Green finance has been gathering momentum globally since the 2015 Paris Agreement on climate change. Since then, we have seen rapid development and growth in sustainability disclosure initiatives and regulations worldwide. The Hong Kong Securities and Futures Commission (SFC) has been monitoring policy developments in green finance for some time. The SFC, along with several leading regulators and central banks, has acknowledged that environmental factors, especially those relating to climate change, are a source of financial risk. The increased interest in ESG funds also calls for internationally compatible guidance to facilitate product disclosure and reporting.
The evolution of green finance and sustainability regulations is rapid and dynamic, presenting many challenges as well as opportunities. The SFC is working closely with local and international counterparts and industry stakeholders to ensure that it continues to lead and influence global regulatory development, while ensuring that local implementation is sound, efficient, and high impact so as to demonstrate a pathway for implementation in the region.
Against this backdrop, the SFC adopts a two-pronged approach to its ESG regulations with respect to the asset management industry. The first prong governs the conduct of fund managers licensed by the SFC, and second prong governs the disclosures and periodic reporting requirements for ESG funds offered to retail investors in Hong Kong. We will discuss each of these in turn.
SFC Climate Regulation On SFC-Licensed Fund Managers
The first prong of SFC’s regulations governs the conduct of SFC-licensed corporations and applies at ‘entity’ level (ie fund managers licensed to carry out asset management (type 9) regulated activity (LCs)).
Following public consultation, the amended Fund Manager Code of Conduct (FMCC) came into effect in August 2022, introducing provisions requiring LCs managing collective investment schemes to take climate-related risks into consideration in their investment and risk management processes, and make appropriate disclosures. The expected standards for compliance are more particularly described in a circular dated 20 August 2021 and FAQs (collectively referred to as ‘the Requirements’).
Scope And Applicability Of The Requirements
The Requirements are applicable to all LCs managing collective investment schemes (whether or not authorised by the SFC) with investment management discretion (in-scope LCs). The scope and applicability of the Requirements vary depending on the level of assets under management and whether the in-scope LC is responsible for the overall management of the fund (ROOF). All in-scope LCs are required to comply with the baseline requirements, whereas in-scope LCs that qualify as ’Large Fund Managers‘ (ie in-scope LCs with assets under discretionary management equal to or in excess of HK$8 billion) are required to comply with enhanced standards in addition to the baseline requirements.
As a first step, in-scope LCs should assess whether climate-related risks are relevant and material to their funds or investment strategies. In making such assessment, in-scope LCs may adopt an approach that is appropriate and proportionate to their circumstances, which can be qualitative, quantitative or some combination of both.
Where climate-related risks are considered irrelevant to a fund, an in-scope LC will need to evaluate the relevancy of climate-related risks at least annually, and a ROOF Manager will also need to disclose such determination to investors. Where climate-related risks are relevant to a fund, in-scope LCs will be subject to the SFC’s governance requirements (see below); and where climate-related risks are considered to be material to a fund, in-scope LCs will additionally be subject to the requirements for investment and risk management processes (see below). A ROOF Manager will need to comply with further disclosure requirements.
Baseline Requirements And Enhanced Standards
The baseline requirements cover:
(i) Governance: Requirements for the roles and responsibilities of the board and management-level positions, and compliance with the amendments to the FMCC in respect of climate–related risks;
(ii) Investment Management: Identification and incorporation of climate-related risks in the in-scope LC’s investment process;
(iii) Risk Management: Implementation of risk management procedures to manage and monitor climate-related risks; and
(iv) Disclosure: ROOF Managers are required to make various disclosures to investors, eg on governance and risk management roles and responsibilities, relevant climate-related risks and risk management policies and procedures.
Large Fund Managers are subject to enhanced standards to assess the relevance and utility of scenario analysis in measuring the resilience of investment strategies against climate-related risks and, if relevant, to develop a plan to implement scenario analysis within a reasonable period of time. Reasonable steps should be taken to identify and calculate the portfolio carbon footprint of Scope 1 and 2 greenhouse gas emissions associated with the relevant funds’ underlying investments. Such calculation must follow a prescribed formula set out in the SFC’s Requirements.
Ongoing Compliance By Fund Managers
While the baseline requirements and enhanced standards have come into full effect, in-scope LCs must continue to observe the relevant requirements that will become part of their ongoing compliance obligations. In recent inspections of licensed entities, the SFC has started to raise questions on issues concerning the management of climate-related risks, which we expect will remain a key focus in its regulatory supervision.
The SFC’s framework allows for a high degree of flexibility for entities to design their own policies and compliance systems having regard to their own individual circumstances. In practice, we observed that different firms have adopted different approaches, and some international fund houses with overseas affiliates have leveraged their existing group policies to address the Hong Kong specific requirements.
The SFC’s framework is principles-based, which can continue to develop and adapt to the rapidly evolving ESG landscape.
SFC Regulations On Authorised ESG Funds
The second prong of SFC’s regulations governs the disclosures and periodic reporting of SFC-authorised ESG funds and applies at ‘product’ level.
In June 2021, the SFC issued a circular to management companies of SFC-authorised funds (ESG Circular), setting out its expectations on product disclosures for funds which are marketed as ESG funds to the retail public in Hong Kong. This aims to provide guidance to fund managers, enabling them to better ensure that product disclosures accurately describe the ESG goals of a fund, and for managers to ascertain whether the fund will in practice deliver the ESG goals it seeks to achieve. Whilst disclosures alone will not prevent greenwashing, accurate and balanced disclosures will undoubtedly assist in bridging any gaps in investors’ expectations as well as holding managers accountable to its product description.
Scope And Applicability Of The ESG Circular
The ESG Circular applies to ESG funds authorised by the SFC for sale to Hong Kong retail investors. In order to qualify as an ESG fund in Hong Kong and to be marketed as such, the relevant funds will need to demonstrate that ESG factors are incorporated as its key investment focus and reflect this in its investment objective and/or strategy (ESG fund).
‘Out of scope’ are funds where ESG factors do not have significant influence on selection of underlying assets, and which do not primarily invest in investments with an ESG investment focus. The ESG Circular only applies to funds which are authorised by the SFC.
General Requirements Of The ESG Circular
The ESG Circular sets out the SFC’s expectations on various aspects of an ESG fund:
Name of the fund: A non-ESG fund should not name or describe itself as an ESG fund unless permitted by the SFC. The particular focus represented by an ESG fund’s name should correspond with its primary investments and/or strategy.
Disclosure in offering documents: An ESG fund’s offering documents must disclose:
a) ESG focus of the fund, eg climate change and sustainability etc, with a list of ESG criteria including filters, indicators, ratings used to measure the attainment of the ESG focus;
b) ESG investment strategy, ie the binding elements and significance of a fund’s investment strategy, including how such strategy is continuously implemented, how ESG criteria are considered and measured, and information relating to the fund’s exclusion policy if any;
c) Asset allocation, ie the expected or minimum proportion of securities or other investments in terms of the fund’s net asset value, that are commensurate with the fund’s ESG focus;
d) Reference benchmark, ie for funds tracking an ESG benchmark, the characteristics and general composition of such benchmark. For funds which measure their ESG focus against a designated reference benchmark, relevance of the designated reference benchmark to the fund;
e) Risks, ie the risks associated with the fund’s ESG focus and investment strategies.
Disclosure Of Additional Information
Additional disclosure requirements cover information on how the fund’s ESG focus is measured and monitored; methodologies used to measure the fund's ESG focus; the due diligence carried out by the manager; engagement policies (including proxy voting); and the source and processing of ESG data or any assumptions made. These aim to provide investors with a better understanding of the fund's approach to ESG investing. Such additional information may be disclosed on the manager’s website or by other means.
Periodic Assessment, Reporting And Monitoring
Annual assessments should also be conducted and the ESG fund should disclose how it has achieved its focus and the actions taken to attain the same. The ESG Circular prescribes areas which the assessment needs to cover as a minimum.
Application Of The Requirements To UCITS Funds
Whilst UCITS funds are required to demonstrate that ESG factors are incorporated as their key investment focus in order to qualify as an ESG fund in Hong Kong, the SFC is prepared to deem UCITS funds, which meet the disclosure and reporting requirements for Article 8 or Article 9 funds under the SFDR, to be compliant with the ESG Circular’s requirements on disclosure (including additional disclosures) and periodic reporting. That said, the SFC retains the discretion to request additional disclosures to better explain the fund’s specific strategies and risks and vary the requirements as it deems fit.
The SFC’s Regulation Of ESG Funds
As ESG investment has become more popular, the Hong Kong market has seen a large number of funds being offered as ESG funds in recent years.
The SFC has continually engaged with fund managers and adapts its requirements to address feedback received. For example, the SFC recently provided guidance to clarify that managers of SFC-authorised Article 8 and 9 funds have discretion to decide whether to include the SFDR pre-contractual disclosures template in their Hong Kong offering documents.
Following the authorisation of the initial wave of ESG funds, the SFC provided further guidance on its expectations of how a fund could demonstrate incorporation of ESG factors as its key investment focus. Such guidance has greatly aided the preparation and authorisation of ESG fund documents, and we have generally seen a reduction in the time required to bring ESG funds to the Hong Kong market.
Challenges And Development
Introducing new regulations will always bring its own challenges, but the SFC has sought to develop regulatory frameworks that are robust and adaptive so as to address the growing needs and risks that will come with the continued rise in popularity of sustainable investing. We expect the SFC to continue with its policy of active engagement and to provide timely guidance to the industry by way of workshops and additional circulars, as well as fine-tuning its regulations to address concerns and challenges faced by the asset management community in Hong Kong.
Despite significant steps forward being made by the introduction of the above measures, there is still much work to be done, particularly on the availability and quality of ESG data and ESG ratings. The lack of standardisation in ESG reporting remains a challenge which makes the comparison of ESG data across different ESG funds difficult. We expect the SFC to issue written guidance for the asset management industry on using and engaging ESG service providers. On ESG reporting, this challenge is not unique to Hong Kong, and we are hopeful that with the emergence of various voluntary frameworks, the continued dialogue between international organisations and regional regulators will bring about some harmonisation and standardisation.
For ESG fund managers, it will be paramount to regularly assess whether a fund’s underlying investments are consistently aligned with its ESG focus and with how its product is described and marketed. This should not be anything new in terms of regulatory compliance. However, it is important for fund managers to develop the necessary processes, controls, data management systems and tools to manage, assess and organise data collected so it can be easily reviewed, evaluated and monitored, as well as to ensure the accuracy of information being reported to regulators and investors alike.
The SFC's regulations on fund managers and ESG funds have strengthened Hong Kong's position as a leading ESG investment hub. However, greater standardisation in ESG reporting and metrics is needed to make it easier for investors to compare ESG funds. The SFC and other regulators are taking active steps to promote standardisation and develop Hong Kong's ESG ecosystem. Nonetheless, creating a vibrant market for ESG products, as well as addressing the pressing problem of climate change, ultimately requires a concerted effort of all stakeholders. The SFC and other regulators in Hong Kong will continue to monitor international developments and enhance Hong Kong’s regulatory and business environment for ESG initiatives.
Ming Chiu Li
Ming Chiu is a Partner at Deacons Financial Services Department in Hong Kong. Ming Chiu holds an LLB degree and a PCLL from the University of Hong Kong and he is qualified in Hong Kong and England and Wales (non practising). Ming Chiu has extensive experience in investment funds, specialising in SFC authorised funds and MPF and pension funds. He also advises clients on a wide range of regulatory and compliance issues that arise in relation to investment management activities and fund operations, under both the SFC and the MPFA regulatory regimes.
Joyce is a Partner at Deacons Financial Services Department in Hong Kong. Joyce holds a BA (Hon) Law degree from the University of Nottingham, a PCLL from the University of Hong Kong and she is qualified in Hong Kong. Joyce has extensive experience in advising asset managers on both Hong Kong retail funds and private funds. Joyce's practice covers SFC authorised Hong Kong domiciled funds and UCITS, Hong Kong open-ended fund companies, and Cayman Islands investment companies. She is also skilled in negotiating and drafting complex fund documentation, advising on regulatory compliance, marketing rules, and fund agreements.