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The regulatory framework behind ESG Lending in Kenya

2023-04-25

The regulatory framework behind ESG Lending in Kenya

Background

In our previous article, we gave a brief introduction to an increasingly significant and novel component in the financial sector, ESG Lending. In this week’s article, we shall expound further on the regulatory framework behind ESG Lending in Kenya. 

Introduction

 The Constitution of Kenya sets out a commitment to an ecologically sustainable development and a clean, safe environment for all. The right to a clean environment is enshrined as a fundamental right under Article 42 of the Constitution while the right to economic and social rights are provided for under Article 43 of the Constitution.  Additionally, Article 69 of the Constitution creates and obligation on the State to protect and conserve the environment.

In Kenya, there are various industry players in the business of providing lending services. They include: banks, financial institutions, microfinance institutions, digital lenders, SACCOs and co-operative societies etc. However, for the purpose of this article, our focus shall be on banks and financial institutions.  

ESG Lending is an impactful concept in the financial sector which is rapidly gaining traction due to the awareness and goodwill of all the stakeholders in alleviating the negative effects of climate change. Given its novelty, there is currently no specific regulatory framework for ESG Lending in Kenya, meaning that financial institutions must rely on general regulations and guidelines to ensure compliance with ESG principles.

Analysis of the regulatory framework governing ESG Lending in Kenya

Below, we highlight several regulations, guidelines, circulars and directives issued by the primary regulator, the Central Bank of Kenya and other industry players which relate to ESG Lending: 

  1. Guidance on Climate-Related Risk Management

The Central Bank of Kenya (“CBK”) is responsible for inter alia regulating and supervising all financial institutions in the country. In regulating the conduct of banks and financial institutions, CBK is mandated to issue regulations, issue guidelines, circulars and directives. The CBK issued a Guidance on Climate Related Risk Management (GCRRM) on 15th October 2021. The primary objective of these guidelines is to assist banks and financial institutions in their governance, strategy and risk management frameworks. 

The guidance aims to ensure the Bank’s internal processes mitigate exposures and asset deterioration, while maximizing the financing and risk management business opportunities presented by the transition to a green and/or blue and circular economy that is aligned to the Paris Agreement. 

Further, the guidance is aimed at steering financial institutions to manage their climate-related risks by integrating climate related risk management into their business decisions and activities. In addition, it provides institutions with a roadmap to integrate climate-related risks in their decision-making frameworks. 

It also  sets out some basic requirements that institutions should consider adopting, to effectively entrench climate-related financial risks in their risk management frameworks and provides for mandatory reporting by financial institutions to the CBK.

In summary, the purpose of these guidance is to: 

  1. embed the consideration of the financial risks from climate change in their governance arrangements; 
  2. incorporate the financial risks from climate change into their existing financial risk management practice; and
  3. develop an approach to disclosure on the financial risks from climate change.
  1. Internal Capital Adequacy Assessment Process (ICAAP)

In 2013, the Central Bank of Kenya introduced the ICAAP in accordance with the requirements of Clause 4.4 of the Central Bank of Kenya Prudential Guideline on Capital Adequacy (CBK/PG/03) to regulate the banking sector and ensure  inter alia capital adequacy and better risk management. ICAAP is the formal process through which a bank identifies, measures, aggregates and monitors material risk, to ultimately build a risk profile that becomes the basis for allocating capital.  

As a result, financial institutions are expected to include climate risks among the risks they are exposed to and if assessed material, capital should be set aside to cater for the same. 

  1. Kenya Bankers Association (KBA) Sustainable Finance (SFI) Guiding Principles.

In 2015, the Kenya Bankers Association issued the KBA Sustainable Finance (SFI) Guiding Principles which is a guide for Banks to create long-term value for their clients, firm, economy and the environment. 

The SFI Guiding Principles inform banks and financial institutions on how to optimize the balance of their business goals with the economy’s future priorities and socio-environmental concerns to ensure sustainable banking. 

These principles include: 

  1. Financial Returns versus Economic Viability

Financial viability is necessary from an investment perspective but not a sufficient condition for sustainable economic development. Hence, banking institutions should consider both financial returns and the economic viability of their financing activities. 

  1. Growth through inclusivity & innovation.

Financial institutions in pursuit of growth should innovate and leverage on existing and emerging technology to reach current and potential markets while economically empowering communities through promoting financial inclusion and financial literacy. 

  1. Managing & mitigating Associated Risks.

Banks should seek to mitigate social and environmental risks associated with their financing activities through client engagement and effective policies and risk assessment procedures. 

  1. Resource Scarcity and Choice

Financial institutions should ensure optimal management of resources so as to avoid compromising the future generation’s needs guided by comprehensive opportunity cost assessment.

  1. Business Ethics & Values.

The leadership of financial institutions should ensure the institutions delivers returns in the long term, and in a responsible manner that underscores optimal utilization of resources. 

Further, the SFI has proposed certain policies to enable the banking institutions realize the SFI principles. They include:

  1. Credit risk policy that incorporates the review and categorization of economic, social and environmental risks.
  2. Human resource policy that incorporates SFI Principles in recruitment and induction programs for all full-time employees. 
  3. Board and management evaluation and reporting of performance against Sustainable Finance priorities.
  4. Formulating, implementing and reporting on national, regional and local programs aimed at mitigating climate change and measures to facilitate adequate adaptation to climate change. 

The aforementioned guiding principles and policies shall assist in ensuring sustainable finance and lending in the banking industry. 

  1. Kenya Banking Sector Charter (KBSC)

The Central Bank of Kenya issued the Kenya Banking Sector Charter (KBSC) pursuant to Section 33(4) of the Banking Act which empowers the Central Bank of Kenya to issue directions with respect to the standards to be adhered to by an institution in the conduct of its business in Kenya. 

The Charter represents a commitment from institutions in the banking sector to ensconce a responsible and disciplined banking sector cognizant of, and responsive to, the unique socio-economic realities of the banking industry. 

The Charter is hinged on four central pillars: 

  1. Adoption of customer-centric business models by banks; 
  2. Risk-based credit pricing; 
  3. Enhanced transparency and information disclosure; and 
  4. Entrenching an ethical culture in banks. 

The ethical culture pillar requires banks to establish a culture of doing the right things as they offer their products and services. This includes embracing and integrating ESG Lending and other sustainable finance principles in their operations.  

Conclusion

It is evident that the implementation of a regulatory framework is paramount in facilitating the growth of ESG lending in Kenya. Financial institutions have a key role to play in promoting sustainable development by incorporating ESG considerations into their lending practices.

A regulatory framework that promotes transparency, disclosure, and accountability in ESG lending will go a long way in encouraging financial institutions to integrate ESG considerations. 

Further, it is evident that financial institutions should be at the forefront in championing for ESG Lending and such institutions have the onus of promoting sustainable development by offering bespoke financial products that are geared towards addressing environmental and social challenges. 

Thus, it is now incumbent upon financial institutions to proactively incorporate ESG considerations into their lending practices whereas the primary regulator, the Central Bank of Kenya, should provide the necessary support through issuing comprehensive policy and regulatory guidelines. 

Isaiah Mungai Kamau and Ian Smith Nalianya