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Responsible Investing in China: What You Need to Know

 
By David Allen, Managing Director, Zephyr Consulting 
Penny Peng, Associate, Mercer 
 

Overview
 
China is making important strides in its movement towards Responsible Investment (RI), which implies incorporating Environmental, Social, and Governance (ESG) factors into investment research and the decision-making process as outlined under the United Nation’s Principles for Responsible Investing (UN PRI). This is evident from the significant capital flowing into China’s ESG products, increased transparency in ESG disclosure, enaction of meaningful regulatory changes, and rapid establishment of ESG management tools with Chinese characteristics. China is on its way to becoming a highly ranked RI country.
 
RI in China provides international and local investors with a means to better manage risks and improve returns in their portfolios, adapt to their investor’s values or ethics, and contribute to specific environmental or social outcomes.
 
The main drivers of ESG integration in China include risk management, regulators and policy-makers, and alpha-generation.


 
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This article provides Recent Updates, Latest Regulations, China’s ESG Evolution focusing on ESG Integration, Screening, and Thematic / Impact Investment, Boots on the Ground Insights, Actionable Steps for Industry Participants, as well as Opportunities for Investors.
  
Recent Updates
 
Investors
 
Globally, UN PRI assets under management (AUM) surpassed USD $100 trillion in 2020, increasing 75% since 2015. International asset managers are now engaging with Chinese companies ranging from Hong Kong listed and New York listed large caps to more recently mid and small-cap A shares.
 
Policy-makers

 
China’s 2060 carbon neutrality goal will enhance climate related efforts particularly in its ambition to reach peak carbon before 2030 a goal outlined in its 2030 Sustainable Development Agenda.
 
Technology and tools

 
Chinese and western capital markets have different characteristics. Utilizing western formulated ESG data compilers in Chinese markets has proven to be insufficient for collecting enough data for investors to make confident investment decisions. Newly developed AI-driven datasets utilizing Chinese characteristics are expediting the evolutionary process of ESG integration through which investors can broadly access quality data more efficiently.

 
Latest Regulations
 
  • In March 2020, Hong Kong Exchange and Clearing House (HKECH) published ESG guidance with its “How to Prepare an ESG Report: A Step-by-Step Guide to ESG Reporting”. 
  • In June 2020, the People’s Bank of China (PBoC), China’s central bank, the China Securities & Regulatory Commission (CSRC) and the National Development & Reform Commission (NDRC) announced an updated Green Bonds Endorsed Projects Catalogue to govern China’s green bonds market in a significant consolidation. 
  • In Sept 2020, the Shanghai Stock Exchange’s (SSE) Science and Technology Innovation Board (STAR Market) piloted voluntarily disclosure of ESG information. There is low willingness to conduct extra ESG data release. Disclosure rates were: 9% corporate, 68% environmental, and 60% social, on annual reports according to STAR Market Report 2019-2020. A move towards mandatory disclosure is expected in 2021. 
  • On January 1, 2021, the long-awaited China Emissions Trading Scheme (ETS) commenced operation, with 2,225 coal-fired power plants participating. Under this new ETS, China’s power operators will have to buy emissions permits if their coal plant exceeds carbon intensity benchmarks, giving power operators an incentive to improve efficiency. 
  • On February 22, 2021, State Council announced the establishment of a Green and Low-carbon Circular Development Economic System to establish and improve a green and low-carbon circular development economic system, as well as promote a comprehensive green transformation of economic and social development, which are the basic policies for solving China's resource, environmental, and ecological problems.  
ESG Integration
 
ESG integration in China began with ESG-themed products (i.e. green themed mutual funds); advanced through the incorporation of ESG terms and requirements used in the investment philosophy of investment managers; and now permeate all aspects of the investment-decision making process. ESG is an approach to investing rather than a product differentiation.

 
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Remaining Challenges

1. ESG data disclosure: Quality and quantity of China’s ESG data is not sufficient to make investment decisions, particularly so as its voluntary. Governance data is accessible and verifiable in existing financial reporting standards. Environmental and Social disclosure will require more groundwork and a framework for evaluation that adopts Chinese market characteristics.
 
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2. Understanding ESG integration: It is not easily discernible what ESG integration involves and what the benefits are, though recent guidance on how to prepare an ESG report, issued by the HKECH will help address this. Awareness needs to be established through industry participant engagement.
 
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Improvements

1. Inclusion: Inclusion of China A share market into major indices (e.g. MSCI) has improved data coverage and has been a good start for listed companies.
 
2. Adoption: Global adoption of responsible investing into the investment process has not been uniform. For instance, Screening is the main method utilized in the European market while ESG Integration is emphasized in the US. China has its own unique characteristics and will adopt in its on way. It is our opinion that negative screening, thematic, and impact investing will see more investment flows over the next three years. 
 
Screening
 
Screening can be divided into negative/exclusionary and positive/best-in-class screening.
 
Negative/exclusionary screening is an easy way to integrate ESG into investment decisions. Initially, industries with negative influences were excluded to reflect commitment for RI (i.e. coal, tobacco, alcohol, etc.). Now the method has developed to remove investments according to specific E, S or G conditions for portfolio construction. For example, Mining, Manufacturing, and Finance & Insurance are regarded as the top three industries with the highest ESG risk.
 
Positive/best-in-class screening is to choose companies with better ESG performance than those in the same industry. For example, even in the Coal industry, which has the most ESG issues including highest carbon emissions, there are leading companies that strive to eliminate the negative impact created and make up for the environment and social costs through additional effort and contributions.
 
This could be the first step to implement RI, but is not being highly valued as it has limited impact on underlying companies. Good stewardship (investor influence) is preferred to lead underperforming companies to develop in certain fields instead of leaving them to their own efforts.
  
Thematic
 
A number of new Chinese ESG themed products are being established, and their performances have made great gains over the past year. Currently, the most popular three themes are ‘energy saving and environmental protection’, ‘poverty alleviation and development’ and the ‘blue economy’.
 
China is now removed from the country poverty list, announced on November 23, 2020.  We expect the poverty alleviation theme to be replaced by ‘rural revitalization.’
 
Impact investing is another approach, which ties environmental or social impact to financial returns. It is facing headwinds due to few participants, materiality, small scale, focus on private equity, lack of communication with international impact investors, and unclear development direction. With frequent social and environmental crises, people have been inspired to reflect unprecedentedly in 2020. For China, 2021 we expect it to be the first year of large-scale impact investment developments.
 
As there are no standards established for these types of products, investors must dig deep into the investment philosophy to understand what they truly are investing in, in order to avoid the problem of ‘green washing, bleaching, or mixing’. In the future, it is necessary to uniformly establish green financial standards, and audit projects strictly in accordance with them.
 
 
Boots on the Ground Insights
 
Excerpt from WEF: A Leapfrog Moment for China in ESG Reporting alongside our local insights.
 
1. Board-level commitment is a primary and indispensable key to a company’s effective reporting and management of ESG issues.
 
Local insight: Board-level commitment is the key fundamental principle that drives the way a company runs business, and many asset owners have this in place around core investment philosophies like active versus passive management, liquidity management, fee budgeting and the role of asset allocation. Establishing the board's view on their ESG investment beliefs is a critical place to start because once the board establishes its beliefs, it can then reflect them in policy, investment mandates, portfolio construction, and manager selection.
 
2. High-growth companies must graduate from a focus on near-term revenue to a purpose-driven strategy that considers a wide range of stakeholders and their interests. Investors are increasingly a driver of this progression.
 
Local insight: COVID-19 has highlighted the urgency of transitioning from shareholder to stakeholder interests. In particular, the way companies treat their customers and workers is likely to have significant implications for their businesses in the upcoming years. If asset owner boards and investment committees want to become long-term stakeholder-oriented future makers, they need to audit current functions and question underlying assumptions to ensure multiple stakeholder perspectives and systemic risks are considered.
 
3. The integration of ESG factors into business strategy formulation and the management of ESG risks and opportunities provide more meaningful information for investors than the traditional CSR approach.
 
Local insight: Markets are starting to recognize climate risks in pricing. Investors should not be caught off guard by carbon-heavy portfolios being affected by market, technological, or regulatory changes. This means investors should exercise DARP — decarbonization at the right price, to build flexibility into their strategic climate-transition plans.
 
4. Successful companies focus their ESG efforts on the issues that are most relevant to their business as identified in their materiality assessment.
 
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Local insight: ESG factor importance and materiality will vary by company and strategy. Materiality assessment helps to better meet the investor preferences, as a one-size-fits-all approach is no longer a fair way to measure ESG performance. Task Force on Climate-related Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB) developed substantive standards for different industries to assist with this.
 
5. As Chinese companies ramp up their ESG reporting, they often find a shortage of ESG professionals and a lack of ESG knowledge across their business units and supply chains.
 
Local insight: Global consulting companies and data providers could support such requirements as an easy startup solution based on their decades of similar service experience and boots on the group insights. Companies’ will be required to build out their own dedicated ESG teams and frameworks given the demands from stakeholders, especially mandatory regulations.
 
6. There are increased demands for supply-chain sustainability practices and disclosure, particularly from global brands.
 
Local insight: In the context of the sustainable development of the global supply chain, international markets’ demands for sustainable supply in Asia are growing exponentially. Asian suppliers will increasingly follow a sustainable development model. 
 
Actionable Steps for Industry Participants
 
When constructing portfolios that incorporate China, new entrant investors can consider utilizing a combination of three ESG approaches: Integration, Screening, and Thematic.
 
 
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Existing investors may wish to enhance performance through engagement or proxy voting. Engagement means communicating with companies to improve their handling and disclosure of ESG data. Proxy voting is a formal expression or approval or disapproval of ESG issues by voting on shareholder resolutions.
 
All participants should increase communication about their ESG requirements and understanding of ESG integration and its benefits. Understanding it’s not only an investment filter but also can unlock opportunities, foster a corporate culture of transparency, trust, and accountability which can lead to long-term gains while minimizing risks.
 
Opportunities for Investors
 
China capital markets have a low correlation to the rest of the world. Adding a China allocation can provide enhanced risk-adjusted returns and utilizing ESG integration can further reduce risk in that process.
 
Nearly 90% of institutions pay attention to RI while only a few have taken action. Although understanding of RI is limited, more than 80% of individual investors have considered relevant factors in their investments.
 
There will be more diversified types of asset owners that embrace ESG. Among them, pension funds with higher flexibility of investment approaches will be more proactive in adopting ESG.
 
Greater communication and cooperation between domestic and foreign Chinese asset owners on ESG investing is expected in the near future. Domestic partners may provide greater insights and resources in addition to capital investment. Indicative of this, in December 2020, the Governor of the People’s Bank of China said that China would proactively promote the convergence of domestic and international green finance standards through revision of domestic standards and international cooperation in order to facilitate international investors’ participation in China’s green finance market.
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References

Webinar 
CAASA Webinar: Investor Views of Public Markets & ESG in China, 3/3/2021
 
Article/Website Links: 
Article Without Links:
  • World Economic Forum: 2015 Global Risk 2015 Report
  • CFA Institute: 2008 Environmental, Social, and Governance Factors at Listed Companies: A Manual for Investors Codes, Standards, and Position Papers Vol. 2008 No. 2 May 
  • CFA Institute: Consultation Paper on the Development of the CFA Institute Disclosure Standards for Investment Products, August 2020
  • CFA Institute & UN PRI: ESG Integration in China; Guidance and Case Studies 
  • CFA Institute: Environmental, Social, and Governance Issues in Investing: A guide for Investment Professionals 
  • Global Sustainable Investment Alliance: 2018 Global Sustainable Investment Review 
  • Ping An Finance and Technology: Shaping a better world: Ping An 2020 Sustainability Report 
  • UNEP Finance Initiative and UN Global Compact: Listed Equity, An Introduction to Responsible Investment 
  • UNEP Finance Initiative and UN Global Compact: PRI Strategic Plan 2021-24 Consultation paper, Building a bridge between financial risk and real-world outcomes 
  • Mercer, City of London, UK-China Green Finance Centre, China-UKPACT: A report for the UK-China Green finance Centre, Resilience: Lessons to scale responsible investing, June 2020
  • WEF and PwC China: A Leapfrog Moment for China in ESG Reporting, White Paper March 2021


David.jpg David Allen, Managing Director, Zephyr Consulting ​

David Allen is the Managing Director for Zephyr Consulting based in Shanghai, with more than 15 years of investment experience in both Canada and China.
 
In Canada, he was responsible for pension fund administration; plan design, asset management, manager search and selection, research analysis, financial statement preparation, and monitoring pension and investment policy and regulation while working for McCain Foods Limited. David volunteered with ACPM in 2011-2014 serving as the Chair of the Atlantic Regional Council in its establishment and was member of the National Policy Committee, National Council, and National Conference Planning Committee.
 
In China, he provides advisory, training, and research services for local, multinational, and state-owned companies including notable names such as the People’s Bank of China and Guotai Junan Securities with areas of focus including emerging technologies: Fintech, Blockchain, InsurTech, and Decentralized Ledger Technology. David volunteers with the Canadian Chamber of Commerce and was instrumental in establishing their Investment Committee.
 
David received his B.B.A Degree in Finance, Economics, and Accounting from the University of New Brunswick; his Masters of Finance Degree from the Shanghai University of Finance and Economics; and obtained the CFA charter in 2016.




Penny.png Penny Peng, Associate, Mercer

Penny Peng is an Associate for Mercer China Wealth based in Shanghai with more than 9 years of experience in advisory service and project management covering ESG / responsible investment, pension scheme design and investment, manager research and selection, operation risk analysis, as well as report delivery etc. As a member of the ESG Upskilling in Asia, Penny regularly communicates policies / regulations, market trends, project practices and training content with experts from the Mercer Responsible Investment team.
 
She’s responsible for investor education, association cooperation, and public speeches. With abundant global investment market and product experience, she’s proficient in qualitative and quantitative analysis on managers and strategies, and engages with market players on fundamental dynamics and product development. Most of the clients she has served are leading insurance groups, fund managers, asset managers, trusts, and multinational corporates. 
 
Penny received her B.A. Degree in Statistics of Finance and Insurance from the Shanghai University of Finance and Economics.