Peter Godwin, Glynn Cooper, Azlin Ahmad and John Patrick Angus

Bank Negara Malaysia (“Bank Negara“) has recently announced this month that it will soon be finalising a Climate Change and Principle-based Taxonomy (“Taxonomy“) which aims to provide a common language to categorise economic activities based on their impact on climate change and facilitate financial flows to activities that support the transition to a lower carbon economy. While the Taxonomy will serve as a guide to all institutions supervised by Bank Negara (which include licensed banks, investment banks, international Islamic banks, development financial institutions and insurers), it may also be used as a reference point by other players in the financial system such as asset management companies, rating agencies and research houses.

Background

Malaysia is a signatory to the 2015 Paris Agreement and has committed an unconditional reduction of greenhouse gas (“GHG”) emission intensity of 35% by 2030 from its 2005 baseline, with a further 10% reduction upon receipt of climate finance, technology transfer, and capacity building from developed countries. The introduction of the Taxonomy evinces Malaysia’s continued efforts towards fulfilling this commitment, and adds to the growing list of guidelines, standards and initiatives which have been introduced in the market.

In the last few years, the focus has been in the debt capital markets space with the implementation of the Sustainable and Responsible Investment Sukuk framework in 2016, the ASEAN Green Bonds Standards in 2017, and the ASEAN Social Bond Standards and ASEAN Sustainability Bond Standards in 2018.  More recently however, the measures implemented have been far broader. In November 2019, Bank Negara issued the Value-based Intermediation (“VBI”) Financing and Investment Impact Assessment Framework (“VBI Framework”), which aimed to facilitate the implementation of an impact-based risk management system for assessing the financing and investment activities of Islamic financial institutions in line with their respective VBI commitments. It also serves as a reference for other financial institutions intending to incorporate environmental, social and governance (“ESG”) risk considerations in their own risk management systems. Since the introduction of the VBI Framework, various guidance documents have been developed to encourage the adoption of VBI. In August this year, the VBI Framework Sectoral Guides on Palm Oil, Renewable Energy and Energy Efficiency were issued to guide financial institutions in implementing the VBI Framework on these sectors at a more granular and transactional level.

Overview of the Taxonomy

The Taxonomy will build on and extend the VBI Framework with a specific focus on climate change and its impact to the wider financial system. Based on the discussion paper issued by Bank Negara, the Taxonomy’s objectives are to:

1. increase awareness and actively respond to climate change
2. identify economic activities that contribute to climate change objectives; and
3. prepare and build capabilities in managing the financial risks from climate change.

Financial institutions are to assess an economic activity and its impact to the broader environment based on the following guiding principles:

1. Climate change mitigation – an assessment of whether the economic activity avoids or reduces GHG emissions
2. Climate change adaption – an assessment of whether the economic activity increases resilience in order to withstand the negative physical effects of current and future climate change
3. No significant harm to the environment – adequate consideration of the impact on the wider ecosystem where the economic activity takes place
4. Remedial efforts to promote transition – financial institutions are expected to take into account the remedial efforts and improvement programmes undertaken by businesses
5. Prohibited activities – financial institutions must verify and ensure that the economic activities are not illegal and do not contravene environmental laws

Applying the above guiding principles, economic activities can be classified and ranked into six categories. Economic activities which support substantial reduction or avoidance of GHG emissions and increase resilience to mitigate the physical effects of climate change are placed at the highest end of the spectrum while economic activities which are involved in prohibited activities are (unsurprisingly) placed at the lowest end of the spectrum. Consideration is also given to whether the business has demonstrated commitment and willingness to improve practices.

The introduction of a consistent and systematic classification of economic activities can help facilitate and promote the channelling of financial flows to activities that support the mitigation and adaptation of climate change including transition towards low carbon and climate resilient businesses. It presents opportunities to financial institutions to nurture businesses by promoting sustainable solutions. While it does not mean that access to funding will be refused to businesses at the lower end of the green spectrum, it is clear that financial institutions will be expected to help them transition towards more sustainable practices.

What will this mean for financial institutions and businesses?

With the introduction of the VBI Framework and the Taxonomy, the message is clear – financial institutions are expected to play their part in pursuing climate action and helping Malaysia fulfil its commitment to reduce GHG emissions. Financial institutions will be expected to integrate climate-related risks and considerations into their business strategies and risk management practices.

The increased spotlight on financial institutions and their investment decisions will have a knock-on effect on business in general. Given the dire economic outlook in light of the current pandemic, banks are tightening their lending requirements and will be less keen to invest in economic activities which are considered to be less sustainable. Businesses will therefore need to improve their practices or risk losing access to cheaper sources of funding or any funding at all.

The finalisation of the Taxonomy is only one of the myriad of developments in climate action. There are other developments in the pipeline. The next VBI Framework Sectoral Guides on Manufacturing, Oil and Gas, Infrastructure and Construction are targeted for issuance in 2021. Bank Negara is also planning for financial institutions to provide more enhanced climate-related disclosure in the near future. This would assist external stakeholders in holding financial institutions to account for their climate risk commitments and investment decisions.

Given the rapid pace of developments in the sustainable finance space, financial institutions and businesses alike would be well advised to keep pace or risk falling behind and placing themselves at a competitive disadvantage. Industry players will need to be proactive rather than reactive in their approach to climate action. While the immediate priority has been to focus on dealing with the challenges caused by the pandemic, they must not lose sight of the long-term goal to ensure  a better and more sustainable future for all.

Disclaimer

Herbert Smith Freehills LLP is licensed to operate as a Qualified Foreign Law Firm in Malaysia. Where advice on Malaysian law is required, we will refer the matter to and work with licensed Malaysian law practices where necessary.