The United Arab Emirates (UAE, Aa2 stable) published its first set of guiding principles on sustainable finance during the second edition of the Abu Dhabi Sustainable Finance Forum on Sunday. The guiding principles will contribute to UAE banks' understanding and management of environmental, social and governance (ESG) risks that affect their credit profiles. Commenting on UAE's bank sector, Moody's Investors Service said last Jan. 23 that environmental and governance risks are the most relevant for UAE banks, while social risks are in line with our assessment for banks globally. Compared with most banking systems, UAE banks have higher exposure and vulnerability to environmental risks because of their indirect exposures to the local climate and to the hydrocarbon sector. The hydrocarbon sector accounted for 26% of the country's nominal GDP and 50% of the government's total revenues as of December 2018, the latest data available. As a major oil exporter, the UAE's environmental risks are predominantly related to carbon transition, despite sizable supportive financial buffers. The UAE is also one of the world's most arid states, and most of the country's water is produced by desalination plants, which are highly energy intensive. Rapid economic and population growth in recent decades has increased challenges surrounding water sustainability, Moody's said. . The three guiding principles are the integration of ESG factors into governance, strategy and risk management, the adoption of a minimum eligibility requirement to help identify sustainable financial products and the promotion of appropriate ESG-related reporting and disclosures. The guiding principles aim to facilitate the UAE's transition to a more sustainable and diversified economy, mitigate the risks of reduced global demand for oil and adapt to the physical risks of climate change. Although the guiding principles are voluntary, as part of an effort to ensure a gradual and consultative transition, regulatory authorities aim to implement appropriate measures for ESG integration once the principles have been endorsed. Measures may include guidelines and policies to encourage UAE-based financial firms to develop strategies incorporating ESG considerations in their business activities, decision-making, risk frameworks and investment opportunities. Transmission channels of environmental risks for UAE banks include credit exposure to borrowers with stranded hydrocarbon assets or hurt by growth constraints in the absence of improved water consumption efficiency. Another transmission channel is the gradual incorporation of environmental considerations in the investment decision making of international investors that provide financing to UAE banks, which will put pressure on banks to show strong ESG credentials. Governance is typically banks' main ESG risk because corporate governance weaknesses can weaken a company's credit quality. In the UAE, as with the rest of the Gulf Cooperation Council (GCC), government and government-related entities (GREs) are often the largest shareholders, depositors and borrowers in banks, which may lead to governance challenges, Moody's further said. Such challenges include sizable related-party lending, with banks extending funding to the government or GREs that are the banks' ultimate shareholders. Nonetheless, the central bank's stricter rules on borrower concentrations following the financial crisis partly mitigate the concentration risk. New regulation caps bank exposure to local governments and to government-related commercial entities, among others, at 100% of total equity each. Lending to the government and the public sector was 26% of the system-wide domestic credit of UAE banks as of November 2019. In terms of social considerations, the most relevant social risks for UAE and global banks arise from the way they interact with their customers, Moody's further said. For all banks globally, social risks related to data security and customer privacy are high, but these risks are mitigated by sizable technology investments and banks' long track records of handling sensitive client data. Fines and reputational damage because of misconduct is a further social risk to banks globally. Societal trends are also relevant in a number of areas, such as shifting customer preferences towards digital banking services increasing information technology cost, or socially driven policy agendas that may translate into regulation that affects banks' revenue base. Overall, we typically consider that banks have moderate social risks. UAE banks, particularly the largest ones, have made progress in ESG integration in recent years. In January 2019, 25 UAE public and private-sector entities signed the Abu Dhabi Sustainable Finance Declaration at the inaugural Abu Dhabi Sustainable Finance Forum, and 11 additional entities signed the declaration in January 2020. Signatories include First Abu Dhabi Bank PJSC (FAB, Aa3/Aa3 stable, a31), Abu Dhabi Commercial Bank (A1/A1 stable, baa3) and Abu Dhabi Islamic Bank (A2 stable, ba1). In addition, Moody's pointed out that FAB raised the first green bond of the GCC region in March 2017, and the bank publishes annual sustainability reports including a corporate ESG report, an Equator Principles report and a green bond report. Emirates NBD PJSC (ENBD, A3/A3 stable, ba1) offers interest rate discounts on auto financing of selected electric and hybrid cars, as part of its "green auto loan" scheme. ENBD also publishes an annual sustainability report. The published three guiding principles are premised on the United Nations Agenda for Sustainable Development, and result from collaborative efforts among several regulatory authorities in the UAE, including the Ministry of Climate Change and Environment, the central bank, the insurance authority, the securities and commodities authority, as well as the Abu Dhabi Global Market, the Dubai Financial Services Authority, the Dubai Islamic Economy Development Centre, the Abu Dhabi Securities Exchange, the Dubai Financial Market and Nasdaq Dubai. — SG