Sustainable Investment in China | What Investors Need to Know About the Top ESG Challenges in China

Integral to BSR’s work with Sumitomo Trust and Banking’s “China Good Company” stock fund, BSR operates a monthly environment, social, and governance (ESG) news screener that analyzes publicly traded companies across more than 90 ESG issues. This helps STB identify high- and low-performing companies based on ESG factors and provides a good overview of some of the major ESG issues facing Chinese companies.

There are several factors that make the investment climate in China different than in other countries, and these need to be carefully considered by investors. They include:

• Large size of the country
• Abundance of local company subsidiaries that are independently run
• Strong relationships with local government agencies that report to provincial authorities rather than to central government agencies
• Fast pace of social change and the changing nature of stakeholder relationships particularly with the media and civil society in the country
• Rapid growth of companies in various dimensions: in different geographies, up and down value chains, and across sectors
• Difficulties in managing staff and enforcing codes of ethics amid high staff turnover and a scarcity of experienced professionals
• Weak enforcement of regulations, which is often related to the close relationships between businesses and (local) governments
• Low ceilings on fines for standards violations and common occurrences of companies using financial influence or relationships in the government to hide information from the media at local levels

Our analysis reveals some important insights for investors who want to better understand how Chinese companies are performing, and how they are responding to ESG issues. In this article, we highlight four specific issues that are of particular importance in China: lack of governance, misleading marketing, substandard product quality, and waste-water pollution.

Lack of Governance

Corruption is a major challenge for business in China, particularly for financial services and energy companies that have large networks that span across the country and struggle to implement effective internal control mechanisms. The most common problems include financial fraud, bribery, and the misuse of company funds. The traditional Chinese practice of giving expensive gifts to business associates is also a primary source of corruption in the country. Companies need to have clear standards and policies governing this practice.

Company spotlight: Earlier this year, Sinopec’s Guangdong branch was involved in a “luxury-liquor” scandal that started when invoices were posted on a Chinese online forum revealing that RMB1.68 million (US$258,000) had been spent on liquor. Sinopec launched an investigation and suspended the Guangdong branch’s general manager for six days after the news broke. He was later removed from Sinopec Guangdong and fined RMB131,100. During the investigation, Sinopec refused to answer questions from journalists.

In response, Sinopec’s chairman stated that the public had a right to criticize Sinopec, as it is a state-owned enterprise. Meanwhile, it was reported that Sinopec Guangdong held internal meetings to discuss how the public relations department should handle media interviews and required all departments to trace the leak in order to punish the whistleblower.

This scandal demonstrates how the spread of the internet and social media is putting increased pressure on companies to maintain high standards. The rise of social media has made it harder for companies to hide illegal practices, with several high-profile companies now facing greater “headline” risks. Companies also face new challenges in how they respond internally and externally to rumors as well as the time it takes them to respond. Lastly, the media reports revealed Sinopec’s unethical business practice of punishing staff who report corruption.

Investors can take concrete steps to help companies strengthen their internal controls. First, investors should review companies’ whistleblower policies to ensure that they provide adequate protection, and provide feedback if the policies fall short. Also, investors should encourage companies to disclose how they deal with internal control problems, which ideally would be in a constructive and transparent manner. Lastly, investors can emphasize the growing importance of maintaining strong internal controls in an increasingly connected world as well as proactively and transparently engaging with stakeholders.  

Misleading Marketing

Recently, there has been a spate of problems with companies—particularly those in the insurance industry—misrepresenting products at local-branch levels by providing false advertising to customers. As with large corporations who lack internal control over their local branches, insurance companies’ main vulnerabilities are rooted in their large numbers of sales agents who possess limited training and industry experience and whose remuneration is highly dependent on commission. This has led to several reported cases of false advertising such as exaggerating policy benefits, concealing details of claims-settlement processes, not fully educating customers, and refusing to provide prizes for competitions.

Company spotlight: In a recent news report, China Life Insurance agents were accused of deliberately misleading customers about the maturity of their investment products, not providing the proper promotional materials, and concealing important information. The company simply replied that everything was stated in the contracts.

Investors should pay close to attention to companies’ sales and advertising practices, and, more importantly, how they incentivize agents and implement their policies.

Substandard Product Quality

Substandard products continually make it onto the market, indicating widespread failures in quality control.The problem affects a wide range of industries, including: energy, consumer products, health care, agriculture, and industrial machinery. Though product quality problems are inherent in all manufacturers, recent stories reveal that companies do not fully understand the risks that exist along their entire supply chain, and they do not have strategies to address those risks. These risks can be minimized with rigorous sampling and testing.

Company spotlight: In April, following consumer complaints and a company investigation, Sinopec Henan’s #93 grade ethanol gasoline was found to contain too much manganese. The company attributed the error to insufficient quality control and operational problems at Anyang Oil Limited’s storehouse.

Sinopec Henan relieved the parties responsible from their duties and offered compensation to motorists whose cars were damaged. Moreover, the company invited government bureaus, consumer groups, and technicians to serve as independent witnesses to confirm the accuracy of complaints, carrying out vehicle repairs and other tasks related to the compensation program.

Sinopec’s response was exemplary from a customer-service perspective, but is typical of many companies’ short-term and reactive approach to such problems. There is no evidence that Sinopec fully understands the underlying causes of the problem and have addressed them with their suppliers in order to prevent this—or similar—problems from occurring in the future.

From an investor perspective, Sinopec should be asked to publicly provide a supply chain strategy, details of the measures they took to resolve the problem, and regular reports on their performance moving forward.

Waste-Water Pollution

The challenge of waste and water pollution in China among manufacturers is two-fold: creating pollution and refusing to clean up pollution. Local governments and civil society groups are increasingly placing pressure on companies that do not respond to calls for action.

Provincial environmental offices have warning lists and blacklists of companies that violate environmental standards, and local governments have jurisdiction to impose fines and close down operations. However, blacklisted companies have the opportunity to rectify their problems by undergoing a series of inspections in order to be removed from the blacklist.

Company spotlight: In February 2011, 24 NGOs called on Chenming Paper to stop illegally dumping sewage. This incident follows 21 previous environmental violations by the company since 2004. The company did not respond to the NGOs’ statement and the company’s spokesperson did not respond when journalists called.

Investors can dramatically reduce their chances of encountering such problems if they examine companies’ environmental track record before they invest in them. In addition to contacting provincial environmental offices, investors can use the Institute of Public and Environmental Affairs’ website to identify companies with poor environmental performance. This website contains a database that tracks water and air-standards violations by manufacturers in more than 300 cities in China. 

The Role of Sustainable Investors

To ensure that companies properly address ESG issues, investors should understand their investees’ internal control policies and systems and work with them to strengthen their controls to prevent future crises. More specifically, investors in China should:

• Pay close attention to local news reports of companies that are fined for violating standards. Problems identified at local levels may indicate wider problems throughout the corporation, even if they are not picked up by national media.
• Actively follow companies’ responses to ESG-related accusations, and work withother investors to influence company actions by using networks such as the UNPRI’s Clearing House.
• Closely monitor warning and blacklists, and inform your investees that you are doing so.  
• Proactively track social media for ESG-related news reports.
• Work with NGOs active on ESG issues in order to identify poor-performing companies.Investors cannot depend on the local media, since the media is not as critical or investigative as media in other countries, and many news stories may not be published as a result of corporate or political influence.
• Visit local branches of investee companies, set-up a local staff presence, and foster a relationship with the management of investee companies through face-to-face meetings.

By effectively and consistently engaging with their investees, investors can play an important role in addressing ESG challenges in China.