ESG Investing and Sustainable Finance Funds in Hong Kong: Regulatory Framework

Introduction

Environmental, social, and governance (ESG) investing has moved from a niche strategy to a mainstream investment approach, with global assets under management in ESG-oriented funds reaching trillions of dollars. In Hong Kong, the regulatory framework for ESG funds has developed rapidly under the Securities and Futures Commission (SFC) and the Hong Kong Exchanges and Clearing Limited (HKEX), creating clear disclosure and governance requirements for fund managers who wish to offer ESG-labelled products to investors.

This article examines the SFC's regulatory framework for ESG funds in Hong Kong, the greenwashing risks that fund managers must manage, the classification approaches used for different types of ESG funds, and the sustainability reporting requirements that apply to listed companies and fund issuers.

The SFC's ESG Fund Framework

Circular on ESG Funds (2021)

The SFC issued a landmark circular to management companies of SFC-authorised unit trusts and mutual funds on environmental, social, and governance funds in June 2021. The circular established disclosure and reporting requirements for funds that use ESG factors as their key investment focus.

The circular defines an ESG fund as a fund that, in its name, investment objective, strategy, or policy, focuses on one or more ESG factors. It requires fund managers to make additional disclosures about their ESG-specific investment focus, related risks, and how ESG factors are incorporated in investment and risk management processes. These disclosures must be included in the fund's offering documents and annual reports.

Enhanced Requirements (2023 Circular)

The SFC issued a further circular in January 2023 setting out enhanced requirements for ESG funds, effective from 1 January 2024. The enhanced requirements address concerns about greenwashing and introduce more rigorous standards for ESG-related disclosures and portfolio management.

Key elements of the 2023 circular include:

Binding investment focus: The investment focus of an ESG fund must be binding — meaning that the fund must follow the ESG-related investment strategy stated in its offering documents in a substantive manner, not merely as a secondary consideration.

Baseline minimum portfolio requirement: Except for funds with exclusion strategies only, at least 70% of a fund's net asset value must be invested in assets aligned with the ESG investment focus stated in the offering documents. This baseline minimum portfolio requirement ensures that ESG labelling is backed by genuine portfolio construction.

Periodic assessment: Fund managers must conduct periodic assessments of the portfolio's alignment with the ESG investment focus, at least annually. The assessment must consider material changes in the ESG characteristics of portfolio holdings and must document how any deviations from the target allocation are managed.

Investment strategy disclosure: Offering documents must clearly disclose the types of ESG investments made, the specific ESG factors considered, the ESG data sources and methodologies used, and the engagement and stewardship approach adopted.

Categories of ESG Funds

ESG funds use a variety of investment approaches, which the SFC and global standard-setters categorise differently:

Exclusionary Screening Funds

Exclusionary screening funds (also known as negative screening funds) avoid investment in companies or sectors that are inconsistent with specified ESG criteria. Common exclusions include tobacco producers, weapons manufacturers, gambling operators, and companies involved in thermal coal extraction. Exclusionary screening is the simplest and most traditional form of ESG investing.

ESG Integration Funds

ESG integration funds incorporate ESG factors into their fundamental investment analysis alongside conventional financial factors. The premise is that companies with superior ESG profiles are better managed, face fewer regulatory and reputational risks, and may therefore generate superior risk-adjusted returns over the long term. ESG integration does not necessarily mean that non-ESG investments are excluded, only that ESG factors are explicitly considered in the investment decision.

Thematic ESG Funds

Thematic ESG funds focus on investment themes related to specific environmental or social objectives, such as renewable energy, clean water, sustainable agriculture, or gender diversity. Thematic funds may invest in companies across multiple sectors that are connected by the relevant ESG theme.

Impact Funds

Impact funds seek to generate measurable positive environmental or social outcomes alongside financial returns. Impact investing requires that the fund manager set specific, measurable impact objectives, invest in assets that directly contribute to those objectives, and report on the achievement of impact outcomes.

Sustainable Funds

Some funds adopt sustainable investment frameworks, such as the UN Sustainable Development Goals (SDGs) or the EU's Sustainable Finance Disclosure Regulation (SFDR) categories, as the basis for their ESG approach. While SFDR is an EU regulation and does not directly apply in Hong Kong, many institutional investors in Hong Kong funds are familiar with the SFDR framework and may use it as a reference point in due diligence discussions.

Greenwashing Risks

Greenwashing — the practice of overstating or misrepresenting the ESG credentials of a fund or investment — is a significant regulatory concern for the SFC. Greenwashing misleads investors, undermines confidence in ESG products, and distorts capital allocation towards activities that are not genuinely sustainable.

SFC Enforcement Focus

The SFC has indicated that it is monitoring ESG fund disclosures closely and has the power to require fund managers to amend misleading disclosures or to revoke the authorisation of funds that do not meet ESG disclosure requirements. Fund managers should treat ESG disclosures with the same rigour as any other regulated disclosure obligation.

Practical Greenwashing Risks

Greenwashing risks arise in several common scenarios: using ESG-related terms in a fund's name without substantive ESG investment criteria; making broad ESG claims in marketing materials without specific disclosure of the underlying investment approach; citing ESG ratings from third-party data providers without assessing the methodology and limitations of those ratings; and claiming to engage with portfolio companies on ESG issues without implementing a robust and documented engagement programme.

HKEX Sustainability Reporting Requirements

The Hong Kong Exchanges and Clearing Limited (HKEX) requires listed companies to report on environmental and social performance under the ESG Reporting Guide. The current requirements include mandatory disclosure of certain climate-related information for Main Board listed companies, aligned with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

HKEX has introduced mandatory TCFD-aligned climate disclosures for large-cap issuers from 2023 and is extending the requirements to all Main Board issuers. The new sustainability reporting requirements, aligned with the International Sustainability Standards Board (ISSB) frameworks, are expected to further elevate the quality and comparability of ESG-related disclosures by Hong Kong-listed companies.

Climate Risk Management for Fund Managers

The SFC issued a circular in August 2021 requiring large fund managers to incorporate climate-related risks into their investment and risk management processes. Large managers (defined as those with AUM of HKD 4 billion or more) are subject to governance, strategy, risk management, and metrics requirements aligned with the TCFD framework. The requirements include:

Governance: Fund managers must establish board-level oversight of climate-related risks and opportunities, with clear management responsibilities and reporting lines.

Strategy: Managers must identify the actual and potential impacts of climate-related risks and opportunities on the fund's investment strategies and consider climate scenarios in assessing portfolio resilience.

Risk Management: Managers must integrate climate-related risk assessment into their investment and risk management processes, including due diligence on new investments and ongoing monitoring of portfolio holdings.

Metrics and Targets: Managers must disclose the metrics used to assess climate-related risks and opportunities, including greenhouse gas emissions data where available, and any climate-related targets they have adopted.

Stewardship and Shareholder Engagement

ESG-focused fund managers are expected to adopt active stewardship approaches, including engaging with portfolio companies on material ESG risks, voting at shareholder meetings in a manner consistent with ESG principles, and escalating concerns through dialogue, public statements, or divestment where appropriate. The SFC's Principles of Responsible Ownership encourage managers to adopt and disclose stewardship policies and to report on their stewardship activities.

Conclusion

The regulatory framework for ESG funds in Hong Kong has matured significantly in recent years, and fund managers who wish to offer ESG-labelled products must invest in robust ESG data, disclosure infrastructure, and portfolio management capabilities. Greenwashing risks are real and the SFC's enforcement focus is increasing.

Alan Wong LLP's investment funds team advises fund managers, institutional investors, and listed companies on all aspects of ESG regulation in Hong Kong, from ESG fund structuring and disclosure compliance to HKEX sustainability reporting and TCFD implementation. We help our clients navigate the evolving ESG landscape with confidence and commercial clarity.