ESG and sustainable investing is a big, important issue. Right now, there is possibly no bigger issue globally than the focus on ESG investing. And the flow of funds into ESG or sustainable investment mandates has accelerated under the influence of the Covid-19 pandemic.
This is not just a western phenomenon.
China has turned its attention to ESG and delivering sustainable outcomes for its population. The rise in the number of signatories to the United Nations Principles of Responsible Investing (UN PRI) is indicative. In 2017, only seven Chinese investors were signatories. This number is now 56. And we expect more will join.
China’s focus is driven by domestic policy.
China’s focus on ESG is recent. In the 1990s and 2000s, China faced scrutiny for its environmental standards that slipped as a consequence of its impressive growth. Since 2015, the narrative changed. China has moved towards sustainable development. The government have made that goal clear in official communications.
China aims to be carbon neutral by 2060. The 14th Five-Year-Plan includes four key environmental targets for the medium-term. These include 1) reducing carbon emissions per unit of GDP, 2) reducing energy consumption per unit of GDP, 3) increasing forest coverage, and 4) moving towards renewable energy sources. These are aggressive targets that show a clear commitment to sustainability.
International investors are adding pressure.
International investors are flocking into Chinese capital markets since foreign ownership limits have been removed. Chinese A-Shares have also been included in the major emerging market and global indices in recent years. This has pressured Chinese companies and asset managers to comply with higher external ESG standards.
ESG is more than risk management.
In China, ESG is seen as a risk, rather than an opportunity, and ESG evaluation is for risk-management purposes, rather than alpha-generation. Top-down environmental regulation policies, such as pollution and waste, act as an environmental risk-management for companies.
And although many companies are turning their focus to the environment, governance has been the key ESG factor driving investment decisions. Many companies recognise that poor corporate governance is a material risk to long-term returns across all sectors.
Sustainable practices are a potential source of alpha.
Outside China, there is growing evidence that sustainable investing is a potential source of alpha for long-term investors. This growing recognition is a key driver of enormous flows into ESG and sustainable investing mandates globally. In the US in 2020, more than USD17 trillion was invested – more than a 40% increase compared with 2018.
China regulators push ESG-themed products.
In 2016, the People’s Bank of China, alongside six other key agencies, issued the “Guidelines for Establishing the Green Financial System”. It included incentives to support green investment and green sectors to support the government’s environmental targets.
The Asset Management Association of China issued the “Green Investment Guidelines” in 2018, establishing basic principles and standards for green investment strategies, regulations, and benchmarks.
Reporting standards are still vague and there are significant gaps in ESG datasets. Exclusion or inclusion of ESG-compliant companies is therefore difficult. The result is a concentration on ESG-themed products, including ETFs. Capital flows into ESG-themed ETFs in China increased by a staggering amount between 2018 and 2019.
Better disclosure will mean better outcomes.
China’s Securities Regulatory Commission (CSRC) encourages disclosure of ESG factors that have material impact to investments. But it still falls short of mandatory, standardised requirements. The CSRC’s goal of introducing mandatory ESG disclosure requirements for all listed companies by the end of 2020 was delayed due to the pandemic. We now expect it by the end of 2021.
Most companies listed on the CSI300 already issue ESG disclosures. But few of these are audited. And the lack of standardised frameworks makes it difficult to assess these disclosures. We expect improved disclosure will make modelling the impact on return and risk, and embracing sustainable investing across the investment process, easier.
Sustainable investing is a journey, not a destination.
China is embracing sustainability and ESG principles at the same time as it opens up to foreign capital. This confluence of events presents a remarkable opportunity for long-term investors.
We have previously identified Chinese capital markets as an important opportunity for diversification and alpha generation. We also believe that integrating sustainable investment beliefs into the investment process opens up a further source of potential alpha.
China’s commitment to sustainability may lag behind parts of the western world but the opportunity for catching up, and generating genuine alpha, are significant.
And this is the point. We expect that investors who are able to harness the positive outcomes generated by the sustainable investing journey in China will find they are well placed to access strong risk-adjusted returns.