Do ESG ratings reveal the full picture?
ESG ratings consistently show Chinese companies lagging behind emerging markets (EM) peers on ESG. With more controversies, weaker corporate governance scores, and red flags concerning human rights leading many to question whether China is investable from an ESG perspective.
What is certain, however, is that the ratings do not capture the full picture. Many Chinese companies are penalised for lack of disclosure, understandably. However, some global ESG issues can be more or less material in a Chinese context due to local nuances and policy priorities. One example is the gaming sector, where more attention is given to preventing gaming addiction among adolescents.
These variations are not well reflected in global ESG frameworks, which can also penalise Chinese state-owned enterprises (SOE) that still dominate the economic landscape, with 71 per cent of Chinese companies listed on the Fortune 500 being SOEs.
Regulatory action driving ESG gains
While China may not be seen as an ESG compatible market, regulatory action is driving improvements across the sustainability agenda. The country’s most significant achievement over the last 40 years has been lifting 800 million people out of poverty through rapid economic growth and government policies to alleviate poverty through the “common prosperity” agenda, targeting regions disadvantaged by geography and lack of economic opportunities. This change has been instrumental in delivering a central aim of the UN Sustainable Development Goals (SDG).
Environmentally, China remains a global leader in solar and energy storage technologies and has a sizeable wind turbine manufacturing supply chain. Hydrogen is also set to play a key role in China’s decarbonisation efforts. While the government continues to order more coal, it is also ramping up new solar capacity which will be instrumental in the country’s bid to reach net zero by 2060.
Outside of the energy sector, there is considerable government support for investments in energy efficiency improvements and process innovation, which are vital to achieving net zero. Progress on creating a circular economy has been slower, with the focus mainly on improving waste management, but it is progressing.
Meanwhile, large companies are aligning with the government’s 2030 and 2060 targets with many going further to set 2050 targets. Supply chain emissions (Scope 3) remain under- reported, yet this is a global issue. We have also seen Chinese export-focused firms spurred on by international regulations such as the EU’s Carbon Border Adjustment Mechanism.
On governance, the State Council has recently issued guidelines to drive improvements in board composition, including a welcome recommendation that all SOEs have a majority of independent directors and fully independent audit committees. Generally, the government is pushing for more mixed ownership and modernisation of SOEs. We are also seeing improvements in ESG disclosure requirements, with mandatory environmental reporting for high-impact companies, albeit less advanced than neighbours, such as India, where more comprehensive ESG reporting is mandatory for the top 1,000 listed companies.
Risks still prevail
This progress is unfortunately not matched on the social side, notwithstanding huge achievements on alleviating poverty, protection of minors on gaming platforms, and female participation in the workforce.
A recent report by Sheffield Hallam University flagged exposure to forced labour in China’s solar and auto supply chains, with the risks well-documented in other industries, including agriculture.
Working conditions in manufacturing also remain an issue with high employee turnover (reaching 40 per cent in some companies) indicating underlying challenges. Internal migrant workers are also vulnerable to exploitation since, on migrating to urban areas to take-up low-paid manufacturing jobs, many still lack access to social benefits under the hukou (household) registration system.
Meanwhile, the “996” work culture in the technology sector remains an issue despite government efforts to address it. Newer social issues – such as digital rights, privacy, and surveillance – are also under the spotlight with technology companies coming under scrutiny for their data-sharing policies with the Chinese government.
While some of these issues are by no means unique to China (modern slavery, for example, remaining a global phenomenon and is reportedly higher in other EM countries), they remain risks that require evaluation, mitigation, and when appropriate, avoidance.
While not all state-owned enterprises are alike, it may pay to avoid SOEs in traditional sectors where the risk of political interference is too high (for example, banks, property and heavy industry) and only invest in SOEs that demonstrate due consideration for minority shareholders.
To invest or not to invest?
While ESG ratings do not capture the full picture, there is no doubt China is challenging for the ESG investor, despite various positive regulatory drivers. Yet the world cannot win the fight against climate change without China successfully transitioning to a low carbon economy. Private investment is critical to help achieve this goal, alongside concerted government action.
A bottom-up approach is needed to identify companies showing positive ESG momentum and openness to shareholder dialogue, while playing into long-term structural themes that will deliver sustainable growth. For the committed, long-term investor, it is possible to achieve this through in-depth qualitative research and focusing on themes set to transform the Chinese economy – notably digitisation, automation, electrification and renewables – with the potential to help achieve the UN SDGs, while addressing China’s social and environmental challenges. Done in the right way, ESG investing in China could present an under-appreciated opportunity.
Olivia Lankester, director, responsible investing and sustainability, Federated Hermes