Former Managing Director, Advisory Services, BSR
In August, the Shanghai Stock Exchange (SSE) and China Securities Index Ltd. launched China’s first index employing environmental, social, and governance (ESG) criteria. The new Social Responsibility Index, which uses homegrown ESG methodologies to select stocks, has the stated objectives of encouraging listed companies to actively manage their social and environmental risks and opportunities, providing investors with a new investment benchmark, and popularizing the socially responsible investment concept.
BSR recently conducted a research study commissioned by the International Finance Corporation (IFC) to analyze the state of ESG investing in China. Based on this research, we believe that, with the right support from government and mainstream investors, these goals can be achieved and could make China’s investment community a leader in ESG investing.
CSR in China
Before discussing the prospects for growth in ESG investing in China, it is worth reviewing the recent growth of corporate social responsibility (CSR) in the country. BSR has worked with foreign and domestic companies in China for some time, and we have seen three important trends in the past three years:
- Chinese multinationals are increasingly investing in strategic CSR: While our work in China had long focused primarily on working with Western brands and their China-based suppliers, we see more and more Chinese companies addressing CSR strategically and reporting on their progress.
- Environmental issues are growing in importance: Social issues, including labor standards and corporate governance, remain high on the Chinese CSR agenda. Recently, however, we have seen business pay more attention to environmental issues such as water pollution and energy efficiency.
- Local stakeholders are increasingly taking an interest in ESG issues and driving the agenda: The Chinese government, consumers, media, and nonprofit organizations are making their voices heard and setting the CSR agenda, with real implications on how businesses operate in China.
All three trends bode well for further growth in ESG investing. More strategic management of CSR, and, more importantly, increased transparency by Chinese multinationals, will give ESG investors data to make investment decisions, and will become suitable targets for those investments.
Increased awareness of business impacts on the environment also can be an important driver: The fact that they are more easily quantifiable makes environmental issues good entry points for ESG investment strategies. Positive strategies such as green funds, which focus on environmental innovation, can also spur mainstream investors who want to avoid ethically based socially responsible investment (SRI) philosophies to embrace broader ESG approaches.
A Nascent Market
Despite the launch of the SSE’s Social Responsibility Index, ESG investing remains a small, nascent market in China. While both the absolute dollar value and the ratio of ESG investment to total assets is very small, a number of segments in the investment market—including retail products, pension funds, private equity, and indices—are starting to integrate ESG factors into investment strategies. However, these efforts are often limited to a broad public commitment to social responsibility with limited evidence of rigorous screening.
In addition to the SSE’s Social Responsibility Index, there are a number of examples of ESG investments in different asset classes: AEGON-Industrial Fund Management Co., Ltd., one of the pioneers in China, offered the country’s first and so far only SRI retail fund in May of 2008. The fund, which had attracted US$506 million as of September, has adopted a positive screening approach and developed a series of criteria used to assess corporate sustainability and environmental compliance. Between its inception and June 30, 2009, the fund did well, outperforming the market benchmark by about 37 percent, according to BSR’s research.
While most pension funds in China still show only limited interest in ESG investing, the National Social Security Fund of China (NSSF), the country’s largest pension fund, with total assets of US$82 billion, lists “responsible investment” as one of its four core investment principles and participated in a roundtable discussion on sustainable investment that BSR recently held with the Principles for Responsible Investment.
Overall, China’s pension system is still immature and lags behind the country’s economic development. By some estimates, only 21 percent of the population is entitled to receive pension benefits, and much of the population in rural areas does not have access to pension schemes. In addition, the current pension system restricts the type of asset classes and the investable amounts or percentage “ceiling” for each asset class. This means that the role of pension funds in the capital market is still limited, which restricts the important position they play as long-term investors.
However, China has been undertaking major reforms in its pension system. According to most estimates, Chinese pension funds will emerge as some of the largest in the world. As this happens, Chinese pension funds could also become a significant group of ESG investors.
In private equity, Tsing Capital, a leading Chinese private equity firm focused on clean technology, performs ESG audits of and engages with investees on the broad range of ESG challenges they face, providing support for investees where necessary. Tsing Capital has demonstrated that ESG investing is possible in China, and serves as a role model for other domestic investors.
Meanwhile, the SSE’s Social Responsibility Index comprises 100 stocks that performed well on the SSE’s CSR rating system. The SSE claims that the index’s average social contribution value per share of RMB2.42 and average earning per share of RMB0.69 in 2008 were both higher than the average of all SSE-listed stocks. As of mid-November, the SSE Social Responsibility Index had closed at 1,138.5 points, representing an increase of 13.85 percent over the base day of June 30, 2009. CCB Principal Asset Management Co. Ltd, a mutual fund management company jointly established by China Construction Bank, the Principal Financial Group, and China Huadian Group, plans to offer an exchange-traded fund to follow this index. This is another example of a Chinese asset manager devoting itself to SRI.
ESG with Chinese Characteristics
Generally, ESG investing employs screens based on three core areas: ESG criteria, shareholder advocacy on ESG issues, and community investment programs. To date, the ESG investment movement in China has been focused almost exclusively on ESG screening criteria.
The limited number of existing ESG products, and the lack of details on the specific screening methodologies, make it difficult to draw conclusions about what a uniquely Chinese approach to ESG investing would look like. The AEGON-Industrial Fund’s ESG screening methodology provides some clues: AEGON employs a positive screening process, which rates Chinese listed companies from four perspectives—economic responsibility, sustainability responsibility, compliance responsibility, and business ethics—and then selects the companies with the highest comprehensive score to join their core stock pool. The fund’s investment committee then selects stocks from this pool to build its portfolio.
The fund’s ESG approach has a primary focus on corporate governance and compliance, which is consistent with many other CSR and ESG philosophies we have observed in China. The fund also has specific ESG criteria that are peculiar to the Chinese market: Special emphasis is placed on a company’s compliance with the law, especially the tax law, and cooperation with government.
Further Growth in ESG
The big question is whether these developments are merely a flash in the pan or the early signs of China’s growing ESG investment market. The increase in strategic management of CSR by Chinese-based companies reinforces the latter view. Taken together, the three trends are a strong sign that we will see significant growth in both CSR and ESG in China in the coming years. A number of additional developments suggest fertile ground for continued growth in ESG investing in China:
- Stronger regulation of social and environmental impacts: Over the past five years, China has significantly reformed its ESG-related regulation of business. For example, the labor contract law enacted on January 1, 2008, strengthened workers’ rights. Also in 2008, the promotion of the State Environmental Protection Administration to Ministry status (as the Ministry of Environmental Protection, or MEP) gave more weight to environmental protection in shaping the country’s development priorities. In addition, the China Securities Regulatory Commission now requires that companies with significant environmental impacts that are seeking to go public follow an MEP approval process and public comment period. In 2008, the MEP inspected 73 companies going public, and among 38 completed inspections, only 18 enterprises passed. All of these changes have mirrored the increasing government emphasis on ESG factors and their growing importance to business and investors.
- Growing awareness of the need for risk management: Increasing numbers of high-profile business ethics cases, such as the 2008 contaminated milk powder scandal, have caused investors to consider ESG factors more seriously when evaluating potential investments. As a result, a growing number of domestic institutional investors are actively screening for governance and compliance issues. In our interviews for the IFC report, Chinese asset managers said they increasingly hold the belief that ESG risk management improves a company’s market value in the long term.
- Increase in transparency: Successful ESG investing is dependent on the availability of material information on ESG issues. A lack of transparency is a well-known shortcoming in China, but recent initiatives indicate some progress in this area. The MEP's May 2008 Provisional Measures on Disclosure of Environmental Information guarantees the public’s right to access environmental information and participate in environmental issues, and sustainability reports are becoming commonplace among larger companies. The MEP has begun collaborating with the People’s Bank of China and the China Banking Regulatory Committee to develop a unified corporate environmental performance database to share with financial institutions.
Despite these encouraging trends, China must overcome a number of hurdles to truly turn the growing interest in ESG investing into a mainstream market. The most significant challenges are threefold: short-termism, limited awareness of and capacity around ESG issues among most market participants, and the limited infrastructure of the sustainable investment market.
Most interviewees for BSR’s research agreed that the mentality of investors in China is still dominated by an emphasis on short-term results, which works against ESG integration. Our research revealed that most asset managers hold stocks for only three months, and thus question why they should consider a company’s long-term performance. Furthermore, individual investors hold about half of the market, so institutional investors play a less important role than they do in other countries. In addition, pension funds and other investors such as insurance companies, which are likely to have longer-term investment horizons, also face restrictions on their equity investments.
A second challenge is ESG capacity and awareness. While CSR management and reporting are becoming more common—and a handful of leading companies have taken steps to improve their sustainability performance—most companies still view CSR as an additional cost rather than an opportunity or a necessary risk-management tool. Consequently, ESG performance among many companies remains relatively low, and few companies publish comprehensive ESG data in their reports, thus limiting choices for ESG investors.
High-quality, dependable information about a company’s social and environmental performance from civil society also remains limited, with stakeholder engagement only recently beginning to take hold.
Challenges also exist on the investment side. Although international research firms have recently opened offices in China, there are no domestic ESG research providers. Through interviews with Chinese mainstream investors, BSR has learned that most domestic investment analysts are not trained to perform both ESG and financial evaluation, and there are limited training opportunities around ESG analysis for financial analysts. Therefore, domestic practitioners have limited sources to build ESG investment knowledge and skills.
The Way Forward
There are a number of steps the Chinese government and the business community can take to overcome these challenges, including to:
- Form a platform for cooperation among the sustainable investment community to work jointly on solutions.
- Enhance ESG disclosure and research capacity.
- Increase public education about ESG and integrate sustainability issues into key training programs for investment and business professionals.
Already, we have seen interest from the major investors in learning from each other and participating in dialogues with the government agencies in relevant events, such as BSR’s roundtable earlier this month. Many systemic problems must be addressed in collective form, especially due to the complexity of the security market in China.
We have also seen a number of public-sector bodies promoting non-financial information disclosure. Guidelines issued by the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC), the stock exchanges, and even local government agencies have all publicly supported more corporate transparency on ESG issues.
For example, in 2006, the Shenzhen Stock Exchange formally issued and put into effect its “Social Responsibility Guidelines for Listed Companies,” calling for listed companies to develop a CSR strategy according to the guidelines and to report on progress. In 2008, SASAC issued guidelines mandating 150 leading state-owned enterprises to issue CSR reports, and the SSE issued guidelines encouraging its listed companies to produce CSR reports. Similarly, local governments and government-oriented business associations are also encouraging the disclosure of ESG information.
With the public’s awareness of climate change, water shortages, and good governance now higher than ever, we have also seen much more attention from the public and investors on ESG issues. If these trends continue—if investors work together to overcome the larger challenges, if ESG data become more available, and if mainstream investors increase their level of awareness and understanding of ESG—ESG investing could flourish in China, with significant benefits to the country and its business community. Transparency would increase, which would lead to better corporate governance and more successful companies. Ultimately, the market would reward the most innovative companies that effectively address the country’s most critical challenges, such as climate change and pollution.
At a time when the country and the world look to Chinese businesses to integrate sustainability into their core strategies, China faces a real opportunity. With improved regulation and a thriving sustainable investment market, businesses and investors in China could make real progress in overcoming the country’s sustainability challenges.
Note: Investment products and organizations referenced here are for illustrative purposes only, and nothing in this article should be construed as investment advice. Investors should, in every case, perform their own due diligence on potential investments.
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