HKMA says banks need to take on climate risks and spells out expectations

The Hong Kong Monetary Authority (HKMA)’s offices sit on the 55th floor of the city's glistening International Financial Centre, some 200 metres above Victoria Harbour and far beyond even the most pessimistic projections by climate scientists for rising sea levels. But a recent flow of HKMA papers shows that, even from this distant perch, Hong Kong’s banking regulator is keenly aware that the landscape it surveys is not immune from climate risks:

• On 30 June 2020, the HKMA published a 40-page white paper on green and sustainable banking (White Paper), setting out its initial (but concrete and tangible) thoughts, expectations and recommendations for how authorised institutions (AIs) can improve their management of climate risks.
• On 7 July 2020, the White Paper was later supplemented by an HKMA circular (and Annex) (Circular), in which the HKMA seeks to “inspire” (rather than to “prescribe”) AIs to develop good practices in managing climate risks.

Tackling climate risks is increasingly seen as a priority by many banking regulators globally, and the HKMA is not alone in setting out clear expectations for banks on this topic. In the past few months, we have seen the European Central Bank (ECB) and the Monetary Authority of Singapore (MAS) consulting on their respective supervisory guidelines on managing climate risks for banks and other financial services firms. In addition, the UK’s Prudential Regulation Authority (PRA) published its own concise set of supervisory expectations  (read our blog post here) and has much more recently said that it expects banks to fully embed their approach to climate risk management by 2021 (read our blog post here).

What are climate risks?

Broadly and simply, "climate risks" can cover any risks posed by climate change. For the HKMA (and other banking regulators), the scope is narrower, as it focuses on those risks that could impact the value and financial health of banks, or which could cause disruption to banks’ business activities and customers. 

The HKMA broadly categorises climate risks into three buckets: 

1. Physical risks include those arising from climate events which might disrupt physical operations. 
2. Transition risks include financial risks which can result from the process of adjusting towards a lower-carbon economy, such as the risk of assets becoming “stranded” (ie facing unanticipated write-downs, devaluations or conversion to liabilities) due to changes in climate policy and/or technological innovation. 
3. Liability risks are associated with emerging legal cases related to climate change, including those seeking compensation from financial institutions for loss and damages caused by climate change.

What are the HKMA supervisory expectations? And how are they different from other jurisdictions? 

The general thrust of the regulatory guidance we mentioned above is clear: banks must institutionalise their monitoring and management of climate-related risks. The supervisory expectations of the regulators in HK, the EU, Singapore and the UK are well aligned, all placing an emphasis on board responsibility, the structure and operations of banks, and climate risk assessment and management.

The White Paper sets out the HKMA’s expectations in the form of nine guiding principles in four broad areas:

Area 1: governance 

The board should be primarily responsible for an AI’s climate resilience and should oversee the AI’s climate strategy development and the incorporation of climate risks into the AI’s risk management framework. 

The HKMA has suggested that banks may consider linking the remuneration of board members and senior management with the AI’s sustainability objectives. This point was also raised in the ECB supervisory guidelines, although not similarly mirrored by the regulators in Singapore and the UK (perhaps unsurprisingly, given the long-standing criticism of the EU’s “banker’s bonus” rules by senior UK figures).

Area 2: strategy

Climate considerations should be embedded into business strategy, and climate strategy should be integrated into business operation and corporate development. In particular, the HKMA said that the use of scenario analysis (ie exploring the impact of alternatives to the bank’s “business as usual” planning assumptions) is particularly relevant to the formulation of a climate strategy and an action plan. This emphasis on scenario analysis is similarly reflected in the frameworks we have seen in the EU, Singapore and the UK. However, unlike the UK’s PRA, the HKMA has not indicated that it will suggest what alternative scenarios banks should consider, meaning there may be more scope for a range of practices to develop.

Area 3: risk management 

Climate risk considerations should be incorporated into a bank’s risk management framework, with effective risk management processes to identify, measure, monitor, report, control and mitigate both physical and transition climate risks (explained under “what are climate risks” above). Other regulators’ expectations are similar to those in the White Paper, although with slight differences: 

• in the EU, the ECB has an additional expectation on financial institutions to comply with other EU-level policies and international initiatives (e.g. when conducting climate-related and environmental due diligence).
• in Singapore, although the HKMA and the MAS both encourage banks to identify industry sectors and clients that are more vulnerable to climate risks, the MAS has gone a step further in suggesting that “banks should develop sector-specific [climate risk management] policies, which clearly articulate the bank’s expectations towards an existing or prospective customer, and where possible, take into account internationally recognised sustainability standards and certificate scheme, as well as the customer’s strategy to manage its environmental risk”.

Area 4: disclosure

AIs should disclose climate-related information to enhance transparency, and they should refer to international initiatives and frameworks when considering what information to disclose. 

As a starting point, the HKMA specified two areas in relation to which disclosure should be prioritised – “governance” (eg an AI’s governance and oversight regarding climate risks) and “risk management” (eg an AI’s climate risk management process). Failure to make disclosures in these two areas may trigger a “comply or explain” obligation for AIs. 

Notably, the ECB and the MAS have not adopted a similar “comply or explain” approach in their disclosure frameworks. Although the UK Financial Conduct Authority (FCA) is currently consulting on a “comply or explain” reporting approach for climate-related disclosures, this proposed approach only applies to commercial companies with a premium listing and does not target financial institutions generally (see Disclosure Chapter of the Climate Financial Risk Forum Guide and the FCA’s consultation paper for more details).

Who do the HKMA supervisory expectations apply to?

We have seen the HKMA taking a careful and pragmatic approach in applying its supervisory expectations – the nine guiding principles apply to all AIs, but on a proportionate basis, taking into account various factors such as the size, nature of business, complexity of operations etc. of the AIs. The HKMA also said that its initial focus is on the larger AIs with greater impact on the Hong Kong economy and financial system.

This pragmatic approach can also be seen from the HKMA’s views on AIs which are local subsidiaries or branches of foreign banks. According to the White Paper, local subsidiaries or branches may adopt their group or parent policy and practice to manage climate risks as long as these are sufficient for meeting the HKMA’s expectations, but any local variations should be “addressed in a way that is commensurate with the size, nature of business, and complexity of operation of the Hong Kong office”. 

One example of the HKMA’s proportionate approach can be seen in how it will apply the disclosure principle to Hong Kong subsidiaries/branches of foreign banks: for local subsidiaries, the HKMA thinks that there are merits for them “to make specific disclosures concerning their approach to climate-related risks and mitigating actions expressly for the Hong Kong operations”, whereas for local branches, the HKMA thinks that “the need for such specific disclosures about the Hong Kong operations appears less compelling as there may not be a standalone governance framework and strategy for the Hong Kong operations”.

HK’s journey towards green and sustainable banking – where are we now and what is coming up next?

The publication of the White Paper forms part of the second phase of the HKMA’s three-phased roadmap to green and sustainable banking. The HKMA has already set its “Greenness Baseline” and initiated a self-assessment exercise among AIs. It may further refine the design of its supervisory expectations and requirements when it receives the self-assessment results. 

The HKMA is also planning to formally consult on its supervisory expectations and requirements in the first half of 2021. Based on the current timetable published in the White Paper (see below), we are likely to see the formal implementation of its supervisory expectations and requirements in 2022.

One final point to note is that the HKMA’s efforts to push the Hong Kong financial sector to better address climate-related risks are not just limited to pulling levers as the city’s banking regulator. The HKMA is also a quasi-central bank, an asset manager and an investor (in fact, one of the world’s largest) and intends to lead the financial industry by example.

We have seen the HKMA taking committed steps, such as setting itself a guiding principle to give priority to green and ESG investments and taking into account ESG factors in the selection, appointment and monitoring of its external managers. Although this is consistent with the global trend towards greater adoption of ESG investments, it is interesting to contrast the HKMA’s approach with the recent US proposal to restrict pension administrators’ ability to prioritise ESG investments/non-financial objectives (read more here).

We expect the HKMA’s recent steps to be the first of many as it continues promoting green finance and climate risk management in the financial sector long into the future.