Chapter One Discussion Paper on Sustainable Finance 1

In light of the Central Bank of Egypt's tendency to establish the concept of Sustainable Finance, which contributes to supporting financial and banking stability and achieving sustainable development goals, and thereby achieving long-term stability for the economy, environment, and society as a whole, the Central Bank has previously issued several initiatives aimed at achieving sustainable development goals and enhancing sustainable finance, such as the Small and Medium Enterprises initiative, initiatives for the industrial, agricultural, tourism, and contracting sectors, the housing finance initiative, the initiative for replacing vehicles with dual-fuel engines, and the gas stations initiative.

It is worth noting that the banking sector is one of the most important sectors supporting development efforts, and thus sustainable development goals, including environmental and social challenges, cannot be achieved without the banks playing an active role in directing finance towards more sustainable economic activities. Furthermore, integrating environmental, social, and governance elements has a positive impact on company performance and reducing risk ratios, in addition to being an important factor in attracting foreign investments.

Given that sustainable finance has become one of the most important topics discussed in international forums and is of interest to many central banks, a general framework has been established for defining sustainable finance and the Central Bank's directions regarding the requirements for its implementation in the Egyptian banking sector.

Introduction

The discussion paper presented serves as an introductory note addressing the concept of sustainable finance, which has become a primary goal for central banks by encouraging banks to integrate environmental, social, and governance elements into their credit granting processes and decisions.

It is worth noting that sustainable finance contributes to achieving sustainable development, which is a national responsibility falling on the shoulders of concerned ministries, where it is defined as "development that meets the needs of the present without compromising the ability of future generations to meet their own needs," according to the United Nations General Assembly, and thus sustainable development aims to achieve long-term stability for the economy, environment, and society as a whole.

The Central Bank of Egypt has moved to support the concept of sustainable development and take steps to enhance and apply Sustainable Finance in the banking sector, as its application has become one of the important topics discussed internationally.

First: Concept of Sustainable Finance

Sustainable finance refers to financial or banking services that consider environmental, social, and governance elements in the bank's decisions when granting credit or making investment decisions, in order to achieve sustainable benefit for customers, stakeholders, and society as a whole.

Second: Elements of Sustainable Finance (ESG - Governance–Social–Environmental)

1. The Environmental Element:

Factors related to the environment such as climate change, gas and carbon emissions, air and water pollution, water scarcity, and global warming.

2. The Social Element:

Factors with social impact, such as providing job opportunities and improving working conditions, which include health, safety, workers' rights, and impact on surrounding communities of the projects concerned, etc.

3. The Governance Element:

Factors related to how the institution is managed, such as the independence and composition of the board of directors, shareholders' rights, and transparency.

Third: Importance of Sustainable Finance

1. At the Central Bank Level:

a. Sustainable finance leads to supporting financial and banking stability, as studies have proven that integrating environmental, social, and governance elements has a positive impact on company performance and reducing risk ratios, and thus providing finance to these companies is considered low risk, which positively reflects on the stability of the financial system.

b. Enhancing investment opportunities and injecting foreign currency by attracting a new segment of investors targeting sustainable finance, along with direct foreign investment for the banking sector and the national economy.

c. Enhancing the issuance of green bonds in light of the increasing spread of environmental and social investment.

d. The possibility of creating green banks in accordance with the provisions of the new Central Bank and Banking Authority Law, where a new type of bank, specialized banks, will be licensed, as green banks help secure low-cost capital finance for clean and renewable energy projects and projects generally aimed at improving environmental quality at suitable prices and terms.

e. Supporting the Central Bank's efforts towards the state's achievement of sustainable development goals, which sustainable finance contributes to achieving directly.

Generally, sustainable finance contributes to maintaining financial stability in the long term. It is worth noting that the Basel Committee on Banking Supervision has recently announced the formation of a working group on climate-related financial risks, and international institutions have pointed to the need for new strategies and partnerships to effectively and efficiently address environmental and social challenges.

2. At the Banking Sector Level:

The banking sector is one of the most important sectors supporting the economy, and thus sustainable development, including environmental and social challenges, cannot be achieved without banks playing an active role in this by directing finance towards more sustainable economic activities. Below is the importance of sustainable finance for banks:

a. Providing new and innovative financial solutions and banking products, and opening new fields and markets for finance, which contributes to achieving more profits.

b. Adopting sustainable finance concepts works to reduce the chances of default, thereby maintaining the quality of the bank's portfolio.

c. Sustainable finance allows banks to contribute positively to community development and preserving the surrounding environment, and improving the reputation of banks locally and internationally.

d. Reducing environmental and social risks.

It is also worth noting that applying sustainable finance in banks does not necessarily negatively affect the bank's profitability or stop financing specific projects or industries, but rather will lead to providing innovative financial solutions and achieving more profits by opening new markets and fields and reducing environmental and social risks.

It is observed that there is confusion between the concept of sustainable finance and corporate social responsibility in banks. Therefore, it is necessary to emphasize that Sustainable Finance is a specific and fixed banking approach applied according to international standards regarding the style and method of lending and investment and reducing related risks. As for social responsibility, it differs from sustainable finance as it stems from the circumstances of each institution, and it is linked to each institution's vision of its surrounding community role, and that vision changes according to initiatives implemented during specific periods and cannot be relied upon in the long term as plans to achieve the desired development. However, it can be said that social responsibility efforts contribute in the short term to achieving some of the sustainable development goals.

Fourth: Central Bank and Banking Sector Efforts

The Central Bank has issued several initiatives aimed at achieving economic development and enhancing sustainable finance by making specific amounts available to banks to use in granting credit facilities to their customers under the umbrella of these initiatives at low interest rates, as this type of finance plays a fundamental role in developing the national economy, providing job opportunities for youth, and reducing unemployment rates. This focuses on sectors such as the new and renewable energy sector, which respects the environmental element of sustainable finance, as well as the social element. Below are some of the related initiatives:

a. Small and Medium Enterprises Initiative b. Initiatives for the Industrial, Agricultural, and Contracting Sectors
c. Housing Finance Initiative
d. Initiative for Replacing Vehicles with Dual-Fuel Engines and Gas Stations Initiative

In addition, the following have been issued, which contribute to achieving sustainable development goals:

a. Instructions for Protecting Bank Customers' Rights b. All efforts made to achieve financial inclusion
c. Issuing rules and systems for digital services such as using mobile phones and digital payment tools

Fifth: Risks Resulting from Not Considering Sustainable Finance Elements

a. Physical Risk

Risks resulting from environmental risks and climate change, which threaten many industries and can disrupt global supply chains, such as droughts, floods, hurricanes, and rising carbon levels, which may affect financial stability through its impact on other sectors such as agriculture, energy, tourism, etc. This may also have a long-term impact on agricultural production rates and inflation rates due to the increase in commodity prices, which also entails risks to the sustainability and stability of the macroeconomy, and thus requires regulatory authorities' intervention.

b. Reputation Risk

Risks resulting from banks focusing solely on achieving profits, without caring about environmental or social risks associated with the bank's activity or financing customers or projects that do not meet sustainability elements, and having negative environmental or social impacts.

c. Credit Risk

Risks resulting from the possibility of customers failing to repay credit facilities due to one of the following reasons:

• Disregard for sustainable finance elements and exposure to related risks.
• Incurring fines or compensation to affected parties that suffered negative social or environmental impacts, which may subsequently affect the value of their collateral or assets.

d. Environmental Risk

Risks resulting from operations carried out by financial institutions that negatively affect the environment, such as energy use, paper consumption, fuel consumption, and waste disposal. Although the direct impact of energy, waste, and paper used by financial institutions on the environment is relatively lower compared to many other sectors, their impact on the environment as a whole cannot be ignored.

e. Social Risk

Risks resulting from not paying attention to social dimensions. Therefore, efforts must be made to enhance the culture of respecting and protecting human rights in general and workers' rights in projects to be financed, in addition to ensuring justice and fairness, providing equal opportunities among individuals, contributing to their growth and development, and ensuring the preservation of a healthy and safe work environment.

f. Legal or Direct Risk

Involves legal obligations that banks and/or companies may incur, for example, paying fines and compensation to affected parties that suffered negative social or environmental impacts.

Sixth: Challenges Associated with Applying Sustainable Finance

Applying sustainable finance gives rise to transition risks resulting from the rapid shift to environmentally friendly industries and economies, known as the "low-carbon economy." Although this transition contributes positively to the environment, it may result in the need to rapidly shift investments away from industries and economies that do not respect the environmental dimension, known as the "carbon economy," which may affect entire sectors within the current economic system, thereby eliminating billions of potential investments.

Based on the above, international practices of several countries whose central banks have issued principles or guidelines in the field of sustainable finance have been studied, such as: Brazil, Ghana, Philippines, Morocco, Cambodia, Nigeria, Georgia, and Bangladesh, as well as the practices and reports of the European Supervisory Authority, the European Union, the Bank of England, and the Sustainable Banking Network. That study resulted in the following:

-1 The Role of Central Banks in the Field of Sustainable Finance

Central banks have recently begun to focus on sustainable finance elements as a means to achieve economic stability, because environmental and social risks harm financial institutions' performance. The role of central banks focuses on encouraging the financing of projects with economic or social viability or positive environmental impact, such as those aimed at transitioning to new and renewable energy. The most important steps taken by central banks in this regard include:

a. Encouraging banks to integrate sustainable finance elements into the bank's credit and investment activities and enhancing this concept to include all bank activities.

b. Directing banks towards financing projects that respect sustainable development goals, such as financing small, medium, and micro-enterprises, and seeking new sectors to achieve growth and profitability while increasing finance availability rates for projects directed towards the most vulnerable groups at reduced interest rates.

c. Directing banks towards investing in or financing projects with low carbon emission rates, new and renewable energy projects, and labor-intensive projects, with banks developing new markets that respect sustainable finance elements.

d. Issuing initiatives with low returns to finance projects that respect sustainable finance elements, especially the environmental and social elements.

e. Encouraging and motivating banks to issue Green Bonds, in light of the growth of the global green bond market, with the possibility of significantly expanding the scope of global finance for projects with environmental and climate benefits.

f. Implementing training programs for banking sector employees to create knowledge and build the necessary capacities in the field of sustainable finance and sustainable development in general.

-2 Most Important International Specialized Bodies in the Field of Sustainable Finance

a. International Finance Corporation (IFC)
A member of the World Bank Group, the largest global development institution focusing exclusively on supporting and developing developing countries, headquartered in Washington, United States.

b. European Organization for Sustainable Development (EOSD) Includes 35 countries represented by financial sector regulatory bodies, banking unions, and sustainable development and environmental bodies, headquartered in Karlsruhe, Germany. It was established according to European Union laws to apply the Union's sustainable development strategy, and its jurisdiction includes developing policies, preparing initiatives, designing training programs, and exchanging experiences between EU member states and other member states. (The Central Bank of Egypt is a participating member since 2018).

c. Sustainable Banking Network (SBN)
A network emanating from the International Finance Corporation (IFC), including 38 countries represented by financial sector regulatory bodies and banking unions in emerging markets committed to developing sustainable finance in line with international practices. It is the most important international body concerned with preparing policies for sustainable finance. (The Central Bank is a member since 2019), headquartered in Washington, United States.

d. Network for Greening the Financial System (NGFS) The network includes 42 countries represented by financial sector regulatory bodies and banking unions, through which experiences are exchanged and best international practices applied in the field of environmental protection and combating climate change are discussed. The French Central Bank in Paris coordinates the network's work.

e. Alliance for Financial Inclusion (AFI)
The leading global organization in supporting financial inclusion, headquartered in Kuala Lumpur, Malaysia. It includes financial inclusion policymakers from more than 95 countries with the aim of exchanging experiences and best international practices in enhancing financial inclusion. (The Central Bank is a member since 2013), and Mr. the Governor of the Central Bank of Egypt chairs the Alliance's board of directors in its current term. The Alliance also established the Working Group on Green Inclusive and Sustainable Finance in 2019.

f. Center for Financial Inclusion (CFI)
The center affiliated with the organization Accion was established as an independent research center focusing on inclusive finance to enhance comprehensive financial systems for low-income individuals worldwide.

-3 Most Important International Standards Regarding Sustainable Finance

a. Principles for Responsible Banking: These are six principles issued by the United Nations Environment Programme (UNEP). The principles aim to establish a framework for creating a sustainable banking system. They were launched by 130 commercial banks from 49 countries. It is worth noting that Bank Misr, Bank of Alexandria, Banque Misr, and the Arab African International Bank in the Arab Republic of Egypt have signed those six principles. In this regard, banks commit to the following:

1. Alignment: Aligning bank business strategies to comply with meeting society's needs and objectives and in accordance with sustainable development goals and the Paris Agreement on climate change, and all relevant national and regional agreements.

2. Impact and Target Setting: Increasing banks' positive impact on the environment and society and reducing any negative impact resulting from their activities, and setting necessary goals by innovating products and services aimed at achieving this principle.

3. Dealing with Clients: Dealing with clients responsibly to encourage sustainability activities and stimulate economic activities that achieve prosperity for current and future generations in general.

4. Stakeholders: Consulting and involving all stakeholders and forming partnerships to achieve society's goals.

5. Governance: Banks' commitment to these principles through applying best governance practices.

6. Transparency and Accountability: Banks periodically review their activities and ensure compliance with these principles and demonstrate transparency regarding the banks' positive and negative impacts and the extent of the banks' contribution to achieving society's goals.

b. The Equator Principles (EPs): These are ten principles issued by the International Finance Corporation (IFC) and represent a framework for managing environmental and social risks that financial institutions adopt in financing projects. The purpose is primarily to provide a minimum standard to support responsible decision-making regarding risks. Below is an overview of the principles:

1. Review and Classification: Classifying projects based on the size of risks and potential environmental and social impacts.

2. Environmental and Social Assessment: The client conducts an assessment of the potential environmental and social risks of the proposed project to be financed and the impact of those risks.

3. Applicable Environmental and Social Standards: Ensuring compliance with laws, regulations, and permits related to environmental and social matters applied within the country.

4. Environmental and Social Management System (ESMS): The bank's client develops an environmental and social management system to deal with any environmental or social risks that appeared in the project assessment process mentioned in the second principle.

5. Stakeholder Engagement: Ensuring the client coordinates with all internal and external stakeholders in continuously assessing the potential environmental and social risks of proposed projects to be financed.

6. Grievance Mechanism: Requiring the client to establish a grievance mechanism within the environmental and social management system (ESMS) (mentioned in the fourth principle) aimed at receiving and facilitating the resolution of complaints from parties affected by the environmental and social impacts of proposed projects to be financed.

7. Independent Review: Conducting an independent review of the environmental and social management system (ESMS) (mentioned in the fourth principle) and the stakeholder engagement process mentioned in the fifth principle by an environmental and social consultant for all proposed projects to be financed.

8. Covenants: The client commits to providing covenants to banks to ensure compliance with all relevant environmental and social laws, regulations, and licenses.

9. Independent Monitoring and Reporting: Appointing an independent environmental and social consultant to evaluate the project's compliance with the principles and monitor the project's environmental and social performance after financing and prepare necessary reports to monitor this performance at least once.

10. Reporting and Transparency: The client commits to making all information regarding the results of the environmental and social assessment mentioned in the second principle for the project available and disclosing greenhouse gas emission levels annually.

According to the aforementioned principles, several procedures and assessments are conducted before making the credit granting decision, and a number of other procedures are taken after the financing process for projects ends to measure the actual environmental and social impact of projects after they begin operation.

In addition to the aforementioned principles, it is worth noting the following related bodies, initiatives, and international standards:

a. The Task Force on Climate-related Financial Disclosures (TCFD): A task force established by the Financial Stability Board in 2015, consisting of 31 members, which issues recommendations on how to disclose financial information related to climate change.

b. Green Bond Principles (GBP): Issued by the International Capital Market Association, these are principles and guidelines regarding the issuance of green bonds.

c. Global Reporting Initiative (GRI): An independent non-profit organization and the first to establish international standards for sustainability disclosure.

Based on the above, and in order to keep pace with best international practices in establishing "Sustainable Finance" rules in the banking sector and supporting the state's efforts to achieve sustainable development, it was appropriate for the Central Bank to issue guiding principles for sustainable finance as an important step to begin setting the general framework for applying sustainable finance.