improving esg fundamentals emerge in china · 3 improving esg fundamentals emerge in china if...

Improving ESG fundamentals emerge in China

June 2020

Previously InvestecAsset Management

Greg KuhnertCo-head of 4Factor

Joanna YangPortfolio manager

The fast view ɽ As China opens up its financial markets and gains

wider representation in global indices, we are seeing an improvement in ESG standards and disclosure, albeit from a very low base in the A-share market

ɽ State-owned enterprises (SOEs) lead the way – many have dual listings, encouraging them to adopt international standards on ESG disclosure

ɽ There are three key drivers of change: greater representation of Chinese equities in global indices, regulatory pressure and active managers exerting influence

ɽ There is still a wide variance in ESG performance, so we believe taking an active investment approach is important to appropriately assess investment opportunities

ɽ The proprietary red and green flags that our 4Factor team use help us eliminate potential risk and highlight potential opportunities to explore further

ɽ Momentum of change is an important indicator for potential alpha opportunities. This could be captured by engaging with companies and uncovering those companies actively improving their ESG practices

For professional investors and financial advisors only. Not for distribution to the public or within a country where distribution would be contrary to applicable law or regulations.

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China’s equity market represents a diverse set of opportunities, with varying standards and levels of disclosure on environmental, social and governance (ESG) issues. Along with greater inclusion into world indices, companies are improving their ESG practices and transparency. Such trends could be given extra impetus by the coronavirus pandemic. What has become clear in the aftermath of the pandemic is that investors are likely to demand more socially responsible corporate practices.

Reputations are easy to damage, as food delivery giant Meituan Dianping recently found out. The company’s social criteria came under scrutiny after it reportedly continued to charge restaurants high commissions and insisted on exclusive delivery rights while its suppliers faced a shrinking revenue base. We believe that companies that navigate their ESG path responsibly are more likely to be rewarded by investors, and those that flout ESG practices could be punished.

Looking across the Chinese equity market, A-share companies – stocks that trade in mainland China on domestic exchanges – are lagging their peers, but the direction towards improvement is clear. Capturing this momentum of change offers alpha opportunities. Whether it takes the form of improved operational efficiency, market share gains from better practices and a higher reputation among investors and customers, or better energy usage, all can be positive drivers of shareholder returns.

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If Chinese equities are considered at their full weightings, they would account for over half of the emerging market (EM) universe, as A-shares are currently undergoing a phased inclusion into MSCI indices as well as other global benchmarks. As international investor participation increases so too will the analysis of the varying ESG standards and transparency that exists in this diverse equity market. We believe this will encourage companies to improve their ESG performance.

For companies listed on the Chinese A-share market, the early signs are positive, albeit from a low base. A recent survey by Corporate Knights, which ranks 47 of the world’s biggest stock exchanges based on sustainability disclosure of their listed companies, highlights the challenges that exist, but the direction of improvement is clear. The Shanghai Stock Exchange was near the bottom of their list in 2019, ranking 41st. However, disclosure growth was in third place at 19.6%. In comparison, the Hong Kong Stock Exchange – which houses Chinese offshore equities – fared better, ranking 27th, while for disclosure growth it came second at 26.1%.1

Almost all listed Chinese companies make some ESG disclosures, ranging from carbon emission data, salary gap and air pollutant reduction plans to governance metrics, such as board tenure, gender diversity and committee independence. However, mandatory ESG disclosure requirements in China are limited to air, water and solid pollutants. Some companies voluntarily disclose ESG metrics beyond what is mandated by environmental regulation, but this is a huge area of growth potential.

With catalysts such as greater inclusion in global indices and expanded regulatory guidance, ESG disclosures are improving. Over 1,300 Chinese enterprises now release annual Corporate and Social Responsibility (CSR) reports, with greater commitment being shown by publicly listed, larger companies. An increasing proportion of the CSI 300 constituents — comprising of A-shares traded on the Shanghai and Shenzhen stock exchanges — release CSR reports (Figure 1). Governance metrics — such as the establishment of audit committees — have gained greater prominence in recent years, but there is significant room for improvement in disclosures, especially those environmental and social indicators which are communicated voluntarily. Change is happening, but it will require continued pressure both from regulators and the investment community.

Figure 1: The proportion of CSI 300 constituents releasing CSR reports has significantly increased

0%

20%

40%

60%

80%

100%

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

43.0%48.7% 50.7%

57.7% 60.0% 62.7%66.3%

71.0%76.7%

81.7%

Source: SynTao Green Finance, December 2018.

ESG improvements are underway, but from a low base

1. Source: Corporate Knights, ‘Measuring Sustainability Disclosure,’ 2019.

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Despite this progress, however, Chinese onshore companies have much lower disclosure rates than stocks listed in the MSCI All Country World Index. Among the key environmental and social metrics, only 16% of Chinese A-share companies report energy usage and this falls to 10% for water use, while carbon emission data, waste generation and social metrics such as injury rates and staff turnover disclosures are all under 10%. Chinese onshore companies are better at revealing average employee compensation than their global counterparts, and they are catching up with their global peers on environmental spend and sustainability investment disclosures.

Chinese onshore companies have significant room for improvement

Figure 2: China A-shares have room for improvement on environmental and social disclosures

MSCI China Onshore A

MSCI ACWI

Resource intensity Water withdrawal m3 per $rev 10% 57%

Water recycling as % of withdrawal 2% 16%

Energy usage (gj) per $rev 16% 64%

Renewable energy as % of energy used 1% 24%

Waste and emissions Total waste intensity tons per $rev 9% 52%

Waste recycling ratio 2% 40%

Hazardous waste intensity (tonnes per $rev) 9% 34%

Hazardous spills intensity 0% 9%

Airlines total ghg emissions per rpm 0% 1%

CO2 equivalents emission total 9% 66%

CO2 equivalents emission scope 1 5% 55%

Voc emissions intensity 2% 12%

Total SOx and NOx emissions intensity 16% 27%

Human capital - talent attraction and retention

Employee turnover 9% 44%

Average training hours 17% 43%

Average employee compensation 94% 60%

Women managers 7% 47%

Women employees 23% 67%

Women mobility gap 7% 45%

Human capital - worker safety

Lost time injury rates 0% 35%

Total injury rates 5% 40%

Fatalities rate 9% 39%

Environmental spend & sustainability investment 16% 21%

Source: Goldman Sachs Global Investment Research, ‘GS SUSTAIN: China: Nine years on, waiting for 2020,’ 26 September 2019.

Crucially, A-share disclosure is improving, spurred on by greater scrutiny from increasing international investor participation in this market and assessing companies against global ESG standards. Disclosure on such metrics as water, energy, waste and emissions is gaining momentum, albeit from this very low base (Figure 3). Greater visibility on these metrics should encourage companies not only to achieve operational efficiencies that flow through to profits, but also open themselves up to a fresh pool of potential investors. In this they are following a path already trodden by state-owned enterprises (SOEs) and offshore Chinese companies.

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Figure 3: Environmental disclosures made by China A-shares are moving in the right direction

Source: Goldman Sachs Global Investment Research, ‘GS SUSTAIN: China: Nine years on, waiting for 2020,’ 26 September 2019.

Perhaps surprisingly, it has been the SOEs that have led the way in ESG disclosure, across all industries. Many have dual listings, which shows the importance of international investor participation to increasing standards. Given that they represent around half of the MSCI All China Index, they are a key part of increasing the market’s appeal. Since 2013, the role of government in these companies has evolved from the management of state enterprises to the management of state capital, and this is reflected in their greater openness to investors. Given China’s centrally controlled model, SOEs have managed to set the benchmark for private onshore firms to follow for three major reasons:

1. SOEs kickstarted the trend of CSR reporting back in 2006, with the largest Chinese SOEs, such as The State Grid Corporation of China, China Mobile, Sinopec, Baowu Group, Shenhua Group and China National Building Material Group, among the leaders. This reflects a strong sense of responsibility by the SOEs to be the face of the country and central government, acting as role models for private entities.

2. SOEs have gone through multiple years of reform, encouraging them to pursue other objectives such as efficiency improvement and to become more market oriented.

3. SOEs often operate in environmentally sensitive industries, such as petrochemicals and energy, and therefore tend to put more effort into upholding their environmental and social responsibilities given their inevitable carbon footprint and global audience.

State-owned enterprises show onshore companies the way

Nonetheless, private enterprises are catching up with ESG reporting as they grow in size and influence. Previously the private sector has had a narrower set of corporate goals, and it is only now increasing its focus on integrating social responsibilities into corporate strategy, especially relating to talent management and engagement, as well as supply chain management.

11%

5% 5% 4%

14%

9%

8% 8%

15%

10%9%

8%

3%

5%

7%

9%

11%

13%

15%

17%

Energy usage Water withdrawal Waste intensity CO2 equivalents emission

2016 2017 Latest available (2017-2018)

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How do Chinese offshore companies compare?

As we have seen, the application of ESG principles varies significantly across the Chinese equity market, often influenced by the size of a company and where it is listed. Larger businesses with global exposure – many of which have international listings – tend to have higher-quality disclosures that reflect the global standards that management expect to be judged against (Figure 4).

Figure 4: Large-cap Chinese companies listed abroad release more extensive ESG disclosures

Source: HSBC (based on Thomson Reuters Eikon data), 16 August 2019. LC= large cap.

1,000

800

600

400

200

0Reporting

companies(57%)

Indexconstituents

Reportingcompanies

(39%)

China domiciledlisted in Chinaand elsewhere

Reportingcompanies

(39%)

Companiesfor inclusionin MSCI EM

MSCI EM MSCI China 233 LC A-share

China Hong Kong US Others

0

695

391

139

697

1

26108

Carbon disclosure has improved across all the companies we looked at in 2018... ... and disclosure among

Chinese companies listed abroad is still higher than those listed domestically

2

44

235

145

18

43

233

Figure 5: China offshore companies score higher on ESG rating categories

Source: MSCI, 12 May 2020.

A AA B BB BBB CCC

MSCI China A MSCI EM, China constituents MSCI EM

400

200

0

300

100

AAA

This greater level of disclosure translates into better ESG ratings for offshore companies. As Figure 5 illustrates, the China constituents in the MSCI Emerging Market index – most of which are offshore – score more in the higher ratings buckets than China A-shares. As onshore companies benefit from increased representation in global indices, we believe this should help lift standards – and investability – through greater levels of disclosure. In our view, this is one of three key drivers of change.

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Three key drivers of change

International standards attract investment

The inclusion of China A-shares in major emerging market and global indices has attracted new international investors to a market dominated by domestic

asset owners and retail investors. Many strictly adhere to global ESG standards, which they apply to portfolios and their analysis of Chinese firms, who have clearly acknowledged this; almost 90% of A-shares with an ESG disclosure are dual listed companies (Figure 6).

This broader inclusion of Chinese companies into global benchmarks has been accompanied by richer data analysis into the ESG practices of index constituents. For example, MSCI has initiated research on more than 400 A-share companies over the last two years. This gives global investors an additional source of research to ensure potential investments meet ESG standards before capital is allocated.

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3Figure 6: Most A-shares with an ESG disclosure score are dual-listed

Source: Thomson Reuters Eikon, 31 May 2018.

Dual-listed securities

Shenzhen/Shanghai-listed securities

12%

88%

Domestic regulators increase the pressure

Chinese regulators have also ramped up the pressure in recent years, with the China Securities Regulatory Commission (CSRC) requesting listed

companies to disclose key environmental information by the end of this year. While it is unlikely that the target will be met given that further detail needs to emerge on carbons emission reporting, the direction of travel is clear and disclosure looks set to improve, particularly for the A-share market. The CSRC has also announced plans for both the Shanghai and Shenzhen stock exchanges to follow the Hong Kong stock exchange’s lead in 2020, mandating all listed companies to produce a statement setting out the board’s considerations of ESG risks and how they assess what ESG issues are material.

On the corporate governance front, last year CSRC made its first revision to the ‘Code of Corporate Governance for Listed Companies’ since 2002. The revision sought to restrict the power of controlling shareholders, encourage board diversity and accountability, require audit committees to be established and promote the role of institutional investors as stewards in oversight.

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Vocal active managers

Such corporate governance improvements are welcome, as these help ease the concerns held by global investors that include factors such as

potential conflicts of interests between listed SOEs and minority shareholders. Domestic institutional investors are also starting to incorporate ESG factors into their investment processes. Some 22 Chinese investment managers became signatories of the United Nations’ Principles for Responsible Investment (UNPRI) in 2019, a 64% increase on the prior year. Members must commit themselves to six core principles that promote ESG responsibility.

Onshore companies are receiving more enquiries about their ESG performance and datapoints as their investor bases become more international. In addition, increasing pressure from active fund managers is influencing positive change. We believe that active engagement pushes companies to not only improve their disclosure, but it also allows investors to exert pressure and influence management on the ESG issues that could be material to improving outcomes for all stakeholders.

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Case study CNOOC. As a subsidiary of Sinopec, the Chinese National Oil

Operating Company ultimately answers to the Chinese state. In collaboration with other asset managers, we have approached the company, which is rated CCC by MSCI, for more detailed information on ESG. We are hopeful that this engagement will improve its ESG disclosures, especially on its environmental impact, and also instigate a carbon emission reduction plan.

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Ninety One’s active approach to ESG integration

Given the varying standards on ESG integration and disclosure, we believe active investing in China’s equity market is crucial to capturing sustainable returns from this alpha-rich market. Our firm-wide engagement objectives largely focus on improving ESG disclosure through co-operative engagement so that we can better understand risks and opportunities as well as influence change. We have observed that companies increasingly understand the need for this and are pro-actively looking to improve their ESG reporting.

Over time, we have added greater detail to our ESG analysis, for example, by unbundling corporate governance into the separate components of board structure, pay, company ownership and control and accounting in our research notes. While we utilise technology to harness third-party research data, most importantly our fundamental research provides the necessary insight to appropriately analyse companies. This is because limited disclosures make it difficult for research providers to do a comprehensive assessment of Chinese companies, particularly for A-shares where coverage is relatively new.

Warning signs and the importance of company culture

First and foremost, ESG is not an afterthought, but a key part of our 4Factor fundamental research to assess the risk/reward balance of an opportunity. We look out for red flags as a reason to eliminate potential investments from further consideration, and green flags that encourage further consideration of a company.

Figure 6: Our proprietary ESG red flags can help eliminate companies from consideration

Accounting policies and corporate behaviour Corporate structure

ɽ Abnormally high revenue growth or margins compared to peers; mismatch between profit growth and cashflow

ɽ High levels of cash and debt; low interest income, but high interest expenses

ɽ Unusual working capital movement (low receivables or inventory turnover; significant increase in receivables or inventories; lower than average bad debt provisioning and inventory impairment policies)

ɽ Frequent M&A and significant goodwill as percentage of assets

ɽ Change of accounting policies ɽ Heavily dependent on related-party transactions

or on subsidies ɽ A high level of share pledging with limited

information on the use of funds. Frequent restructuring and capital raising, especially issuing shares at very low valuation

ɽ Unnecessarily complex corporate structure ɽ Appointment of broader family members on

the board or in key management roles ɽ Large owner or key executives have significant

percentage of stakes pledged or record of suspicious stock transactions

ɽ Management has past track record of being related to personal or professional scandals

ɽ Frequent change of management, especially the chief financial officer

ɽ Using auditors who were responsible for previous responsibility failures

Environmental issues Social issues

ɽ Punishment by authorities for breaching environmental regulations

ɽ Negative media comments regarding relationship with employees or local communities

ɽ High employee turnover and a poor reputation among employees

General

ɽ Bad or deteriorating ESG third-party ratings ɽ Lack of willingness to respond to ESG engagement

Source: Ninety One, May 2020.

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Figure 7: Our ESG green flags highlight the best practices that companies should adhere to

Accounting policies and corporate behaviour Corporate structure

ɽ Consistent and conservative accounting policy without, for example, capitalisation of operating expenses

ɽ Rational expansion plans; improving returns by giving cash back to investors when there are no major expansion projects

ɽ Regular voluntary disclosure of operational metrics that help investors understand business development

ɽ Management is willing to communicate with investors and provides clear and consistent messages about the business strategy and the execution

ɽ Straightforward corporate structure with very few layers

ɽ Stable and motivated management, whose interest is aligned with minority shareholders through key performance indicators and share incentives

ɽ For private companies where the founder or large shareholder is the key manager, ideally the stakeholder should be focused on the business with limited or no other business interest outside of the core entity

ɽ Good quality Board of Directors, with more than a third of the members being independent with relevant skill sets to the company business and holding as few positions in other companies as possible

Environmental issues Social issues

ɽ Greater transparency on environmental metrics and signs of improvement

ɽ Good track record of supporting local communities

ɽ Good reputation among employees

General

ɽ Good or rising ESG ratings from third parties ɽ Voluntary disclosure of ESG metrics ɽ Active involvement in industry standard setting

Source: Ninety One, May 2020.

While these flags are helpful indications, we do not make assumptions without proper fact finding and engagements. This includes asking direct questions about how companies are managing their operations, especially for products and services that are subject to increasing social and environmental scrutiny. We use this to gain insights into a company’s strengths and weaknesses along with our fundamental analysis. We also respect the culture of relationship building when requesting for information, allowing us to open up a dialogue with the company on ESG issues.

Momentum is an important indicator

A company’s willingness to change, and successfully deliver that change, is also important. Making comparisons with global peers that already operate at a high standard is less meaningful than tracking the momentum of change over time. Greater economic benefit can be captured from ESG improvements that may result in market share gains and a better reputation among investors and customers, or profiting from higher energy efficiency or happier and more productive employees. The earlier that momentum is uncovered, and capital allocated, the bigger the potential returns.

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Moreover, we regard it as crucial to exercise our ownership rights and fiduciary responsibility, which involves proxy voting and participation in AGMs. We follow international corporate governance best practice (as specified in the ICGN principles) and apply our policy to guide our voting. In the past year, we have voted in 115 meetings for Chinese companies, and in nearly one-third of cases this included voting against management on one or more resolutions.

We also work with regulatory bodies to establish clearer and implementable guidelines. Last year, we engaged with the Shanghai Stock Exchange on the China A-share market. We raised concerns on the foreign ownership limit, ESG disclosure requirements, the widely spread practice of investment in wealth management products and lack of disclosure of investment details, lack of transparency on complex ownership structure and related-party transaction risks, as well as stock suspensions. The SSE provided some useful colour on the progress they have made and expressed the willingness to make further efforts.

Government regulation is also an important driving force to change corporate mindsets and achieve a wider scope of positive influence. For instance, during the 2015 market turbulence, more than half of the A-share listed companies suspended their shares, some for as long as five months. Subsequently, the Shenzhen and Shanghai stock exchanges strengthened the rules for share trading suspensions to curtail abuse of the practice, by limiting the amount of time share trading could be suspended. Understanding the local market and actively engaging with companies’ management and regulators in a constructive way can influence change and build investor confidence in China.

Case study Anhui Conch Cement. The company responded positively

to our request for engagement, primarily focused on its environmental impact and energy usage as a large cement manufacturer. Meetings have been held with management who are keen to get advice from investors on how to improve data disclosure. We are providing them with industry peer group analysis so they can compare themselves with the ‘best in class’ operators, as well as working with regulators to create standard reporting guidelines and targets.

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ESG improvements are here to stay

The appetite for ethical and sustainable investments has grown markedly in recent years, and China’s efforts in promoting its ESG credibility stems from the very highest levels of government. The COVID-19 pandemic also highlighted the need for greater ESG transparency and focus. This positive development benefits ESG-friendly sectors and services, creating attractive investment opportunities.

As China opens up to a wider pool of investors and becomes a larger part of global benchmarks, there is greater recognition among Chinese companies that they need to adopt global standards and disclosure on ESG to attract investors. Capturing this improving momentum can unveil alpha opportunities for investors.

An active approach is therefore critical to help identify the companies that are resilient through the crisis and encourage improvement in ESG fundamentals. Our 4Factor team believes through engagement with companies, stock exchanges and other bodies, companies can be encouraged toward greater openness and higher standards. In turn, this will attract more investment, particularly from overseas, into China’s equity market. Ultimately, such developments would be positive for companies, investors and, most importantly, society in general.

General risks: The value of investments, and any income generated from them, can fall as well as rise.

Specific risks: Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.

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Important information

This communication is for institutional investors and financial advisors only.

The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Ninety One’s judgment as at the date shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct and may not reflect those of Ninety One as a whole, different views may be expressed based on different investment objectives. Although we believe any information obtained from external sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Ninety One’s internal data may not be audited. Ninety One does not provide legal or tax advice. Prospective investors should consult their tax advisors before making tax-related investment decisions.

Except as otherwise authorised, this information may not be shown, copied, transmitted, or otherwise given to any third party without Ninety One’s prior written consent. © 2020 Ninety One. All rights reserved. Issued by Ninety One, May 2020.

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improving esg fundamentals emerge in china · 3 improving esg fundamentals emerge in china if...

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