Commentary
Environmental, social, and governance (ESG) investing standards—also called “sustainable investing” and “socially responsible investing”—have taken on greater importance in the investment community in recent years.
Such investing has also reached the shores of China.
With this, ESG investing reaches an inflection point. Will the standards have real bite, effecting change at companies, or will they become an irrelevant article for portfolio managers to simply “check the box” and move on?
ESG Standards
What factors do ESG investing usually consider? There isn’t a uniform standard of ESG, but generally speaking it looks at a company’s environmental impact and policies such as waste management, emissions impact, and environmental protection; social policies such as labor standards, employee relations, equal employment, and impact on local communities; and governance factors such as ownership/structural transparency, investor voting rights, independence of the board/oversight, business ethics, and executive compensation fairness.
Today, this trend has migrated from a niche investment product to the mainstream, whereby many portfolio managers consider ESG factor even when constructing non-ESG investment portfolios. And many companies, desperate to add new investors or keep existing ones, are voluntarily publishing reports on how they meet various ESG criteria.
Proponents say that ESG will finally compel companies to become better corporate citizens. And ESG allows investors to use their cash to force change at companies. Critics argue that ESG is another costly regulatory measure that creates another cottage industry, allowing cash-rich companies to rubber-stamp their ESG credentials and skate by, while smaller companies are crippled by the increased burden.
Regardless, one cannot escape ESG. When BlackRock CEO Larry Fink—who oversees the world’s biggest asset manager with $7 trillion in assets—says sustainability will bring “a fundamental reshaping of finance” in its annual open letter to CEOs, company executives will pay attention.
In the letter, Fink calls climate change a “long-term crisis.” And “companies, investors, and governments must prepare for a significant reallocation of capital,” he said.
Finks calls on companies to both increase disclosure and enact policies to support ESG factors. He warned that BlackRock “will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”
Keep in mind, BlackRock and its peers in the passive investing space are often one of the biggest single investors within S&P 500 companies and wield enormous influence in their voting power. So Fink’s letter isn’t just an empty threat.
Investing in China
Chinese Communist Party (CCP) regime boss Xi Jinping made environmental protection one of the three biggest priorities in December 2017, and green finance has been a key policy initiative for Beijing. Green finance in this application means private capital to fund environmental improvement infrastructure projects. Technically, it is different from ESG, but it is nevertheless a component of the CCP’s broader virtue-signaling efforts.
Beijing certainly doesn’t want to jeopardize its foreign inflows. So Chinese authorities are increasingly beating the drum on ESG factors to attract more capital.
It seems absurd on the surface. But you have to respect Beijing’s boldness.
On Dec. 18, 2019, the Hong Kong Stock Exchange (HKEX)—where many successful mainland companies have listed their publicly traded shares—published its ESG guidance to mandate improved ESG disclosures among companies listed on the bourse.
Hong Kong’s new requirements govern fiscal years starting in July 2020. From that point forward, companies must produce a statement documenting the board’s discussion of ESG risks as they relate to the company, how the board considers the importance of ESG factors, and how they impact the company’s business.
Later this year, stock exchanges in Shanghai and Shenzhen are expected to follow suit.
One firm’s response to HKEX’s May 2019 open consultation period regarding its ESG mandate said, “we do not consider a mandatory disclosure of this statement will motivate companies to improve on ESG matters.”
An individual investor’s response was more blunt: “Please be reminded that wasting a listed company’s money is [the] same as wasting investors’ money,” and that the ESG disclosure is “not more than a paper target for fulfilling the listing rules (no matter how silly and stupid and unrealistic it is, something that an issuer has to do).”
Dennis Kwok, the Canadian-born member of Hong Kong’s Legislative Council, believes the HKEX must do more to address human trafficking among its listed companies. “While the criminal law and government policy in Hong Kong fall short of reflecting the severity of modern slavery… the risks associated, however, are not sufficiently reflected in existing ESG reporting.”
While one can understand the HKEX’s intentions, most mainland-domiciled companies likely cannot meet globally recognized ESG criteria and the exchange runs the risk of devaluing the entire ESG effort. At best, Chinese companies will view this as a meaningless “tick-the-box” exercise and waste investor resources, and at worst, companies will lie on their disclosures and bribe ESG consultants.
Even for Western companies operating in a more established and tenured ESG environment, such disclosures are difficult to implement in earnest.
But for many Chinese companies, this is simply impossible to fulfill, at least not in the short term and without some fundamental changes in mainland China.
Let’s examine each pillar of ESG with respect to Chinese companies. The environmental disclosure is probably the easiest to assess—since Beijing has made it such a priority—but progress simply isn’t fast enough. That means the initial disclosures by Chinese energy companies would likely look far from ideal.
China has around 1,000 gigawatts of national coal power capacity and another 121 gigawatts of new capacity under construction, a figure that is more than the rest of the world combined, according to Global Energy Monitor. The Wall Street Journal declared on Dec. 23, 2019, that “the world’s biggest carbon emitter is putting economic growth and energy security above its ambitions to be a leader in combating climate change.”
In China, national policy always trumps individual company policies. But at least on the environmental front, there’s a path forward.
What about social issues? This requires some fundamental changes. Chinese technology companies are known for their “996 working hour” culture, meaning workers work from 9 a.m. to 9 p.m., six days a week. That’s a total of 72 hours per work. Technology workers are sick of this and have increasingly taken to the internet to complain.
However, the long hours at China’s technology giants must seem like a blessing to China’s hoard of factory workers. China Labor Watch in 2016 documented workers in southern China’s toy factories working in toxic and dangerous environments while earning minimum wages.
So social issues likely won’t go away any time soon.
Lastly, governance is the aspect of ESG that Chinese companies will have the hardest time passing. It cuts to the heart of the CCP.
Many Chinese listed companies have an opaque and confusing ownership structure where investor voting rights have no actual weight. And that’s not an accident or error—it’s by design. In addition, Chinese companies, even non-government owned ones, must implicitly answer to local CCP bosses and party cells. This is an overhang for each and every Chinese company no matter where its stock is traded—and a key reason why Huawei, a privately owned company, poses a national security risk to the United States.
Of course no company board would come out and admit these realities on their ESG report; it would be career and perhaps literal suicide. But to outside investors, this fact makes governance an almost impossible challenge to overcome.
And what about business ethics? Some firms could run afoul there too. Last October, the U.S. Commerce Department put 28 Chinese companies and organizations on a U.S. trade blacklist for their role in persecution of Uyghur Muslim minorities in Xinjiang. Hikvision, a Shenzhen-listed global leader in making surveillance equipment, is one of the barred companies.
This isn’t to say companies elsewhere don’t have degrees of ethical issues; many do, and it remains to be seen how they tackle this on their ESG reports. But these issues are more pervasive and harder to address for Chinese firms. Often, the boards of their publicly listed subsidiaries have no power to challenge the parent companies.
Without fundamental changes to China’s broader political and economic system, mandating the implementation of ESG standards within this environment is fruitless.
But you can bet that most Chinese companies will pass their ESG exams with flying colors somehow. There’s no way that Beijing would allow ESG to go forward otherwise. So portfolio managers and exchange operators are faced with a conundrum. Can they be believed? And does it matter? How market participants deal with this would speak volumes about how seriously global investors are taking ESG.
And those who buy their claims at face value are likely either ignorant or willingly fooling themselves.
All of this risks cheapening the global ESG effort and reducing it to a triviality. The hope is that ESG will become more than a meaningless box-checking exercise for virtue-signaling investment managers to proceed with business as usual.
