ESG gains traction in China as foreign investor base expands

AWARENESS of environmental, social and governance (ESG) issues has increased in China, and government initiatives and increased foreign investor participation in China's markets are largely driving it.

Over the years, China has slowly opened up its equity markets to foreign investors. The introduction of the Shanghai-Hong Kong Stock Connect programme in 2014 was a milestone, followed by the government's decision to lift restrictions on foreign investment in China in 2019. The rapid expansion of China's equity markets is evident - foreign holdings of Chinese equities hit a record of 1.77 trillion yuan (S$349 billion) in the third quarter of 2019.

As China's equity markets hit the international stage, it also propelled ESG issues to the forefront.

As the participation of foreign institutional investors in the China A-share market rises, Chinese companies are likely to face greater scrutiny from these investors, who often have high ESG requirements. This in turn should lead Chinese companies to improve their ESG standards. However, at this point in time, China is still in the early stages of embracing ESG. As such, disclosures remain fairly weak compared to Western markets where ESG awareness is ahead of China.

The number of A-share companies disclosing ESG information has been rising over the past few years, yet there is still ample room to improve. As of September 2019, 945 companies issued a corporate social responsibility (CSR) report, representing about 26 per cent of all China A-share listed companies. Within the CSR reports, the quality and frequency of key ESG data were also relatively low compared to international standards.

For example, with the constituents of the Shanghai Shenzhen CSI 300 Index, corporate governance has the highest disclosure average rate of 66 per cent, while the average disclosure rate was lower for environmental and social responsibility factors at 40 per cent and 29 per cent respectively. Due to the new regulatory requirements, all China A-listed companies must now report on environmental measures/metrics and disclose the volume of total emissions of air pollutants such as nitrogen oxide, sulphur dioxide and water pollutants.

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ESG EXPECTATIONS

We find that companies with a larger share of foreign ownership and large cap private-sector companies - typically sector leaders or those with a larger overseas exposure - tend to be more advanced in their adoption of ESG disclosures and policies. This is because these stakeholders have higher ESG expectations and may need to align with overseas competitors' practices so as to remain competitive outside of China.

Large companies also have more resources on issuing ESG-specific reports relative to smaller firms, which tend to have a less diversified, more domestically-oriented investor base that, for now, remains less sensitive to ESG matters. However, this is gradually changing.

More often than not, we have found that a rise in awareness from a social responsibility standpoint can contribute to better outcomes for the company - with greater social consideration there will likely be improved disclosure and ESG practices, which generally leads to a positive outcome for shareholders and stakeholders. For example, Chinese technology companies tend to benchmark themselves and compete against competitors in Western countries which operate in regions where ESG awareness is ahead of China. As a result, they often place more importance on ESG practices than companies operating in so-called "old economy" sectors, such as industrial manufacturing.

By contrast, state-owned enterprises (SOEs) tend to lack high standards of corporate governance. That said, we favour SOEs with good management teams that align with minority shareholders' interests, and believe solid ESG practices are important as part of a long-term corporate strategy.

While ESG standards may not be as high in China as in the West just yet, we believe improvements in this area will continue. We do recognise that the pace of adoption may vary across industries and across companies, but believe a research-driven approach focused on quality and sustainability remains crucial to investing in China equities.