Insert - Poolebeg WastetoEnergy (centre left) incinerator along side chimney stacks of traditional power station (centre right). Interesting story about profitable private public partnership showing how waste is being used to replace fuel. WastetoEnergy.
Note: Cognitive GRC provides services mainly to regulated firms in Hong Kong that provide services to institutional and professional investors only. We work with international service providers to deliver a global service for firms located in Hong Kong. The following topics are raised as part of regular updates we provide to our clients during the year to assist with business planning and should not be considered legal advice. We work with leading service providers to deliver holistic solutions in areas where we have developed unique symbiotic relationships but please note that some of the content below links to other websites and we are not responsible for the content or security of those external sites. Please contact your adviser in relation to any matters raised in this discussion and obtain legal advice where necessary.
Climate Risk Exposure and Engagement in Hong Kong
Unless you have been lost in a landfill a key topic of concern with approaching deadlines for SFC asset managers is climate policy.
It is a highly emotive topic, with contradictions and evangelists dispersed throughout the eco system. Fundamentally the world has a lot of catching up to do to achieve the climate change objectives on all fronts. While there are rules to push the larger members of the financial service industry into action first, the typical pace of implementation of regulatory change is probably too slow to make the difference needed on climate targets and there is a lot more to be done. However, for now, firms will be expected to lean into their moral obligations and at least be involved in the search for a solution.
As a reminder, Hong Kong Large Fund Managers (i.e., Firms with more than HKD8 Billion in Assets under Management and registered with the SFC and responsible for overall fund strategy) have until 20 August 2022 to resolve the key issues (Baseline Requirements) and sub threshold Managers of Collective Investment Schemes have until 20 November 2022 at which point the Large Managers will also need to comply with Enhanced Standards and Disclosures.
Baseline requirements include Governance, Investment Management, Risk Management and Disclosure adaptations to take into account climate risk. If you have the bandwith, it is probably a good idea to consider these adjustments within other updates to ESG (Enviromental Social Governance) obligations such as sustainability, social change or responsible investment policies. If firms have already started to address those either on a voluntary basis or as part of investor requests, it should prove the most efficient as the baseline requirements should track across the different sub-topics of ESG. Indeed, if you have already adopted an appropriate Fund Manager Code of Conduct (FMCC) compliant risk policy, the addition of climate to the list of relevant risks should allow you to address most of the fundamental governance requirements that are being expected. Clients can refer to instructional resources under our datasite portal under Newsletters 2021 (ESG Updates Oct 2021, Supplement A - SFC Climate Risk) for a checklist on what needs to be done.
In order to achieve compliance on investment and risk policy content, the first step for SFC regulated asset managers, who are in control of a fund's strategy, if not already decided, is to determine if climate risks are irrelevant or immaterial, and if not immaterial, to determine the extent of materiality of such risks in their portfolio or potential portfolios. This is part of the investment analysts/risk managers expected duties which will become formally part of the day job of doing investment research on investment exposures for those firms with relevent exposure.
We have been feeding into an industry working group trying to calibrate the terms "relevant" and "material" and expect to see some further industry guidance soon (update: now issued by AIMA) but you can refer to the SFC circular and FAQs on some of the key matters here if you are not already clear about the ambiguity.
Once firms understand the extent that they are exposed to climate risk through their investments, they need to consider how to disclose their exposure level, and then they need to decide the extent they are going to do anything extra to mitigate the material risks (i.e., by engagement, graded activism, or various levels of avoidence of climate risk), other than the short term liquidity related climate risks which they should already be considering as part of the traditional liquidity risk mitigation concerns.
The market is likely to become more sensitive to changes in climate risk as more participants become engaged. Therefore, even if you have limited appetite for this topic, having access to data sets will become more of a must have. but there exists a challenge in obtaining the datasets that will make this a more passive affair. Simply put, they are still under development.
As far as we can see, no financial regulatory authority is mandating engagement (other than what is already part of fiduciary expectations) but the clear message that is starting to resonate from the collective is coming from the ever present mis-selling corner. i.e. If you are chasing green aligned allocation and represent that you are so aligned, you will need to make your position clear and be able to prove what you are doing. This direction of travel is consistent with a renewed focus on marketing disclosures in both Europe and the US. This focus is likely to change as the obligations are being pushed into non-retail focused managers by allocators who wish to enhance their green credentials without giving up on alpha.
In an attempt to put perspective on this, we thought we should start with a basic, minimal effort policy to allow firms to frame the discussion about what the obligations will mean. Under the impending requirements in Hong Kong, where firms determine their exposure is relevant and relatively material, they might wish to say the following with regards to engagement on climate:
We aim to continue to monitor climate risk to the extent extra data becomes available. We will continue to monitor risks in the portfolio, including those climate risks that create exposure to fund liquidity, but we will not be taking additional measures (portfolio construction led, engagement led, or attempting to alter) to reduce impact or enhance sustainability until we have satisfied ourselves that in doing so we will be effective in achieving the stated sustainability aims while also satisfying our current mandate. If our mandate changes through discussion with current investors, we will consider altering our portfolio objectives to satisfy such demands and updating our investors accordingly.
We are not saying that this is the strategy that firms should follow, as some investors may already be expecting firms to be preparing for an engagement phase, but our aim here is to show the possible base position to start from. Even this minimal effort expenditure will require firms to at least monitor their climate risk exposures on an ongoing basis and prove that they will be doing so. In fact, even if you believe that climate risk is irrelevant, you will still need to verify that position on an ongoing basis.
There exists climate risk exposure in most portfolios, no doubt, but the extent that firms are able or indeed willing to adjust their target exposures to achieve some form of combined climate positive adjusted return is a current enigma that requires much deeper thought. It is a conversation that must be had with the investment team as they are in the best position to determine their own abilities and to look at the types of investments that they will be targeting to determine if it is something that they wish to bend their strategy to.
Institutional/Retail managers should have found it somewhat easier to adapt and provide their consumers with a choice in relation to their capital deployment by adjusting the investment policies of assorted products that may be selected. However, it would be a challenge for a firm to claim that they are a responsible investment firm, for example, if they were not offering products that were engaging on climate change. There are also a number of different disclosure conflicts to address under these broadening expectations and firms need to be careful to ensure they are doing what they say they are doing.
Having spent an extended period in Europe, seeing the various advertisements seeking to source investors with social conscience, it is clear that it is indeed possible to offer products with different levels of climate risk exposure. However, for long only/absolute return managers, trying to the find the point at which climate consciousness and positive returns align (due to the current energy market) is a clear dilemma.
Being too aggressively green may risk short term performance issues that will be unlikely to be forgiven, but not doing something will (allegedly) risk reduced allocation as government/green aligned allocators are pressured to seek out strategies that provide verifiable green credentials without giving up on the expected returns.
The argument is that going green will mean greater return [1} as we transition to renewable energy. This indeed may prove true as fossil fuel assets become stranded and new energy technology is on the up but for portfolio managers tracking absolute performance on a shorter term basis the policy transition needs to be handled extremely delicately as it does not necessarily follow on that green will equal better return, at least, in the short term. (Putting the moral point aside for now)
I am reminded of fictional archaeological figure trying to swap over a golden statue for a sandbag by trying to judge the weight of the statue by sight alone. I am sure we want to avoid being chased out of a temple of doom, by a rolling boulder of inevitability, through an obstacle course, only to be met by an coming battelion, of showering poison darts. I may be mixing my references and hyping the hyperbole here but I hope the point is made that a small error in judgement, made in good faith of achieving targets, could lead to significant impact on a firms survival if either over or understated.
International Climate Policy and Mis-selling Risk
The building blocks for compliance are already in place. We can help firms go through the expected processes to achieve compliance on paper. Governance and risk policies can be achieved in line with the updated fund management code of conduct, which should already address the governance expectations under other categories of risk or ESG, but the fundamental data, and the information that needs to be produced by the underlying companies, (to feed into funds, and index exposures) to allow managers to calculate and disclose their relative exposure is still being developed and calibrated as the global industry matures. There are lots of data sets chasing peoples needs but the market is still maturing.
The bottom line with regards to the 2022 SFC deadlines is that firms will need to have an idea of what their policy will be, whether they are going to commit to try and achieve any improvement (i.e., reduction in climate risk exposure), and whether they will be able to objectively demonstrate that they are being successful in doing so (in order to avoid the allegation that they are greenwashing).
It will be extremely easy to criticise any policy as either not enough or too much (and therefore in the greenwashing zone for failure to achieve strategy) in absence of objective benchmarking data in each geographic location.
The difficulty for firms is all too clear when we see that the SEC (Securities and Exchange Commission) is already fining firms (Source SEC, May 2022) for greenwashing while only recently issuing proposed rules (Source ACA Global, March 2022) for issuers to produce energy data. They have only recently updated proposed rules (Source ACA Global, May 2022) for transparency on ESG for investment advisers that have a longer horizon than some of the SFC advisor expectations. There is also a more general proposal on naming conventions for funds which is relevant to mis-selling/greenwashing (Source ACA Global, May 2022) on the usage of fund names to focus on the idea that the portfolio must be delivering what it describes itself as (be it climate, social impact, or governance etc). There are certain similarities to the SFC requirements on climate (as they come from the same governance groups), but the SEC has clearly considered that they need to get the issuers to provide the initial data for this to work better and they have outlined a more reasonable timeline for this to be achieved. But they have done this without taking their foot off the enforcement pedal for mis-selling/greenwashing.
Regulators are aware of the challenge. On sustainable investment; regulatory priorities the SFC's CEO, referencing IOSCO's 2020 report on sustainable financing, which recognised the urgent need to improve consistency, comparability and reliability of sustainability reporting at the corporate level, brings up the key importance of jurisdictional interoperability and puts forth the International Sustainability Standards Board (ISSB) as the solution. In this speech, it is recognised that issuers cannot be expected to be compliant with the disclosure standards on day one. However, the silence on how that impacts manager who are trying to achieve requirements with a tighter deadline is telling. [Updated 28/06/2022 - See further updates in synopsis of latest speech by SFC CEO at IFRS Conference]
We hope (and expect based on general approach that we see the regulator take) that as a result, at least for the boutique, single strategy firms, that enforcement of the requirements in Hong Kong will be proportionately applied to allow time for jurisdictional interoperability to be achieved and for the market to catch up on the data gaps. {Updated 28/06/2022 - See further commentary on data market from ESMA released 27/06/2022 for state of data market in ESG]
Mis-selling is always going to be an issue for regulators but as long as you can demonstrate that you are doing what you are saying you will be doing, with whatever data is available at the time, we can only hope that you will be given the benefit of the subjectivity that currently exists in certain markets due to the absence of reliable data. This will obviously change over time.
Navigating climate change obligations
None of these existing challenges are likely to be accepted as reasons not to have conducted the the base analysis but it is worth knowing that there are limits to what may be concluded. Relying on the larger firms to light the runway may not be the best approach either as they have a lot more fossils to burn on this topic, while waiting to see what others are doing is also potentially dangerous.
Managers indeed have a part to play in finding the solution but small to medium size managers, with single strategies, need to be given more flexibility in trying to remain in existence while also seeking to participate in the solution.
Larger managers have been given the lead, but their institutional approach might not match the needs of the smaller firms, in a way that will lend itself to a copying out approach. It is not impossible to successfully find a solution and implement a self developed solution, it is just it is a difficult ask in absence of raw data or analysis in the market (There is data, but as far as it goes, it is not yet there, either incomplete or inconsistent across geographic locations, and not yet properly priced).
Therefore, for a lot of boutique firms, without institutional backing, to address the challenge properly, in absence of quality data, it could mean creating a whole department that would double a firms size.
It is more likely that firms will need to enlist support and/or at least mean a separate and sustained project over a multi-year target to achieve a reasonable outcome in line with the global efforts and in line with the approaches expected in other countries. Firms are unlikely to have the resources or appetitte to re-invent the wheel and it is likely that the expertise that has been nurtured in the retail industry is becoming available to support such projects.
We applaud those who have invested in this thus far, as they have recognised the magnitude of the task but are probably limiting the extent of thier disclosures for obvious reasons. We are highlighting the significant challenge for firms to acheive the right balance, while everything else is going on.
Doing nothing is not an option. Finding out what your base exposure is, is important but as the data is not completely available across all markets/issuers, this process will involve data gathering across a firm's investments/investment universe and recording the analysis that has been done.
Some analysts will already have collected the relevant information about the companies that they are investing in but some may have not. Therefore, a good practice will be to poll them on the stocks that they cover to see where they are right now. This is a start.
Unless completely irrelevant to the types of companies that firms invest in or the strategy they follow, firms will need to do a materiality assessment.
In absence of available independent data, firms may need to consider developing their own risk assessments (i.e. the ones which are not yet producing the required data themselves). As nobody can predict the pace at which the data will become more widely available or complete (at least within this year), its seems that the prudent approach would be to identify the data gap in your current portfolio profile and work out how much work will be necessary to plug that gap so that you plan enough time to be able to do so. To wait and see will become a less viable approach as the deadline approaches.
Firms will need to disclose the extent to which they are committed to a strategy by the deadline, but we suspect that at least in the initial stage, they can pre-empt the charge of greenwashing by highlighting all the points for which they cannot form a measurable or determinable position on.
The key control obligation is that you will need to record what you are doing, and what you are saying you are going to do and track that. This is not much different than what was introduced in the FMCC for the other risk categories and can be dealt with by internal reporting and record keeping of the discussions you have on what you are doing.
On the level of engagement, depending on what you commit to, in the short term at least, you may need to consider giving up some alpha targets (e.g. Oil Prices are going up) to satisfy some investors need for access to more green accredited firms/investments. The door is left open to promte a less commited strategy and run the risk of subjective judgement or simply the uncertainty that it will bring.
As you know, forgiveness for an absence of performance is not something that you would typically wish to be seeking, in particular, when the arbitrator of allocation will remain to be your investors, during a challenging environment. Therefore the decision on commitment cannot be lightly taken.
We can guide firms that have not already implemented a full risk programme, through the policy and procedure changes, but those persons appointed to lead the charge will need to engage with their investment teams to address the fundamental strategy points around climate risk as it will become part of the ongoing oversight on portfolios for the future.
These determinations will have an impact on the outcomes and given their importance it is probably not best left to the last minute. We also expect that the experienced climate risk specialists will become a scare resource themselves as the deadlines approach.
Clients may find our basic resources on ESG and Climate change via datasite under Newsletters for 2021. This includes guidance and framework documentation for your consideration. Please reach out to your consultant to discuss your plans as we have more indepth analysis and can put you in touch with the right people to address more technical and immediate climate risk needs (Redlinks/ACA Global/Data Providers).
We are happy to help you confirm your plans sooner rather than later. as ideally despite the absence of data you should be able to get most of the policy work done ahead of the deadlines but it will definately be an ongoing theme.
With August approaching at pace, there is likely to be significant updates following that deadline. Non-ongoing customers can enquire directly with us at info@cognitivegrc.com
[1] There is data to support that retail funds can achieve greater return over periods but typically this is based on longer term projections on retail/diversified funds with different characteristics. It is not yet clear whether this will mean that same for more concentrated portfolios. It would be too general to make that claim for conviction led portfolio structures which if not long term in nature may have variable exposure to climate risk exposed investments/sectors through the life of their portfolios.