The ESG-focused investing sector has once again called its standards into question.
The $2.7 trillion global market for environmental, social, and governance (ESG) funds invests in the debt and equity of companies purported to be socially responsible. There’s an entire cottage industry formed around ESG, including ratings agencies, auditors, and investment consultants. The industry has become increasingly mainstream, and many publicly traded companies are altering their corporate strategies to qualify.
Today, Russia’s ongoing invasion of Ukraine has prompted debates about the industry’s practices.
International investment funds, including those managed by UBS’s own so-called “green bonds”—debt whose proceeds are supposed to fund initiatives considered sustainable and environmentally friendly—are issued by Russian Railways JSC and Russian bank Sovcombank PJSC. Both Kremlin-affiliated firms are now sanctioned by the United States and its Western European allies, forcing ESG-aligned investors to divest their holdings of green bonds from these issuers.
Suffice it to say, securities issued by many more Russian companies—locked out of global capital markets, with some being cut off from the SWIFT dollar network—no longer qualify for ESG investments.
This brings us to China, Russia’s closest ally.
China presents a similar set of issues for ESG investors. China’s ruling regime, the Chinese Communist Party (CCP), is closely aligned with Moscow and thus far has refrained from condemning Russia’s invasion of Ukraine. Some political experts even believe Beijing views Russia’s aggression as a “dress rehearsal” ahead of its own ambitions to reclaim Taiwan.
Yet many ESG investment funds own Chinese stocks and bonds. More than 1,000 Chinese A-share firms listed in Shanghai and Shenzhen publish ESG reports. MSCI, the global investment indexation firm, assigns ESG ratings to more than 700 Chinese companies. A plurality of Chinese firms is AAA-rated in ESG by MSCI.
In a country where political and business lines are often blurred and all companies—public and private—must swear allegiance to the CCP, assigning high ESG ratings to Chinese companies appears nonsensical.
Paul Clements-Hunt, a founding father of ESG investing who helped coin the term, is one expert who has been warning investors about the watering down of ESG qualifications.
“If you don’t factor in autocracy and a malevolent government, then you have failed in your ESG assessment,” Clements-Hunt said in a recent interview with Bloomberg.
Yet the ESG investing industry seems to overlook such issues while assessing China’s vast capital markets. China owns the world’s second-largest economy, and investors have been eager to invest there. Chinese companies happily churn out ESG reports while ignoring the elephant in the room—the fact that most Chinese firms would fail the S (social) and G (governance) aspects of ESG.
Many such reports are copied from one another and have similar language and qualifications. Yet ESG rating firms happily assign positive ratings to them, carrying on a foregone conclusion that Chinese companies should qualify for ESG inclusion.
This process makes a mockery of investors who truly care about ethical conduct, transparent governance, and sustainable business practices.
The fact that China is the world’s No. 2 economy and a key component of the global supply chain means it’s even more critical to apply ESG properly to Chinese constituents. If done correctly, real impact is achievable.
I’ve heard from institutional investors who acknowledge the double standards, yet caution that blacklisting Chinese firms could upend the ESG investing industry.
That’s no excuse for losing sight of ESG’s original purpose. If industry participants are resigned to this, then the ESG industry has failed its mission.
