ASIA-PACIFIC (Apac) investors are expected to lead a turning tide towards owning environmental, social and governance (ESG) “improvers” in 2023, instead of owning only stocks that screen as “best in class” on a range of ESG metrics, said Morgan Stanley Research.

Against this backdrop, China is an “attractive market for ESG”, given that most ESG stocks in the region are from the country, said the US investment bank’s research arm in its latest Asia sustainability outlook report.

The report first cited an investor survey, which found that fewer investors in Apac have exclusion policies on oil and nuclear. An exclusion is the act of barring a company’s securities from being purchased for a portfolio. This is often due to business activities that are deemed unethical, harmful to society, or in breach of laws or regulations.

The survey also uncovered that exclusionary thresholds are less common among Apac funds – 72 per cent have them this year, versus 89 per cent among European funds.

Dialogues with investors, meanwhile, illuminated a growing interest in assessing companies’ ESG performance by considering regional differences and characteristics amid a trend of “slowbalisation”, the report stated.

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Slowbalisation is a slowdown or even partial reversal of globalisation both in revenue mix and supply chains as some industries shift towards localisation. The report said this is driven by direct competition between US and China, which pushed Europe, Japan, and the rest of the world to attempt a balancing act, while they vie for influence and economic opportunity. 

Taking all these into account, the bank’s analysts said a focus on “rate of change” will gain traction in 2023, and could lead to both outperformance (alpha) and impact.

The analysts explained that future ESG improvement areas are usually information that have not been priced in yet, and that bigger ESG impacts often come from companies with potential to improve.

“Our US utilities team demonstrated this approach in a report showing how both alpha and impact could be achieved at the same time; we believe this is an approach that will be effective in Asia-Pacific too,” they wrote.

It helps that Apac has a high concentration of emerging markets that are in very different stages of economic and ESG development, the analysts said. Furthermore, the principles and concepts of transitioning towards sustainability have become embedded in policies and taxonomies released by regulators across Apac, they added. 

A case for ESG plays in China

The Morgan Stanley analysts then pointed to China’s status as the largest ESG market in the region, citing its abundance of pure-play ESG companies, ranging from renewables and electric vehicles (EVs) to energy efficiency, hydrogen and food sustainability.

They tracked the stock price performance of Apac sustainable solution stocks with 50 per cent or above revenue or earnings before interest, taxes, depreciation, and amortisation (Ebita) exposure to ESG themes, and found that more than half of these companies – 175 out of 345 – are from China. 

They then built the case with estimations that China’s investment in key decarbonisation technologies, which includes smart grid, EV charging stations, and hydrogen refuelling stations, could, in the near term, grow to US$132 billion a year under Beijing’s long-term decarbonisation commitment. This is 37 per cent higher than today, they stated.

“We believe these investments will help drive down the cost of ‘enabler technologies’ in decarbonisation compared with incumbent technologies, making ‘enabler stocks’ more attractive in an economic sense,” they said.

The analysts also pointed out that China represents more than two-fifths of the ESG assets under management (AUM) in Apac, a region with “significant room for growth”. From an ESG penetration percentage perspective, they said Asia remains in the relatively early stages, with a penetration of 3 per cent of broader market AUM. In Europe, this figure is at 30 per cent as at September, according to data from Morningstar.

They highlighted that China’s ESG AUM has been growing at a robust clip as well, saying that it has expanded at an average of 75 per cent per year over the past three years as at September, versus 17 per cent in Europe, 26 per cent in the US and 48 per cent across Apac over the same period.

“We believe the low penetration rate in Asia and the strong growth momentum in China indicates a long runway for growth in ESG AUM in China,” the analysts concluded.

Other themes

Morgan Stanley Research highlighted two other themes that are expected to drive alpha and impact in Apac going into 2023 – supply chain disruptions and continued regulatory changes to counter greenwashing.

On supply chain headwinds, the report said investors should focus on the implications of due diligence rules, carbon prices and requirements to disclose a company’s indirect non-power emissions – also known as Scope 3 in industry shorthand – and physical risks next year.

The due diligence rules proposed this year include the European Union’s Directive on Corporate Sustainability Due Diligence and Japan’s Guidelines on Respect for Human Rights in Responsible Supply Chains, which may propel companies and investors to step up their focus on labour and supply chain issues once adopted.

A third theme was an ongoing spotlight on defining “sustainability” and “green” for both corporates and investors in Asia, as well as a slew of regulations and policies expected to be implemented next year. These include the disclosure and reporting guidelines for retail ESG funds in Singapore, expected to take effect in 2023.