Impact Investing Must Hold Chinese Companies to Same Ethical Standards

As China stocks gain foreign investors, their ESG impact should be assessed lest global investors practice hypocrisy

Delegates arrive at the second Plenary Meeting of the second session of the Chinese People's Political Consultative Conference in Beijing's Great Hall of the People March 9. Fred Dufour/AFP/Getty Images

Commentary

Socially responsible investing has gained traction in recent years. Traditionally, an underperforming niche product ignored by most serious investors, it has become a key investment rationale and a differentiator among portfolio managers.

There has been tangible growth of investment in companies that make a positive impact in terms of environmental, social, and governance issues—or ESG for short.

As of 2018, $12 trillion of professionally managed assets consider ESG factors in their criteria, according to a 2018 report issued by the Forum for Sustainable and Responsible Investment. That represents 25 percent of all professionally managed money in U.S. assets, and a 38 percent growth since 2016.

Despite the prominence of ESG in portfolio construction, ESG investing is still largely confined to U.S. companies. In other words, only U.S. companies are judged on their ESG impact.

The fact that ESG only applies to U.S. companies—compared to their counterparts around the world, which are competing in the same global market for customers and the same global financial markets for capital—is increasingly concerning.

This double standard is most egregious when discussing investing in China. China is the world’s second-largest economy, and wishes to be viewed as an equal partner in ongoing negotiations toward a trade deal with the United States. Its technology companies, such as Huawei, seek to have a level playing field when pitching services to global governments, and, in general, Beijing believes its stock markets are as transparent, liquid, and prestigious as those in Hong Kong, Singapore, and Tokyo.

Yet when it comes to investing in Chinese companies, foreign investors suddenly toss ESG factors out the window. Investment managers and index providers are eager to jump into the Chinese market, abandoning the otherwise pragmatic, skeptical (and with ESG criteria, supposedly ethical) lens through which they judge other stocks.

At best, it’s disingenuous—at worst, it almost seems there is Chinese political influence at work.

Palpable ESG Growth

Definitionally, ESG is very broad—it’s a measure of how “good” a company is outside of financial performance. Entire industries can be expelled, such as those involved in selling tobacco and alcohol, or manufacturing guns and ammunition. It can apply to a company’s environmental impact—do its products help or harm the environment, what is the firm’s carbon footprint, or does it produce toxic waste, and how does it mitigate the effects?

It can also apply to a company’s governance and behavior such as ethics, transparency, executive pay, diversity in culture and thought, ownership structure, and whether it exhibits anti-competitive behavior.

 “We see wealth transferring from baby boomers to millennials, who are more interested in social responsibility,” Mamadou-Abou Sarr, head of sustainable investing at Northern Trust Asset Management, which manages $1.1 trillion in total assets, told Barron’s magazine recently.

“The younger generation is demanding ESG options,” he added.

That’s true to anyone familiar with recent developments in the asset management industry. ESG is no longer an underperforming niche sector; it’s become front and center in picking stocks. In the past, there was little incentive for companies and CEOs to respect ESG impact, but now, investors have a say and they can vote with their capital.

And generally, that’s a positive development.

Sarr said that Northern Trust’s ESG screening noticed red flags in Volkswagen Group AG’s governance, which caused its funds to cut exposure to Volkswagen before its emissions scandal came to light. That allowed most of its clients to avoid the approximately 23 percent decline Volkswagen stock suffered subsequently.

China A-Shares Cannot Be Ignored

That’s an instance where ESG works and Northern Trust stock pickers should be applauded. But those efforts should be expanded.

Billions in capital are about to pour into China. Global index provider MSCI recently announced that it would increase the allocation of China A-shares in its global and emerging markets indices by the end of 2019. Another index provider, Russell FTSE, is also increasing exposure to China stocks in its indices.

That means many passive funds and exchange-traded funds will be set to auto-purchase swaths of China A shares in 2019, flooding Chinese companies and stock markets with fresh foreign capital.

This is the time to have a serious ESG discussion with respect to Chinese companies.

The biggest listed A-shares are state-owned enterprises such as Bank of China, PetroChina, and Sinopec. Massive state-owned firms of this kind are controlled by the Chinese Communist Party (CCP) and are used by official families as piggy banks to fund their lifestyles and dynastic political wealth.

Even private companies, such as the well-known Alibaba and Baidu, are indirectly controlled or influenced by the CCP. CCP members officially sit on their boards, and Party cells are embedded in the majority of non-government owned businesses in China. Some companies, such as Hangzhou Hikvision Digital Technology, are directly involved in administering the Communist Party’s police state in Xinjiang, where Uyghur Muslims are being incarcerated en masse in concentration camps, while others like AVIC International Holdings are subsidiaries of state firms that develop weaponry for the People’s Liberation Army.

“China’s large privately owned firms are becoming more like state-owned enterprises, as many in recent years have implanted in their businesses cells of the Communist Party, the Communist Youth League and even discipline inspection committees,” columnist Zhang Lin wrote in the Hong Kong-based South China Morning Post in a Nov. 2018 editorial.

Even the CCP’s own statistics report that 68 percent of China’s non-state enterprises, and 70 percent of foreign-funded companies had set up party cells as of 2016.

The National Intelligence Law of 2017 obligates every organization and citizen to assist and cooperate with national intelligence efforts. Given the breadth of the definition of “national intelligence,” it’s clear that all companies large or small, private or government-owned, must ultimately answer to the CCP when called upon.

Itemizing all the ways in which the CCP fails to meet most ESG factors is outside the scope of this article. Suffice to say, the list is long.

Beijing has also set up the world’s most comprehensive surveillance system to track every movement of each citizen. This culminates in a “citizen score” that rates each individual and determines what type of services can be accessed.

Meanwhile, the CCP—as a reminder, an entity that seeks to control and influence all Chinese businesses—has committed human-rights atrocities such as jailing and torturing millions of Uyghur Muslims, Underground Christians, and Falun Dafa practitioners.

This isn’t to forcibly weave social factors into investment decisions and financial returns. But as ESG rises in prominence, we can’t be prejudiced in its application. And as the Volkswagen example demonstrated, investors who perform honest ESG due diligence can be rewarded.

In today’s investing environment, investors can’t succumb to hypocrisy—espousing the virtues of ESG on one hand, yet completely ignoring it when investing in China.