Sustainability-minded Chinese investors remain largely focused on what companies produce, rather than how they produce it. China’s sustainable fund universe reflects this, in that the total number of purely thematic funds vastly exceeds those integrating ESG more broadly, while thematic funds have also received the lion’s share of inflows over the past few years.
This preference is further revealed in the equity valuations of underlying companies themselves, where a sustained premium for thematic sustainability stocks has been observed in China for many years.
To quantify this preference, we back-tested valuations of thematic companies – those deriving at least 50% of their revenues from one of five sustainability themes: climate change, resource management, health and wellbeing, inclusion, and safety and security – and found that they had traded at 15% to 90% premium over the broad MSCI China Index since at least the end of 2016.
Conversely, unlike what companies produce, whether they produce it sustainably does not factor highly in Chinese investors’ decisions, a fact reflected in the absence of any aggregate valuation premium for companies effectively managing material ESG risks and opportunities facing the business (in contrast to the premium for those operating in sustainable industries).
Indeed, a reliable linear relationship between ESG and improved risk-adjusted performance of Chinese stocks has yet to be conclusively established.
This is a product of several interrelated factors: (i) as an emerging concept in China, ESG has only recently received attention; (ii) inexperience is particularly acute among retail investors – historically dominant in onshore stock markets – whose sole focus is on returns (and then, often short-term returns) when selecting financial products; (iii) even among ESG-aware investors, there persists a view that integrating ESG into investments comes at the expense of returns by unnecessarily raising costs and transferring scarce resources away from activities which maximise shareholder wealth.
Benefits
Nevertheless, we find several reasons to integrate ESG into Chinese investments. The first is in developed markets research, which finds that managing material ESG issues has positive long-term effects on corporate operational and financial performance; the fewer emerging markets studies available also indicate that firms managing ESG issues outperform their peers over the long-term.
Early evidence emerging from China also points to benefits of integrating ESG and we see no reason why, with time and continued development of ESG in China, similar positive relationships can’t be observed.
Second, ESG improvers have been found to be a source of alpha in China. The rationale is several fold: (i) local ESG funds have chased the few “best-in-class” ESG companies, crowding space and inflating valuations, while improvers have slipped under the radar; (ii) improving ESG performance provides another lens to management quality, a key attribute of future success in China; (iii) by better managing their material ESG risks and opportunities, companies might benefit from enhanced growth, profitability and less risk.
That ESG improvers are a source of alpha is a huge opportunity for investors in China, where companies have plenty of room for improvement: MSCI research ranks China 47 out of the 50 countries in the MSCI All Country World Index.
Third, Chinese investors do respond to ESG information, which is improving in quality and coverage. Much has been made of ESG “data issues” when investing in China and the same challenges apply to academic research studying the effect of ESG issues on company operational and financial performance.
To overcome these problems, academics have studied the effect of ESG-related news on investor behaviour in China and found that share prices react to both positive and negative ESG news, with environmental news typically associated with the greatest investor response.
Fourth, externalities are increasingly costly for Chinese companies. In addition to the Emissions Trading Scheme, national systems to fine companies for pollution and ecological damage are stricter and impose greater costs on businesses neglecting their environmental responsibilities – last year, such fines reached their highest level ever last year.
On the social side, China’s Corporate Social Credit System assessments affect the intensity of company monitoring by local government, nudging corporations to modify their behaviours to score more highly. What is important to remember is that addressing externalities imparts costs upon companies and thus upon shareholder value. Managing environmental and social impact has therefore become a source of competitive advantage for companies in the affected sectors, an advantage that is only set to grow with increasing scrutiny from the government and investors alike.
Last, the composition of China’s stock markets is changing rapidly as institutional investors take share from hitherto dominant retail investors; foreign institutional investors are also increasing their ownership of China’s A-share listed companies.
This is important because institutional investors (and particularly foreign institutional investors) increasingly incorporate ESG considerations into their investments, with implications for stock valuations and also for pressure applied on Chinese companies to improve their management and reporting on material ESG issues.
Indeed, a recent study of 3,400 listed companies in China, from 2013 to 2020, found that good ESG performance by listed companies not only directly reduced their financing constraints and cost of capital but also encourage institutional investors to increase their positions.