such disclosure, for example the relevant guidance provided by accounting standards bodies. 2.3 Company’s Climate Transition Strategy to be Science-based including Targets and Pathways Issuer’s climate strategy should reference science-based targets and transition pathways. The planned transition trajectory should: be quantitatively measurable (based on a measurement methodology which is consistent over time); be aligned with, benchmarked or otherwise referenced to recognise, science-based trajectories where such trajectories exist; be publicly disclosed (ideally in mainstream financing filings), include interim milestones, and; be supported by independent assurance or verification. Sustainability performance improvement targets are typically set in accordance with a number of considerations. These include alignment with the Paris Agreement, market and stakeholder expectations, the company’s starting point, track record of achievement to date and the feasibility of improvement measures, including economic constraints/cost-benefit analyses, and the existence of proven techniques or technologies which deliver the anticipated improvements. With regards to climate change, authoritative scientific analysis has determined the rate of decarbonisation (the ‘decarbonisation trajectory’) required in the global economy in order to align the various economic activities with those scenarios which imply a Paris Agreement- aligned level of warming. Science-based targets are targets that are in line with the scale of reductions required to keep the global temperature increase below 2°C above pre-industrial temperatures. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 17 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG As part of a credible transition proposition, issuers should reference appropriate benchmark, sector-specific decarbonisation trajectories in communicating their strategy in this area. It is likely that an aim to align the business plans with a 1.5°C trajectory will be perceived as most credible8 to the increasing proportion of market participants. 2.4 Company’s Implementation Transparency Market communication in connection with the offer of a financing instrument which has the aim of funding the issuer’s climate transition strategy should also provide transparency to the extent practicable, of the underlying investment program including capital and operational expenditure. This may include R&D-related expenditure where relevant, and details of where any such operating expenditure is deemed ‘non-Business as Usual’, as well as other relevant information indicating how this program supports implementation of the transition strategy, including details of any divestments, governance and process changes. Acknowledging the various pressures that issuers from hard-to-abate sectors are currently coming under, there is an obvious incentive to respond in the short term with announcements regarding strategy, targets and related commitments. However, addressing the issue of financing of business operations and infrastructure to ensure the operational picture can deliver the announced response over extended time horizons is more challenging and time- consuming. Ultimately however it is the internal allocation of capital by the company in order to implement the strategy which will be most important, alongside the governance that supports such re-allocation. For this reason, it is recommended to provide transparency with regard to the planned capital and operational expenditure decisions which will deliver the proposed transition strategy. Issuers should report in qualitative and quantitative fashion the climate-related outcomes and impacts that these expenditures are intended to result in. It is also worth highlighting here that it is not solely ‘greening by’ or ‘greening of’ expenditures that contribute to a proposed transition strategy. Where a transition may have negative impacts for workers and communities, issuers should outline how they have incorporated consideration of a ‘just transition’ into their climate transition strategy, and may also detail any ‘social’ expenditures that are considered relevant within the context of transition finance. Disclosure of capital expenditure (capex) and operational expenditure (opex) plans and other relevant financial metrics to the extent they relate to a transition strategy may be made via a Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 18 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG company’s annual report, website, or sustainability report. Disclosure of anticipated capex and opex line items may take the form of a simple table providing detail on specific elements and their connection to the announced strategy, with estimated amounts involved. Suggested information and indicators Disclosure on the percentage of assets/revenues/ expenditures/divestments aligned to the various levers outlined in the “Company’s Climate Transition Strategy” above; Capex roll-out plan consistent with the overall strategy and climate science. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 19 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG 3. Introduction to Green Loans and Green Bonds 2. 3.1 Green Loan Principles Introduction The green loan market aims to facilitate and support environmentally sustainable economic activity. The Green Loan Principles (GLP) by Loan Market Association (LMA), Asia Pacific Loan Market Association (APLMA), and Loan Syndications & Trading Association (LSTA) have been developed by an experienced working party, consisting of representatives from leading financial institutions active in the global syndicated loan markets, with a view to promoting the development and integrity of the green loan product. Their aim is to create a high-level framework of market standards and guidelines, providing a consistent methodology for use across the green loan market, whilst allowing the loan product to retain its flexibility, and preserving the integrity of the green loan market while it develops. The GLP comprise voluntary recommended guidelines, to be applied by market participants on a deal-by-deal basis depending on the underlying characteristics of the transaction, that seek to promote integrity in the development of the green loan market by clarifying the instances in which a loan may be categorised as “green”. The GLP build on and refer to the Green Bond Principles (GBP) administered by the International Capital Market Association, with a view to promoting consistency across financial markets. The GBP are the internationally recognised voluntary issuance guidelines that promote transparency, disclosure and reporting in the green bond market. The GLP are intended for broad use by the market, providing a framework within which the flexibility of the loan product can be maintained, and will be reviewed on a regular basis in light of the development and growth of green loans. Green Loan Definition Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 20 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Green loans are any type of loan instrument made available exclusively to finance or re- finance, in whole or in part, new and/or existing eligible Green Projects. Green loans must align with the four core components of the GLP, as set out below. Green loans should not be considered interchangeable with loans that are not aligned with the four core components of the GLP. Green Loan Principles – Core Components The GLP set out a clear framework, enabling all market participants to clearly understand the characteristics of a green loan, based around the following four core components: Use of Proceeds Process for Project Evaluation and Selection Management of Proceeds Reporting Use of Proceeds The fundamental determinant of a green loan is the utilisation of the loan proceeds for Green Projects (including other related and supporting expenditures, including R&D), which should be appropriately described in the finance documents and, if applicable, marketing materials. All designated Green Projects should provide clear environmental benefits, which will be assessed, and where feasible, quantified, measured and reported by the borrower. Where funds are to be used, in whole or part, for refinancing, it is recommended that borrowers provide an estimate of the share of financing versus refinancing. Where appropriate, they should also clarify which investments or project portfolios may be refinanced, and, to the extent relevant, the expected look-back period for refinanced Green Projects. A green loan may take the form of one or more tranches of a loan facility. In such cases, the green tranche(s) must be clearly designated, with proceeds of the green tranche(s) credited to a separate account or tracked by the borrower in an appropriate manner. The GLP explicitly recognise several broad categories of eligibility for Green Projects with the objective of addressing key areas of environmental concern such as climate change, natural resources depletion, loss of biodiversity, and air, water and soil pollution. This non-exhaustive Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 21 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG list is intended to capture the most usual types of projects supported, and expected to be supported, by the green loan market. However, it is recognised that definitions of green and green projects may vary depending on sector and geography. Process for Project Evaluation and Selection The borrower of a green loan should clearly communicate to its lenders: its environmental sustainability objectives; the process by which the borrower determines how its projects fit within the eligible categories; and the related eligibility criteria, including, if applicable, exclusion criteria or any other process applied to identify and manage potentially material environmental and social risks associated with the proposed projects. Borrowers are encouraged to position this information within the context of their overarching objectives, strategy, policy and/or processes relating to environmental sustainability. Borrowers are also encouraged to disclose any green standards or certifications to which they are seeking to conform. Management of Proceeds The proceeds of a green loan should be credited to a dedicated account or otherwise tracked by the borrower in an appropriate manner, so as to maintain transparency and promote the integrity of the product. Where a green loan takes the form of one or more tranches of a loan facility, each green tranche(s) must be clearly designated, with proceeds of the green tranche(s) credited to a separate account or tracked by the borrower in an appropriate manner. Borrowers are encouraged to establish an internal governance process through which they can track the allocation of funds towards Green Projects. Reporting Borrowers should make and keep readily available up to date information on the use of proceeds to be renewed annually until fully drawn, and as necessary thereafter in the event of material developments. This should include a list of the Green Projects to which the green loan proceeds have been allocated and a brief description of the projects and the amounts allocated and their expected impact. Where confidentiality agreements, competitive Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 22 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG considerations, or a large number of underlying projects limit the amount of detail that can be made available, the GLP recommend that information is presented in generic terms or on an aggregated project portfolio basis. Information need only be provided to those institutions participating in the loan. Transparency is of particular value in communicating the expected impact of projects. The GLP recommend the use of qualitative performance indicators and, where feasible, quantitative performance measures (for example, energy capacity, electricity generation, greenhouse gas emissions reduced/avoided, etc.) and disclosure of the key underlying methodology and/or assumptions used in the quantitative determination. Borrowers with the ability to monitor achieved impacts are encouraged to include those in regular reports. Review When appropriate, an external review is recommended. There are a variety of ways for borrowers to obtain outside input into the formulation of their green loan process and there are several levels and types of review that can be provided to those institutions participating in the loan. Such guidance and external reviews might include: Consultant review – a borrower can seek advice from consultants and/or institutions with recognised expertise in environmental sustainability or other aspects of the administration of a green loan. “Second party opinions” may also fall into this category. Verification – a borrower can have its green loan, associated green loan framework, or underlying assets independently verified by qualified parties, such as auditors or independent ESG rating providers. In contrast to certification, verification may focus on alignment with internal standards or claims made by the borrower. Certification – a borrower may have its green loan or associated green loan framework certified against an external green assessment standard. An assessment standard defines criteria, and alignment with such criteria is tested by qualified third parties/certifiers. Rating – a borrower can have its green loan or associated green loan framework rated by qualified third parties, such as specialised research providers or rating agencies. An external review may be partial, covering only certain aspects of a borrower’s green loan or associated green loan framework or full, assessing alignment with all four core components of the GLP. It should be made available to all institutions participating in the green loan on request. When appropriate, and taking into account confidentiality and competitive Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 23 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG considerations, borrowers should make publicly available the external review, or an appropriate summary, via their website or otherwise. Alternatively, given that the loan market is traditionally a relationship-driven market and therefore lenders are likely to have a broad working knowledge of the borrower and its activities, self-certification by a borrower, which has demonstrated or developed the internal expertise to confirm alignment of the green loan with the key features of the GLP, may be sufficient. Nonetheless, borrowers are recommended to thoroughly document such expertise, including the related internal processes and expertise of their staff. This documentation should be communicated to institutions participating in the loan on request. When appropriate, and taking into account confidentiality and competitive considerations, borrowers should make publicly available, via their website or otherwise, the parameters on which they assess Green Projects, and the internal expertise they have to assess such parameters. 3.2 Green Bond Principles Green Bond Definition Green Bonds are any type of bond instrument where the proceeds or an equivalent amount will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible Green Projects (see Use of Proceeds section below) and which are aligned with the four core components of the GBP. It is understood that certain eligible Green Projects may have social co-benefits, and that the classification of a use of proceeds bond as a Green Bond should be determined by the issuer based on its primary objectives for the underlying projects. (Bonds that intentionally mix eligible Green and Social Projects are referred to as Sustainability Bonds, and specific guidance for these is provided separately in the Sustainability Bond Guidelines). It is important to note that Green Bonds should not be considered fungible with bonds that are not aligned with the four core components of the GBP. Bonds issued under earlier Green Bond Guidance released prior to this version are deemed consistent with the GBP. Green Bond Principles Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 24 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG The Green Bond Principles (GBP) are voluntary process guidelines that recommend transparency and disclosure and promote integrity in the development of the Green Bond market by clarifying the approach for issuance of a Green Bond. The GBP are intended for broad use by the market: they provide issuers with guidance on the key components involved in launching a credible Green Bond; they aid investors by promoting availability of information necessary to evaluate the environmental impact of their Green Bond investments; and they assist underwriters by offering vital steps that will facilitate transactions that preserve the integrity of the market. The GBP recommend a clear process and disclosure for issuers, which investors, banks, underwriters, arrangers, placement agents and others may use to understand the characteristics of any given Green Bond. The GBP emphasise the required transparency, accuracy and integrity of the information that will be disclosed and reported by issuers to stakeholders through core components and key recommendations. The four core components for alignment with the GBP are: Use of Proceeds Process for Project Evaluation and Selection Management of Proceeds Reporting The key recommendations for heightened transparency are: Green Bond Frameworks External Reviews Use of Proceeds The cornerstone of a Green Bond is the utilisation of the proceeds of the bond for eligible Green Projects, which should be appropriately described in the legal documentation of the security. All designated eligible Green Projects should provide clear environmental benefits, which will be assessed and, where feasible, quantified by the issuer. In the event that all or a proportion of the proceeds are or may be used for refinancing, it is recommended that issuers provide an estimate of the share of financing vs. re-financing, and where appropriate, also clarify which investments or project portfolios may be refinanced, and, to the extent relevant, the expected look-back period for refinanced eligible Green Projects. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 25 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG The GBP explicitly recognise several broad categories of eligibility for Green Projects, which contribute to environmental objectives such as: climate change mitigation, climate change adaptation, natural resource conservation, biodiversity conservation, and pollution prevention and control. The following list of project categories, while indicative, captures the most commonly used types of projects supported, or expected to be supported the Green Bond market. Green Projects include assets, investments and other related and supporting expenditures such as R&D that may relate to more than one category and/or environmental objective. Three environmental objectives identified above (pollution prevention and control, biodiversity conservation and climate change adaptation) also serve as project categories in the list. As such, they refer to the projects that are more specifically designed to meet these environmental objectives. The eligible Green Projects categories, listed in no specific order, include, but are not limited to: Renewable energy (including production, transmission, appliances and products); Energy efficiency (such as in new and refurbished buildings, energy storage, district heating, smart grids, appliances and products); Pollution prevention and control (including reduction of air emissions, greenhouse gas control, soil remediation, waste prevention, waste reduction, waste recycling and energy/emission-efficient waste to energy); Environmentally sustainable management of living natural resources and land use (including environmentally sustainable agriculture; environmentally sustainable animal husbandry; climate smart farm inputs such as biological crop protection or drip-irrigation; environmentally sustainable fishery and aquaculture; environmentally sustainable forestry, including afforestation or reforestation, and preservation or restoration of natural landscapes); Terrestrial and aquatic biodiversity conservation (including the protection of coastal, marine and watershed environments); Clean transportation (such as electric, hybrid, public, rail, non-motorised, multi-modal transportation, infrastructure for clean energy vehicles and reduction of harmful emissions); Sustainable water and wastewater management (including sustainable infrastructure for clean and/or drinking water, wastewater treatment, sustainable urban drainage systems and river training and other forms of flooding mitigation); Climate change adaptation (including efforts to make infrastructure more resilient to Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 26 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG impacts of climate change, as well as information support systems, such as climate observation and early warning systems); Circular economy adapted products, production technologies and processes (such as the design and introduction of reusable, recyclable and refurbished materials, components and products; circular tools and services); and/or certified eco-efficient products; Green buildings that meet regional, national or internationally recognised standards or certifications for environmental performance. While the GBP’s purpose is not to take a position on which green technologies, standards, claims and declarations are optimal for environmentally sustainable benefits, it is noteworthy that there are several current international and national initiatives to produce taxonomies and nomenclatures, as well as to provide mapping between them to ensure comparability. These may give further guidance to Green Bond issuers as to what may be considered green and eligible by investors. These taxonomies are currently at various stages of development. Furthermore, there are many institutions that provide independent analysis, advice and guidance on the quality of different green solutions and environmental practices. Definitions of green and Green Projects may also vary depending on sector and geography. Finally, where issuers wish to finance projects towards implementing a net zero emissions strategy aligned with the goals of the Paris Agreement, guidance on issuer level disclosures and climate transition strategies may be sought from the ICMA Climate Transition Finance Handbook. Process for Project Evaluation and Selection The issuer of a Green Bond should clearly communicate to investors: The environmental sustainability objectives of the eligible Green Projects; The process by which the issuer determines how the projects fit within the eligible Green Projects categories (examples are identified above); and Complementary information on processes by which the issuer identifies and manages perceived social and environmental risks associated with the relevant project(s). Issuers are also encouraged to: Position the information communicated above within the context of the issuer’s overarching objectives, strategy, policy and/or processes relating to environmental Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 27 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG sustainability. Provide information, if relevant, on the alignment of projects with official or market-based taxonomies, related eligibility criteria, including if applicable, exclusion criteria; and also disclose any green standards or certifications referenced in project selection. Have a process in place to identify mitigants to known material risks of negative social and/or environmental impacts from the relevant project(s). Such mitigants may include clear and relevant trade-off analysis undertaken and monitoring required where the issuer assesses the potential risks to be meaningful. Management of Proceeds The net proceeds of the Green Bond, or an amount equal to these net proceeds, should be credited to a sub-account, moved to a sub-portfolio or otherwise tracked by the issuer in an appropriate manner, and attested to by the issuer in a formal internal process linked to the issuer’s lending and investment operations for eligible Green Projects. So long as the Green Bond is outstanding, the balance of the tracked net proceeds should be periodically adjusted to match allocations to eligible Green Projects made during that period. The issuer should make known to investors the intended types of temporary placement for the balance of unallocated net proceeds. The proceeds of Green Bonds can be managed per bond (bond-by-bond approach) or on an aggregated basis for multiple green bonds (portfolio approach). The GBP encourage a high level of transparency and recommend that an issuer’s management of proceeds be supplemented by the use of an external auditor, or other third party, to verify the internal tracking method and the allocation of funds from the Green Bond proceeds. Reporting Issuers should make, and keep, readily available up to date information on the use of proceeds to be renewed annually until full allocation, and on a timely basis in case of material developments. The annual report should include a list of the projects to which Green Bond proceeds have been allocated, as well as a brief description of the projects, the amounts allocated, and their expected impact. Where confidentiality agreements, competitive considerations, or a large number of underlying projects limit the amount of detail that can be Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 28 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG made available, the GBP recommend that information is presented in generic terms or on an aggregated portfolio basis (e.g. percentage allocated to certain project categories). Transparency is of particular value in communicating the expected and/or achieved impact of projects. The GBP recommend the use of qualitative performance indicators and, where feasible, quantitative performance measures and disclosure of the key underlying methodology and/or assumptions used in the quantitative determination. Issuers should refer to and adopt, where possible, the guidance and impact reporting templates provided in the Harmonised Framework for Impact Reporting. The use of a summary, which reflects the main characteristics of a Green Bond or a Green Bond programme, and illustrates its key features in alignment with the four core components of the GBP, may help inform market participants. Green Bond Frameworks Issuers should explain the alignment of their Green Bond or Green Bond programme with the four core components of the GBP (i.e. Use of Proceeds, Process for Project Evaluation and Selection, Management of Proceeds and Reporting) in a Green Bond Framework or in their legal documentation. Such Green Bond Framework and/or legal documentation should be available in a readily accessible format to investors. It is recommended that issuers summarise in their Green Bond Framework relevant information within the context of the issuer’s overarching sustainability strategy. This may include reference to the five high level environmental objectives of the GBP (climate change mitigation, climate change adaptation, natural resource conservation, biodiversity conservation, and pollution prevention and control). Issuers are also encouraged to disclose any taxonomies, green standards or certifications referenced in project selection. When communicating Paris-aligned transition strategies in the context of projects targeting climate change mitigation, issuers are encouraged to use guidance from the ICMA Climate Transition Finance Handbook. External Reviews It is recommended that issuers appoint (an) external review provider(s) to assess through a pre-issuance external review the alignment of their Green Bond or Green Bond programme Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 29 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG and/or Framework with the four core components of the GBP (i.e. Use of Proceeds, Process for Project Evaluation and Selection, Management of Proceeds and Reporting) as defined above. Post issuance, it is recommended that an issuer’s management of proceeds be supplemented by the use of an external auditor, or other third party, to verify the internal tracking and the allocation of funds from the Green Bond proceeds to eligible Green Projects. There are a variety of ways for issuers to obtain outside input to their Green Bond process and there are several types of review that can be provided to the market. Issuers should consult the Guidelines for External Reviews for recommendations and explanations on the different types of reviews. These Guidelines have been developed by the GBP to promote best practice. They are a market-based initiative to provide information and transparency on the external review processes for issuers, underwriters, investors, other stakeholders and external reviewers themselves. 3.3 Social Bond Principles Social Bond Definition Social Bonds are any type of bond instrument where the proceeds, or an equivalent amount, will be exclusively applied to finance or re-finance in part or in full new and/or existing eligible Social Projects and which are aligned with the four core components of the SBP. It is understood that certain eligible Social Projects may also have environmental co-benefits, and that the classification of a use of proceeds bond as a Social Bond should be determined by the issuer based on its primary objectives for the underlying projects. (bonds that intentionally mix Green and Social Projects are referred to as Sustainability Bonds, and specific guidance for these is provided separately in the Sustainability Bond Guidelines). It is important to note that Social Bonds should not be considered fungible with bonds that are not aligned with the four core components of the SBP. Bonds issued under earlier Social Bond Guidance released prior to this version are deemed consistent with the SBP. Social Bond Principles Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 30 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG The SBP are voluntary process are voluntary process guidelines that recommend transparency and disclosure and promote integrity in the development of the Social Bond market by clarifying the approach for issuance of a Social Bond. The SBP are intended for broad use by the market: they provide issuers with guidance on the key components involved in launching a credible Social Bond; they aid investors by promoting availability of information necessary to evaluate the positive impact of their Social Bond investments; and they assist underwriters offering vital steps that will facilitate transactions and preserve integrity of the market. The SBP recommend a clear process and disclosure for issuers, which investors, banks, underwriters, arrangers, placement agents and others may use to understand the characteristics of any given Social Bond. The SBP emphasise the required transparency, accuracy and integrity of the information that will be disclosed and reported by issuers to stakeholders through core components and key recommendations. The four core components for alignment with the Social Bond Principles are: Use of Proceeds Process for Project Evaluation and Selection Management of Proceeds Reporting The key recommendations for heightened transparency are: Social Bond Frameworks External Reviews 3.4 Sustainability Bonds Guidelines Sustainability Bond Definition Sustainability Bonds are any type of bond instrument where the proceeds or an equivalent amount will be exclusively applied to finance or re-finance a combination of both Green and Social Projects. Sustainability Bonds are aligned with the four core components of both the GBP and SBP with the former being especially relevant to underlying Green Projects and the latter to underlying Social Projects. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 31 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG It is understood that certain Social Projects may also have environmental co-benefits, and that certain Green Projects may have social co-benefits. The classification of a use of proceeds bond as a Green Bond, Social Bond, or Sustainability Bond should be determined by the issuer based on its primary objectives for the underlying projects. It is important to note that Sustainability Bonds should not be considered fungible with bonds that are not aligned with the four core components of the Principles. Bonds issued under earlier Green and Social Bond Guidance released prior to this version are deemed consistent with the SBG. Finally, where issuers wish to finance projects towards implementing a net zero emissions strategy aligned with the goals of the Paris Agreement, guidance on issuer level disclosures and climate transition strategies may be sought from the ICMA Climate Transition Finance Handbook. Source: ICMA In conclusion, while the GLP and GBP are voluntary process guidelines, they are now widely adopted and referenced by many green certification providers in their reviews of green loans and bonds. Besides, many corporates and financial institutions develop their sustainable Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 32 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG finance frameworks largely based on the GLP and GBP. “Green” itself may not have a consensus definition among the investment community, but the wide adoption of GLP and GBP by borrowers and issuers, credit rating agencies, certification reviewers and most importantly investors can help standardize, to a certain extent, the market practice relating to the green loan lending and green bond issuance. 3.5 Green Regulatory Development Hong Kong Monetary Authority (HKMA) Climate change is one of the major risks threatening the well-being of mankind. How the banking and financial system operates will clearly have an impact on the way in which climate risk is managed or reduced. The HKMA is committed to promoting green and sustainable finance in order to address climate risk. In particular, the HKMA adopts a three-phased approach to promote green and sustainable banking: Phase I – developing a common framework to assess the “Greenness Baseline” of individual banks. The HKMA will also collaborate with relevant international bodies to provide technical support to banks in Hong Kong to better understand the green principles and methodology in undertaking the baseline assessment; Phase II – engaging the industry and other relevant stakeholders in a consultation on the supervisory expectation or requirement on Green and Sustainable Banking, with a view to setting tangible deliverables for promoting the green and sustainable developments of the Hong Kong banking industry; and Phase III – after setting the targets, implement, monitor and evaluate banks’ progress in this regard. The HKMA is also actively participating in international forums to support global development of green finance. As a member of the Central Banks and Supervisors Network for Greening the Financial System (NGFS), the HKMA participates in the Network’s working groups to explore how to incorporate climate risk and other green and sustainable factors in the supervisory framework and macro surveillance work. Securities and Futures Commission (SFC) Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 33 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG SFC plays a key role in the development of green and sustainable finance initiatives to support Hong Kong’s position as a green finance hub within the Greater Bay Area and internationally. In September 2018, the SFC published its Strategic Framework for Green Finance, which covers three major areas: (i) enhancing listed company, asset manager and investment product disclosures and their consideration of ESG factors, especially environmental and climate risks; (ii) facilitating the development of green or ESG-related investment products, and supporting investor awareness and capacity building, and (iii) promoting Hong Kong as an international green finance centre. The SFC has established an internal cross-divisional working group to consider policies to develop Hong Kong as a green finance hub. In May 2020, the SFC initiated the establishment of the Green and Sustainable Finance Cross- Agency Steering Group (CASG) to accelerate the growth of green and sustainable finance in Hong Kong and support the Government’s climate strategies. Co-chaired by the SFC and the HKMA, the group comprises of the Financial Services and the Treasury Bureau, the Environment Bureau, Hong Kong Exchanges and Clearing Limited (HKEX), the Insurance Authority and the Mandatory Provident Fund Schemes Authority. The CASG announced its green and sustainable finance strategy for Hong Kong in December 2020 and will be following up with actions on the following five points: Climate-related disclosures aligned with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations will be mandatory across relevant sectors no later than 2025. Aim to adopt the Common Ground Taxonomy, which is being developed by the International Platform on Sustainable Finance (IPSF) Working Group on Taxonomies co-led by China and the EU. Support the International Financial Reporting Standards (IFRS) Foundation’s proposal to establish a new Sustainability Standards Board for developing and maintaining a global, uniform set of sustainability reporting standards. Promote climate-focused scenario analysis to assess the impacts on financial institutions under different climate pathways, such as through the pilot climate risk stress testing exercise for banks and insurers, and the use of scenario analysis by large asset managers. Establish a platform to act as a focal point for financial regulators, government agencies, industry stakeholders and the academia to coordinate cross-sectoral capacity Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 34 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG building, thought leadership and as a cross-sectoral repository of green and sustainable finance resources. The SFC has been collaborating with overseas regulatory counterparts to consider the development of sustainability practices in the financial sector. The SFC is the Vice-Chair of the Sustainability Task Force of IOSCO. It also leads the Sustainable Finance Working Group of IOSCO’s Asia-Pacific Regional Committee. The SFC is a member of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and the Advisory Group of the United Nations Sustainable Stock Exchanges Initiative. The SFC is also a supporter of the recommendations of the Task Force on Climate-Related Financial Disclosures. Green and Sustainable Finance Grant Scheme The green and sustainable finance grant scheme provides subsidy for eligible bond issuers and loan borrowers to cover their expenses on bond issuance and external review services. It commenced in May 2021 and was renewed for another three years in May 2024: General Bond Issuance Costs: covering bond issuance expenses (e.g. arrangement, legal, audit, listing fees, etc.) for eligible first-time green, social, sustainability, sustainability-linked and transition bond issuers; and External Review Costs: covering transaction-related external review fees (e.g. including pre-issuance external review and post-issuance external review or reporting) for eligible green, social, sustainability, sustainability-linked and transition bond issuers and loan borrowers, including first-time and repeated issuers and borrowers. General Bond Issuance Costs First-time green, social, sustainability, sustainability-linked and transition bond issuers are issuers that have not issued any green, social, sustainability, sustainability-linked or transition bonds in Hong Kong within five years preceding the eligible issuance), excluding issuers that also act as arranger for the eligible bond issuance. Eligible issues must satisfy the following criteria: Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 35 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG being issued in Hong Kong; having an issuance size of at least HKD1.5 billion (or the equivalent in foreign currency); being lodged with and cleared by the Central Moneymarkets Unit (CMU) operated by the HKMA in its entirety, or being listed on The Stock Exchange of Hong Kong Limited (SEHK); and being, at issuance, issued in Hong Kong to (i) 10 or more persons or (ii) less than 10 persons none of whom is an associate of the issuer. Eligible green, social, sustainability and sustainability-linked bonds must satisfy the following criteria: pre-issuance external review related to the issuance demonstrating alignment with internationally-recognised principles, standards or guidance, as provided by a recognised external reviewer. Eligible transition bonds must satisfy the following criteria: developed and appropriately disclosed transition plan (or equivalent disclosures on climate transition strategy) at the entity-level; pre-issuance external review demonstrating the adoption of internationally-recognised transition finance principles, standards or guidance (including the transition plan related elements under such principles, standards or guidance), as provided by a recognised external reviewer; and for use-of-proceeds instruments, pre-issuance external review demonstrating alignment with an having procured pre-issuance external review services related to the bond issue that is provided by a recognised external reviewer. The grant amount for each green and sustainable bond issue is equivalent to half of the eligible expenses, up to the following limits: HKD2.5 million where the bond, its issuer or its guarantor(s) possess a credit rating by a rating agency recognised by the HKMA (including CCXAP, Fitch, Moody’s, Rating and Investment Information, and S&P); or HKD1.25 million where none of the bond, its issuer or its guarantor(s) possess a credit rating by a rating agency recognised by the HKMA. Eligible expenses include the following: Fees to Hong Kong-based arrangers Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 36 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Fees to Hong Kong-based legal advisors Fees to Hong Kong-based auditors and accountants Fees to Hong Kong-based rating agencies SEHK listing fees CMU lodging and clearing fees External Review Costs First-time and repeated issuers and borrowers are entitled to the external review cost reimbursement but each entity can apply for subsidy for two eligible loans at most. Eligible issues must satisfy the following criteria: being issued in Hong Kong; having an issuance size of at least HKD100 million (or the equivalent in foreign currency); being lodged with and cleared by the CMU in its entirety, or being listed on the SEHK; and being, at issuance, issued in Hong Kong to (i) 10 or more persons or (ii) less than 10 persons none of whom is an associate of the issuer. Eligible green, social, sustainability and sustainability-linked loans and bonds must satisfy the following criteria: pre-issuance external review related to the issuance demonstrating alignment with internationally-recognised principles, standards or guidance, as provided by a recognised external reviewer. Eligible transition loans and bonds must satisfy the following criteria: developed and appropriately disclosed transition plan (or equivalent disclosures on climate transition strategy) at the entity-level; pre-issuance external review demonstrating the adoption of internationally-recognised transition finance principles, standards or guidance (including the transition plan related elements under such principles, standards or guidance), as provided by a recognised external reviewer; and for use-of-proceeds instruments, pre-issuance external review demonstrating alignment with an having procured pre-issuance external review services related to the bond issue that is provided by a recognised external reviewer. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 37 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Full cost of eligible expenses paid to recognised external reviewers, capped at HKD800,000 per bond issuance/loan: HKD250,000 for all pre-issuance external review services; and HKD200,000 per year for all post-issuance external review services for the first three years from the date of the eligible issuance or up until the maturity of the issuance, whichever is shorter. Eligible expenses include all transaction-related fees for: pre-issuance external review e.g. example, certification, second-party opinion, verification, ESG scoring/rating, assurance etc., including external review based on applicable internationally-recongised principles, standards or guidance (including the Hong Kong Taxonomy for Sustainable Finance published by the HKMA); post-issuance external review. A bond is considered issued in Hong Kong if half or more of the involved lead arranger(s) are recognised arrangers. Bond arranging activities comprise originating and structuring, legal and transaction documentation preparation, and sale and distribution. A loan is considered issued in Hong Kong if at least half of the loan amount is borrowed from Hong Kong-based lenders. When assessing an external reviewer, the HKMA will consider whether it has: considerable presence in Hong Kong; satisfactory observance of internationally-recognised standards; and proven track records in providing external review services to green and sustainable bonds and loans, especially international issuances. 3.6 Emergence of Blue Finance The ocean’s contribution to the economy has been described as the “blue economy”, the sustainable use of ocean and coastal resources to drive economic growth and improve livelihoods, while protecting and nurturing healthy marine ecosystems. The importance of ocean health is recognised by the Sustainable Development Goals (SDG) through SDG 14: Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 38 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG Life Below Water, which is focused on the inclusion of conservation and sustainable use of the ocean. Despite the environmental and economic benefits, a growing number of natural and human-induced threats to this precious resource continues unabated. Climate change, environmental pollution, unsustainable fishing and mining practices, unregulated coastal development, and dumping of solid and liquid wastes pose a grave threat to marine life and humanity, undermining the productivity of our ocean. Recognition of the growing threats to the ocean have resulted in an increase in global “blue” initiatives. Given the wealth and biodiversity of its natural resources, the potential for a vibrant blue economy is especially high in Southeast Asia, where intensive farming and aquaculture, rapid urbanisation and industrialisation, and the rising prevalence of plastic pollution are damaging the region’s waters. Economies of the Association of Southeast Asian Nations have launched initiatives to stimulate a sustainable blue economy, mostly financed by public sector spending and assisted in part by international organisations. The ocean, if treated like a country, is the seventh-largest economy in the world with an estimated value of USD2.5 trillion. However, financing remains a key concern for realising the blue economy’s potential. The nature and characteristics of blue economy projects imply that financing options need to extend far beyond the conventional multilateral and bilateral aid to leveraging blended finance options and attracting a diverse set of impact investors. Blended finance vehicles have a role to play in increasing blue economy investments, but more innovative structures like blue bonds, debt-for-nature swaps, credit enhancements, and social impact bonds to tap regional capital markets could be explored to suit the needs of specific projects. A key challenge encountered by blue finance is the lack of clear definitions and project selection criteria. In the absence of well-defined principles and a framework for “blue economy investing,” investors will shy away from this sector. Standardisation in terms of transparency, independent verification, and reporting is critical for building investors’ confidence in environmental credentials and performance of the investments. Blue finance principles are being developed by many agencies including the Asian Development Bank (ADB), the United Nations Environment Programme, and partners that seek to align the project outcomes to blue economy impacts, and these frameworks are expected to provide a template for investing in the blue economy. To accelerate the investments in the blue economy, this report proposes an ocean health mechanism, structured as a facility which can provide tailored concessional finance and de- Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 39 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG risking instruments to blue economy projects along with support for structuring sustainable project models and improving institutional capacity. A blue finance investment facility with provisions for technical assistance could be set up at either a regional or national level, to identify, originate, design, and structure projects based on ocean finance frameworks and standards, along with an objective to achieve desired financial bankability metrics. The capital structure of such a facility could be a mixture of grant funds, zero interest loans, and concessional funds. The facility could draw its funds from a combination of government budgetary allocations (including those committed in climate change nationally determined contributions), multilateral, bilateral agencies and development partners, private, philanthropic, institutional, and commercial capital. The funds could be used to support (i) specific government-originated projects including public–private partnership projects (through an integrated package comprising project development, structuring, and financing components using a variety of investment instruments) that have limited revenue streams but have considerable potential for avoided costs and environmental savings; (ii) individual projects promoted by private investors that adhere to the blue principles; and (iii) knowledge, awareness, and capacity building for stakeholders and institutions concerned and pipeline creation. It is expected that a significant component of the blue finance mechanism would be to catalyse high‑impact projects, which the public sector project proponents will be mandated to develop and implement. The capacity-building support could be in the form of assistance in generating and developing project pipelines, preliminary project structuring, monitoring, measurement and impact assessment, institutional strengthening of project sponsors, policy, governance and institutional strengthening, and knowledge dissemination. The instruments that could potentially be part of the mechanism include concessional finance, guarantee for bonds and revenue support structures, and subscription to first loss tranches. The blue finance mechanism could assist the proponents in developing innovative finance instruments. One such instruments could be an “ocean health credit.” This ocean health credit could be configured either as a certificate or structured note or as predetermined payments to the project for achieving desired impacts. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 40 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG The impact investors and project stakeholders could issue ocean health credits, an instrument that offers a rate of return comparable with other similar environmental, social, and governance (ESG) products, when held to maturity. The returns on the ocean health credit could be structured with minimal payments in the initial years (to provide immediate low-cost funds to the project proponents), with rates stepping up over a period. The investors could have the option to either hold on until maturity and exit (with returns similar to other ESG instruments) or can be given an option to exchange their ocean health credits into equity. The conversion into equity would provide these investors a stake in the project and increased community participation. The guarantee component of the blue finance framework would be extended to the full principal and interest for the ocean health credit investors at the time of exit. The direct and indirect benefits or “avoided costs” (relating to health care, livelihoods, education, credit, infrastructure, political participation, etc.) resulting from blue economy interventions could be captured and financially valued, which could potentially become an additionality to the project revenues. An alternate structure of an ocean health credit could entail the national entity or sovereign (through the blue finance mechanism) providing a predetermined annual payment or ocean health credits to a project’s implementing entity, linked to performance or impact indicators that a project needs to achieve. The functioning of ocean health credits should be seen as aligned with the principle of “avoided costs” from alleviating future economic or health disasters, such as diseases arising from lack of access to clean water, polluted river bodies, or decline in fishing stocks. An estimate of such avoided costs could provide a benchmark to limit the level of ocean health credits provided to a project. The blue finance mechanism could support blue economy projects initiated by private sponsors, which have untested revenue streams, or those adopting new technologies, or those with significant blue economy benefits. The facility could offer a guarantee (“ocean health credit guarantee”) at concessional rates on debt repayment to the blue bond holders for a defined percentage of the principal and interest payments. Appropriate market sounding and context-based structuring need to be undertaken prior to the launch of the ocean health credit mechanism. Copyright © 2022 The Hong Kong Institute of Bankers CH 1 - 41 Last updated: 6 July 2024 Chapter 1 Overview of Green Finance and ESG 4. Chapter Summary 3. ESG investment can be categorized into carious sustainable investment strategies. On one hand, simplification is done through excluding certain firms categorically (e.g. moral considerations). On the other hand, full ESG integration is integral to the culture of investing, such that it becomes an essential part of the investment processes, governance and decisions. The approaches are not mutually exclusive and portfolios could simultaneously apply more than one approach at a time. Although sustainability and ESG are similar, there's one main difference: sustainability is vague, whereas ESG is specific and measurable. While sustainability can mean different things to different companies, ESG provides a specific set of criteria - namely, environmental, social, and governance - that companies can measure and report against. Climate-related risks are risks posed by climate change, such as damage caused by extreme weather events or a decline of asset value in carbon-intensive sectors. They are broadly classified into physical risk, transition risk and liability risk. Given that the ESG market does not currently fall within the typical remit of securities regulators, IOSCO has sought to strengthen its knowledge by undertaking a fact-finding exercise with ESG ratings and data p

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