On the face of it, financial markets and energy transition do not seem like natural bedfellows.
Traditionally there has been a tendency to see financial markets as largely driven by the need to create short-term returns for investors, rather than being a valuable tool in finding long-term solutions to the climate crisis.
However, with increasing focus on the environmental, social and governance (ESG) agenda, perceptions are changing.
It is clear that regulators, policymakers, investors and financial institutions see that sustainable finance strategies can be the key to mobilizing the trillions of dollars of capital needed to decarbonize the global economy.
To date, markets like the EU have taken the lead and made invaluable contributions in developing the sustainable finance agenda.
Other jurisdictions are taking action too, however, with the UAE leading the field in the Middle East.
Net Zero and an issue of supply and demand
The UAE was the first country in the Middle East to commit to achieving net zero by 2050, a commitment which is being applied to both private and public sector bodies.
In order to meet this deadline, big private sector organizations are beginning to put their own Net Zero plans and policies in place.
Meanwhile, wealthy regional and domestic investors conscious of the need to tackle climate change are looking for opportunities to make a difference and invest in genuinely sustainable financial products.
But these are early days for ESG investing and the demand for sustainable financial products and services currently outstrips supply. While that’s the case, there is a clear moral hazard that products will be brought to market which claim to be sustainable, but really do not come close to qualifying for that label.
Regulators are therefore increasingly looking for solutions that will offer investors real certainty that their money is having the positive impact that they want, and are taking steps to combat greenwashing by financial institutions.
At the same time, they are trying to balance necessary intervention with the need to stimulate the development of a much wider range of sustainable investment opportunities, acutely aware that overzealous action could stifle innovation and have other unintended consequences.
It’s a fine balancing act, but progress can be expedited by the way financial services are governed within the country.
The role of free zones
The UAE has three distinct financial services regimes – two “offshore” regimes located within financial free zones (FFZs), set up in both Abu Dhabi and Dubai, and one “onshore” regime covering all of the UAE outside the FFZs.
The onshore regime is regulated by the Securities and Commodities Authority, and has the look and feel of a more traditional Middle Eastern financial services market.
For the FFZs, the Abu Dhabi Global Market (ADGM) is regulated by the Financial Services Regulatory Authority, while the Dubai International Financial Centre (DIFC) is regulated by the Dubai Financial Services Authority.
The ADGM and DIFC are governed by their own financial services laws and regulations, predicated on English law. The FFZs tend to be more nimble than the onshore regime in bringing about new regimes to cover novel investment products, practices and services.
This is principally due to the FFZs’ nature as global and regional platforms for the provision of investment services, where resident firms will more typically be focused on serving an international and sophisticated client base rather than retail clients in need of greater protection. The FFZs are consequently where we are seeing the quickest progress in the development of sustainable finance regimes.
This being the case, we are also seeing efforts to develop best practices between the UAE’s three financial services regimes through the Sustainable Finance Working Group (SFWG), which includes regulators, stock exchanges and other relevant public bodies.
The Group provides a platform for collaboration and aims to promote greater regulatory consistency across the UAE. Amongst other things, the SFWG has advanced sustainable finance reforms in the UAE by promoting ESG risk management and governance, and in September 2023 has proposed principles for sustainability-related disclosures made by certain participants in financial markets.
The proposed principles, which are subject to consultation at the time of writing, are intended to represent a common declaration of understanding between SFWG members that will guide the implementation of specific disclosure frameworks within their respective jurisdictions.
The ADGM sets the pace
Whilst many groups in the UAE continue to make valuable contributions to the sustainable finance agenda, the ADGM and its financial services regulator appear to be the current leader in the field. A good example of progress spearheaded by the ADGM’s Financial Services Regulatory Authority is its implementation of a new labelling framework for ‘green’ and ‘climate transition’-aligned funds and segregated portfolios.
The labelling framework represents a voluntary initiative for funds or segregated mandate services to demonstrate their sustainable finance credentials by qualifying for either a ‘green’ or ‘climate transition’ designation endorsed by the ADGM. To qualify, funds or portfolios must meet certain ‘green’ or ‘climate transition’ criteria attached to the assets invested in, compliance with which is verified by a third party.
An applicant must prove that a majority percentage of the assets in the fund are invested in ‘green’ or ‘climate transition’ projects as well as meeting a restrictive criteria to not invest in assets deemed to run counter to the fund or portfolio’s ‘green’ or ‘climate transition’ objectives.
For determining what constitutes an asset that furthers the ‘green’ or ‘climate transition’ agenda, it is worth noting that the UAE has not yet developed its own taxonomy of the sort that underpins regulation in other markets.
In the short term, the ADGM has sought to leverage taxonomies already developed elsewhere in the world, and institutions are invited to measure their products against standards and benchmarks that are widely accepted as credible.
Where next for ESG in the UAE?
It remains to be seen whether the UAE will ultimately decide to develop an ESG taxonomy of its own, rather than use existing and credible frameworks developed elsewhere. In our experience, the FFZs are pragmatic and will generally not see value in reinventing the wheel where this comes at the cost of implementing needed regulation quickly.
A key challenge we see is the trend in many markets to view ESG holistically and combine the three elements into one agenda. This may cause problems where investments furthering one of the three elements of the ESG agenda may concurrently run counter to another.
Further, even the most sophisticated regulatory regimes have yet to develop convincing taxonomies, particularly around the ‘social’ element to ESG. Differences in culture and values may also impede development of a truly global consensus of what constitutes impactful investment on the social level and could lead to that element falling by the wayside in favor of the ‘green’ agenda.
Consequently, the question for regulators in the UAE is whether they follow the trend of combining all three elements of ESG in their financial regulations – something that financial institutions will be accustomed to seeing in other markets – or decide to separate the ‘E’, ‘S’, and ‘G’ out into their constituent parts and develop regulation on that basis.
It is an issue that we know regulators worldwide are grappling with, and for our view, on this basis the direction taken in the UAE to first tackle the environmental agenda in isolation is justified.
A more nuanced approach to ESG that separates the three elements and addresses each individually could be an innovative step for the UAE to take. It’s one that may potentially avoid some of the pitfalls and trade-offs that have led to what we perceive as a lack of development on the social dimension in other markets.
Whether the UAE will pursue this path, and how it will balance the interests and expectations of its diverse stakeholders, remains to be seen.
