China Plays Fast Catchup with the Global ESG Wave

The environmental, social and governance (ESG) movement has swept the globe, being transformed from a luxury toy of the ethically engaged to a pillar of mainstream investment practice. Investors increasingly seek to align themselves with concern for the environment, the impact of their investments on society, and a desire to invest in companies run with transparency, paying heed to the interests of minority shareholders and in accordance with best accounting practices.

Some 25% of all professionally managed assets are now invested in accordance with ESG criteria, but ESG has exerted significant influence on the global investment community for only a few years. Until recently, it had barely registered as a ripple in China, despite Beijing being a major global investor.

Most Chinese investors considered compliance with ESG guidelines to be an unacceptable compromise on returns, with the country’s corporations viewing ESG as little more than a box-ticking compliance exercise. But China is now playing catch-up in the ESG stakes with speed, narrowing the gap between the government’s global aspirations and the conventional mindset of its international investors and corporate boards.

China is in the process of transitioning from being the world’s greatest polluter to one of its greatest environmental champions, reflecting Beijing’s future-oriented frame of reference, which manifests itself in much of what the Chinese do – from five-year economic plans to the Belt and Road Initiative. From its participation in the Paris climate agreement to its leadership in solar technology and move away from near-total reliance on coal-fired power plants to a pursuit of wind power, Beijing has made a noteworthy contribution to environmental consciousness.

The change in mindset at the corporate level is being driven both by government regulation and the internationalization of China’s capital markets. Policies, even though further regulatory and legislative development, are required to address teething problems as China embarks on a comprehensive embrace of ESG practice. For example, there needs to be an incentive mechanism in the corporate and investor arenas to support long-termism and to set a level playing field for administration and supervision.

The previous “box ticking” approach, under which companies made voluntary ESG disclosures without fear of regulatory action for failing to comply, will become a more serious endeavor once regulations come into force next year, making ESG disclosure mandatory for 3,000 of China’s listed companies and bond issuers. China presently scores 21.6 in Bloomberg’s average ESG disclosure score, less than half of the top rank scorer, France. That is set to change as disclosure becomes mandatory, but also as the country aims to attract international capital.

The inclusion of 233 China A-shares in Morgan Stanley Capital International’s (MSCI’s) Emerging Market Index – presently representing just 1.7% of that Index, but expected to hit 4% by the end of 2019 and above 10% within a few years – will force the disclosure discipline upon constituent companies. This will improve their current ESG score of CCC according to MSCI’s criteria – the lowest – which 37% of the Chinese companies in the index now achieve.

Internationalization is also driving the same dynamic in China’s flourishing Green finance market. From zero issuance in 2015, the country became the world’s largest issuer of Green bonds a year later, accounting for 26% of sustainable bond issuance globally. Adhering to internationally agreed Green finance guidelines requires disciplined reporting if debt is to be placed with the growing global pool of ESG-focused investors. There is also China’s likely adoption of the European Union’s recently published Green finance taxonomy, whereby definitions of what constitutes a sustainable use of proceeds will necessarily prod the country’s Green bond issuers to adopt sustainable business practices.

This alignment of corporate behavior with the government’s mission statement chimes, given that China is the world’s largest investor in renewable energy and energy efficiency, accounting for 30% and 27% of the global total, respectively.

Recent moves, such as China’s decision to ban the import of plastic waste, as well as its exclusion of coal from the universe of sustainable investment, bolster that mission statement. Further ESG alignment will be prodded by the launch of China ESG indices from the likes of MSCI and by other initiatives such as the inclusion of Green loans and AA-rated Green finance bonds as eligible collateral in the People’s Bank of China’s repurchase agreements.

China’s banks are also a crucial element in the ESG dynamic – seven of the country’s largest banks have signed up to the Green Investment Principles, which have been established in cooperation with the European Union – with internationalization a key underpinning, given that these banks seek to syndicate loans within a consortium of overseas peers. The balance of Green credit in China exceeded Rmb9 trillion in 2018 and is expected to surpass Rmb10 trillion this year, with the risk weighting of such assets on banks’ balance sheets likely to be reduced.

Corporate China’s rising cognizance of ESG and the role banks play in this dynamic was recently provided by the signing of a $2.1 billion sustainability loan by Cofco, China’s biggest food company.

Interest payments on the loan – the largest so far raised in the fast-growing sustainable loan market – will decline if the company meets ESG targets, such as the sourcing of soybeans produced without contributing to deforestation. China’s companies are waking up to the message that ESG is not simply a compliance exercise but a central element of long-term corporate strategy, but there is a long way to go. In China’s male-dominated corporate universe, stakeholders will also need to consider that, as noted by MSCI, companies with gender diversity achieve a superior return on equity.

At the investor level, the mindset in China is also changing fast, linked to the rise of the country’s asset management industry, which has been using the proven long-term equity outperformance of ESG-compliant companies as a selling hook. Seven Chinese asset managers signed up to the UN-supported Principles for Responsible Investment in 2018, bringing the total number of signatories in the country to 18, more than double the 2017 total. These include heavyweights such as China Life Asset Management, Harvest Fund Management, and China Southern Asset Management.

The recent pairing of APG (the Dutch pension fund) with E Fund Management (China’s third-largest asset manager) to invest in China A-shares with high ESG scores illustrates the growing demand for ESG-compliant investment products in China. SynTao Green Finance and the China Social Investment Forum expect that more Chinese funds will begin to adopt ESG investment strategies and that themed mutual fund products will emerge alongside the promotion and dissemination of ESG-linked educational information.

At the same time, it is anticipated that insurance and pension funds seeking to match long-term liabilities with assets will embrace ESG, as China Life Asset Management Company has, together with charitable organizations, and venture capital and private equity funds.

So the Chinese government’s aspirations in the ESG arena are becoming a reality as the crucial actors on the ground – companies, and investors – move quickly into alignment with official thinking. This is an example of how forward-thinking, government policy, competitiveness, and a social conscience have converged to have a favourable outcome in China.