08 Aug 2022
While the economic case for investing in the Chinese stock market is straightforward, when it comes to China and sustainability, the arguments are more complex. Howard Wang, Head of Greater China Equities, looks at the considerations for investors when investing sustainably in China, with a focus on the opportunities, as well as the risks, from an ESG standpoint.
Investing sustainably in China isn’t a black and white issue. While some investors will be put off by China’s headline record on environmental or social issues, a closer look reveals a much more nuanced picture, with many Chinese companies ranking favourably in ESG terms compared to their peers in the US, or even in Europe. In this sense, it’s not the market itself, but what lies within, that’s important.
The wide dispersion of ESG scores, combined with the fact that China is a market where data transparency can vary massively, and where government intervention is also a factor, means that it’s important to consider sustainability issues on a case-by-case basis, rather than taking a blanket approach based on often outdated opinions.
Government policy support is perhaps the key factor for ESG investors in China. While some sectors, such as internet stocks and real estate, have suffered from regulatory tightening in recent years, sectors that are more closely linked to the Chinese government’s environmental targets, such as renewable energy and electric vehicles, are benefiting from long-term policy tailwinds.
Renewable energy producers, for example, are benefiting from a growing number of environmental-related rules that are aimed at accelerating China’s transition away from coal. Policy goals and five-year plans to boost the proportion of renewables in China’s energy mix are vital if China is to meet its emissions reduction targets.
To support the energy transition, renewable energy companies face less regulatory uncertainty and are benefiting from a lower cost of capital from state-owned lenders, as well as from tremendous growth in demand. We’d expect this confluence of positive factors to lead to higher valuation multiples in the renewables sector, where we are pursuing several opportunities, including in China’s largest hydroelectric power company.
The renewables sector isn’t, however, only attractive to sustainable investors because of China’s growing consumption of clean energy. China is also a significant producer of renewable energy equipment, with leading positions in wind turbine production and the manufacturing of solar panels. Chinese companies will play a crucial role in the global battle to reach net zero.
What makes these China energy transition beneficiaries particularly attractive is the fact that policy support is likely to be long term. It’s unlikely that regulations will be tightened anytime soon. One reason why is that the energy transition is not a quick fix, but will require continued public and private investment over multiple years. Another reason is the political rationale. Not only is cutting emissions the right thing to do for the environment, but it is also helping to boost China’s competitive advantage in many important industries.
We’d further expect China’s energy transition to be managed to minimise any negative impact on GDP. Not least because economic stability is a priority for China’s leadership in order to prevent social unrest. In the solar energy sector, for example, local governments will be expected to achieve their solar panel installation targets over a five-year period while maintaining GDP growth.
This isn’t to say that there won’t be periods of volatility along the way, such as near-term energy price rises caused by the war in Ukraine, or the recent electricity blackouts caused by overenthusiastic local government implementation of emissions-reduction targets. Nevertheless, over a long-time horizon, we’d expect the energy transition to create opportunities for ESG investors at the corporate level across a range of industries.
While environmental policy is a priority, social factors are also increasingly important for the Chinese government and for Chinese companies. As with the environment, China ranks lowly on social issues in international comparisons, and investors don’t have to look far to find stories about long working hours and poor labour conditions. But once again, progress is being made at the policy level, pushed by a government that’s eager to maintain popular support and avoid unrest. Recent reports of long working hours in the technology sector have led to a broad national push to raise wages and productivity, with the policy impetus on local governments to keep people happy and minimise the risk of worker protest or dissent.
Investors can play this productivity theme through stocks that we call “productivity multipliers” – mainly software companies and industrial automation companies that are improving manufacturing productivity and accelerating the policy drive to push up wages. Investors can also find Chinese companies that treat their workers fairly and support their local communities in a variety of other sectors. To identify them, we deploy alternative data, such as supply chain/channel checks, to assess competitive dynamics, management quality and business conditions. We make no wholesale exclusions, but assess the social impacts of companies on a case-by-case basis.
Another feature of the Chinese stock market that raises ESG concerns is state ownership. It’s an interesting fact that China has more companies in the Fortune 500 than any other country, but 75% of these are government owned. Many of China’s state-owned enterprises, or SOEs, aren’t very ESG friendly at all. Some are responsible for environmental damage, for example, or have investments in countries subject to western sanctions. Many maintain governance structures that aren’t designed to serve the interests of shareholders.
However, not all SOEs are created equally. There are SOEs that are less subject to government interference and some that are leaders in their sectors from an ESG perspective. Therefore, rather than place limitations or restrictions on portfolios, investors should consider SOEs on their individual ESG merit, as long as they know who is running the company and how they are incentivised.
One final consideration for ESG investing in China is data transparency. The availability and credibility of financial disclosures, especially those related to ESG, varies widely, making it difficult for investors to compare China ESG scores with other markets or regions. Things are changing, however, as China’s authorities look to attract more foreign investment into the $10 trillion domestic A-share market. With that in mind, China has been trying to improve company disclosures and the rule of law, step by step.
More than 50% of listed companies in the energy, materials and industrial sectors (especially the largest companies) publish Corporate Social Responsibility (CSR) reports and set targets, although these goals are often still more qualitative than quantitative. Third-party researchers can be a useful source of China ESG data, but they often lack the local resources to cover China’s markets in any real detail, leaving significant information gaps. Therefore, while ESG data is becoming easier to find, it’s still necessary to engage with companies and speak to management teams in order to gain a true picture of ESG initiatives and activities. Nothing is a substitute for in-house research.
China’s suitability for sustainable portfolios can be a divisive issue, and investors need to consider a range of ESG factors before making their own decisions on how to invest. One thing that is worth remembering is that the dispersion of ESG scores within markets is much wider than between markets. As a result, there are clear merits to researching stocks from the bottom up and engaging with the ESG issues raised in China, rather than implementing rigid exclusion policies, either at the market or sector level. For some investors, China equity does not, on the face of it, lend itself readily to sustainable investing. For us, however, it’s what lies beneath that counts.
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