Is China the elephant in the ESG room?

The Chinese equity market has long posed a conundrum for investors. With a population of more than 1bn, China is an economic superpower with a vast equity universe, estimated to be around $19tn (£13.7tn) in size, but its relatively opaque financial markets have posed significant barriers to many.

Currently, institutional investors such as pension schemes face another layer of issues around many elements of their sustainability agendas. So, despite the potential offered by Chinese equities, can these find their way into ESG-compliant portfolios?

Clearing the air

China already features in many investment conversations around the environment, largely due to its unenviable status as the worst polluter in the world.

Institutional investors have a huge opportunity to make material improvements to global ESG by working with Chinese companies to improve their impact on the E and S. The potential results could be dramatic

Xiaoyu Liu, Aviva Investors

“Just as China represents an essential building block in a portfolio, it is vitally important to progressing global environmental and social goals,” said Rob Morgan, investment analyst at Charles Stanley Direct.

“Bluntly, if China continues to follow the US’s resource-intensive model of development, the battle against climate altering rising temperatures will be lost,” he added.

Crucially, China has changed its narrative. In September 2020, President Xi Jinping announced the country was aiming to reach peak carbon emissions by 2030 with a target of 2060 for net-zero emissions. This has encouraged some investors.

“Ignoring the size of the economy and market, China is the first major emerging market to commit to a carbon emission target,” said Xiaoyu Liu, portfolio manager at Aviva Investors.

“This creates substantial investment opportunities in decarbonisation solution providers, such as solar panel makers, wind farm operators, and key component suppliers in the electric vehicle supply chains.”

The Chinese government has been keen to nurture the development of alternatives and has subsidised their development. It is this theme that has found its way into the Templeton Emerging Markets Investment Trust.

Though not an ESG fund, lead portfolio manager Chetan Sehgal is confident in the return potential of this investment theme.

He said: “We anticipate the decarbonisation to accelerate. China now leads the world in clean energy production and produces more than 70 per cent of all solar photovoltaic panels, half of the world’s electric vehicles and a third of its wind power.

“Moving forward, we anticipate a widespread increase in the adoption of renewable energy technologies.”

But China’s environmental revolution still has further to go to convince other ESG investors. In its April 2021 report about China’s decarbonisation, entitled ‘Turning the supertanker’, data provider TransitionZero commented: “Thus far, local government and state-owned enterprise decision-makers appear to be defying the central government’s net-zero pledge.

“China is continuing to build more coal plants than it needs and in doing so is misallocating capital at an alarming rate.”

Humanitarian concerns

The Chinese government has long been criticised by western society about how some of its citizens are treated, including condemnation from the UN for its persecution of the Uyghur people. This poses a challenge for ESG investors but, as RisCura head of investment research Faisal Rafi explained, these concerns are not solely restricted to China.

“Human rights concerns are a threat to ESG across emerging markets, including in China,” he said.

“This has been prevalent in the private sector for many decades, whether Nike’s historical record in Cambodia, or the poor treatment of Bengali workers in the clothing industry.

“This is a global challenge and applies to all companies and not just to Chinese ones. Therefore, proposed EU regulation to make European companies responsible for their supply chain is movement in the right direction.” 

Scrutiny of China’s humanitarian issues may be widespread, but analysts focused on the country argue the vast nature of China means it warrants a more nuanced approach. Haiyan Li-Labbé, fund manager at Carmignac, points to progress being made in the country that is often overlooked.

“[Our emerging markets] team believes that China should be ranked high in the emerging markets universe as China has lifted over more than 1bn people out of poverty, 95 per cent of the population benefits from a basic medical insurance and 900m people are covered by pension funds as of today,” Li-Labbé said.

“Further, female labour force participation rate was around 60 per cent, versus a 47 per cent world average. This represents some of the biggest humanitarian progress in the past century.”

Reading between the lines

Strong corporate governance relies upon clear communication and reliable information, but is China — dominated by SOEs with infamously poor transparency levels — anywhere near the international standard?

“We have noticed significant progress in terms of transparency and corporate governance, as well as the addition of specific of ESG segments in annual reports and specific ESG reports,” Li-Labbé said.

“However, Chinese companies listed in the domestic markets need to do more to welcome foreign investors, who have only around 5 per cent of the total domestic market: reports need to be in English, top managers should speak English, and publishing ESG reports as a percentage is still very low.”

The Chinese government, as part of its long-running campaign to attract international investment, is introducing new measures to encourage better standards of corporate governance.

This has included the China Securities Regulatory Commission implementing a code of corporate governance for listed companies. And more Chinese companies are listing in places like Hong Kong and the US, where they have to adopt different reporting standards.

“Transparency of corporate governance in Chinese equities is definitely improving, driven by more stringent regulation from the government and increased awareness from both companies and investors,” said Aviva’s Liu.

“For instance, the domestic ‘A’ share market has been dominated by retail investors, but with more participation from international and domestic institutional investors, companies are becoming more engaged and focused on ESG and corporate governance matters.”

Ultimately, China is a very different country — economically, demographically and culturally — to those many international equity investors may be looking at. It is this that means it has such great potential for ESG investors, explained Rafi.

“For dedicated ESG funds, there is a huge investment opportunity,” he said.

“There is a lot of opportunity for ESG funds that specialise in promoting change as opposed to the current status quo, and one always needs to adapt the ESG criteria to any local market with a different culture.”

Rafi continued: “Institutional investors have a huge opportunity to make material improvements to global ESG by working with Chinese companies to improve their impact on the E and S. The potential results could be dramatic.”