Opinion: Beyond the Bottom Line

China is moving fast to embrace environmental, social and governance (ESG) as a critical input in government policy and in boardrooms, although in comparison with many developed Western economies, the country falls far short and has a lot of catching up to do.

For the ESG spectrum, the ‘E’ stands for environment, in particular greenhouse gas emissions, pollution and environmental degradation. The ‘S’ encompasses employee relationships, safety and the effect of an entity’s operations on the local community. The ‘G’ covers shareholder rights, executive pay and general standards of governance, such as stringent adherence to accounting principles and operational transparency.

China lags in ESG compared with the European Union and countries such as Canada, Australia and Singapore, where there are stringent regulatory frameworks in place.

For example, in China there is a lack of formal regulatory mechanisms that require investors, and in particular asset owners, to take ESG factors into account in their investment processes.

Furthermore, there is a dearth of guidance to help investors integrate ESG factors into their investment decision-making, as well as difficulties in engaging companies on ESG issues due to the lack of consistent, comparable and reliable corporate reporting.

But although ESG integration is still in its early stages in China, support from the public sector is helping to create momentum.

The China Securities Regulatory Commission recently announced that it will require listed companies by 2020 to disclose key environmental information in their annual or semi-annual reports.

Meanwhile the Shanghai and the Shenzhen stock exchanges have joined the U.N. Sustainable Stock Exchanges initiative and are committed to supporting the development of green and transparent markets in China.

And China is increasingly recognized by the international community for its leading role in green finance development worldwide, for taking green finance to the G20 and for enhancing inter-governmental dialogues on issues related to private sector climate disclosure.

Chinese policymakers are working closely with nongovernmental organization (NGO) think-tanks that aim to foster the growth of ESG as a critical input into the business models and mission statements of corporations and institutions around the world. There are catalysts driving China’s transformation. 

A critical input is the roadmap for China’s ESG evolution, which was unveiled recently at an event in Beijing and drafted by the Principles for Responsible Investment, the United Nations Environment Programme Financial Initiative, the Generation Foundation and China’s International Institute of Green Finance.

Key takeaways from the roadmap include the need to develop a culture of fiduciary duty among China-based institutional asset managers and the recommendation to establish a mandatory environmental framework for Chinese companies, aligned with international standards of ESG disclosure and the standardization of supporting frameworks and formats in green finance deals.

Still, there is a long way to go. The investment case for integrating ESG factors to drive value creation, and how company performance in relation to ESG factors might be used in investment research and decision-making processes has yet to come to the fore in China.

Certainly the perception that ESG is something of a luxury, rooted in ethics and likely to compromise returns — something entirely separate from fundamental investment analysis — is lodged in the DNA of a large swath of Chinese companies and investors.

But research has demonstrated that ESG-compliance produces superior investment returns, and the ongoing surge in China’s investment industry — which encompasses private equity, wealth management and retail — allied with that empirically established fact, is likely to drive ESG momentum.

Meanwhile the rise of green finance presents a powerful transformational dynamic. Domestic and international capital markets are expected to play a significant role in financing China’s green transformation and growth, and with it the attendant rise of ESG awareness and regulation.

For example, the ambitious Belt and Road Initiative to develop infrastructure linking China to countries along the ancient Silk Road trade route is likely to generate a swath of ESG-compliant projects, with green bond and loan funding envisaged by Beijing as crucial to generating capital from international investors to finance the initiative.

Recently, the European Investment Bank and the China Green Finance Committee presented the initial conclusions of a project that ultimately seeks to facilitate the establishment of a common language in green finance via a partnership of multilateral development banks and the International Development Finance Club.

This momentum has been fueled by the rapid growth of green bond issuance in China, which totaled a record $37.1 billion in 2017, making China the world’s second biggest issuer of the product.

Still, the limited number of existing ESG products, and the lack of details on the specific screening methodologies used by Chinese investors can make it difficult to draw conclusions about what a uniquely Chinese approach to ESG investing would look like.

But the backdrop is shifting as major government-linked entities look to align with ESG. While most pension funds in China demonstrate limited interest in ESG investing, the National Social Security Fund of China, the country’s largest pension fund with total assets of $82 billion, lists “responsible investment” as one of its four core investment principles. The trend is there for ESG to take hold in China.

If investors work together to overcome current barriers and if more mainstream investors increase their level of awareness and understanding of the key issues, then ESG investing in China has the potential to significantly expand over the next 10 to 20 years.

Fiona Reynolds is managing director of the London-based Principles for Responsible Investment, a nongovernmental organization that aims to foster the growth of ESG.