For investors in emerging markets, China is hard to avoid. But how are they monitoring the ESG standards of their investments in the People’s Republic?
At first glance, China appears to offer plenty of green investment opportunities. In 2021 alone, it reported a record $46.7bn (£41.1bn) inflows into climate funds, according to Morningstar. This represents a 150% increase compared to the previous year.
While demand for Chinese funds dropped in 2022, investor appetite for investments in China seems to have made a comeback in 2023.
For investors replicating an index, China remains hard to ignore. About a third of the MSCI Emerging Market Index is represented by Chinese firms and the country also dominates emerging market bond indices. “Because of the introduction of Chinese debt to leading bond market indices from 2018 on, institutional demand for strategic allocations to Chinese bonds has been on the rise,” said Georg Inderst, who acts as an independent advisor to pension funds.
But a range of ESG scandals illustrate that investors might want to approach the green credentials of some Chinese ESG funds with caution. One example is a report that major Chinese firms are benefiting from forced labour of the Uyghur minority.
This applies to at least 13 firms included in global equity indices such as the MSCI Emerging Market and Morgan Stanley’s All World Index, for example Foxconn and China Railway Construction, according to the think tank Hong Kong Watch. Institutional investors with a passive exposure to China could therefore be inadvertently complicit in human rights violations.
The E the S and the G
Another issue to consider is the discrepancy between the stand alone environmental, social and governance factors. Some firms perform reasonably well based on environmental metrics but less well when it comes to the S and G in ESG.
One example is Tencent, which accounts for more than a quarter of MSCI’s China ESG Leaders Index, due to its clear decarbonisation targets and relatively low carbon emissions. More than half of the market-cap based index consists of only three firms, the tech giants Tencent and the shopping platforms Alibaba and Meituan. Another prominent index constituent is micro-blogging service Baidu.
But both Tencent and Baidu have recently been downgraded by Morningstar Sustainalytics. As a result of the downgrade, Wisdom Tree decided to remove these firms from its China Ex State Owned Index, which resulted in an adjustment of 28% of the overall index, explained Liqian Ren, director Modern Alpha at Wisdom Tree.
Neither Tencent nor Baidu are formally state-owned. But in a state capitalist economy, this distinction between state and private sector is far from straightforward.
One decisive factor that motivated the Morningstar Downgrade is the fact that Tencent, Baidu and Weibo were found to have violated UN Global Compact Guidelines.
“While we are primarily known for our ESG Risk Ratings, which focus on financial and material risk factors, we also have a team which analyses firms based on the UN Global Compact Principles such as respecting human rights,” explained Remco Slim, product strategy and development manager at Morningstar Sustainalytics.
These UN Global Compact assessments are based on reports in Chinese and international media, supported by a team of Mandarin speaking researchers. “We noticed that firms like Tencent are increasingly playing a role in the oppression of freedom of speech and their data is also frequently used in court cases against dissidents,” said Slim.
Human rights violations have increasingly become an exclusion criterion for institutional investors. This includes Capitulum Asset Management, a Berlin-based boutique advising institutional investors on global fixed income strategies.
“When it comes to Chinese bonds, the distinction between state and private sector remains almost impossible”, argued Ernst Theodor Kirschner, a fund manager at the boutique. “The majority of green bond issuers in China are state-owned banks which are closely connected to the Chinese government, which is why we are very sceptical of these issuers from a social and governance perspective, even if they have been labelled as green bonds by some of the major rating agencies. We have opted not to invest in local issuers, despite the fact that China’s share in bond indices has been growing significantly over the last few years,” said Kirschner.
Green bonds: Dodgy definitions
Up until last year, the Chinese definition of green bonds has been significantly less stringent. This meant that up to 50% of the proceeds from green bonds could be dedicated to general refinancing projects. This included fossil fuel producers and even so called “clean coal” mining.
The Climate Bond Initiative has seen this as one of the reasons to exclude more than 60% of Chinese green bonds from its database.
But Chinese green bond standards are evolving, Inderst stressed. Indeed, the Chinese Green Bonds Standards Committee has published a new set of principles in July last year which obliges issuers to dedicate 100 % of their proceeds to financing sustainable projects. China has also signed a Common Ground Taxonomy with the EU last year.
While China had “a lot of catching up to do”, excluding it entirely also meant abandoning some significant investment opportunities, particularly in green technology sectors, Inderst warned. And when it comes to ESG standards, other emerging markets are far from perfect, he added.
Another factor to consider is China’s growing share in global carbon emissions. The People’s Republic now accounts for almost a third of global carbon emissions. Tackling climate change without China remains therefore impossible.
Nevertheless, the question remains how investors can gain exposure without being complicit in human rights violations. Some investors are eyeing a “Greater China Approach” focused on firms which operate in China but not listed there. For fixed income investors, Yuan denominated green and social bonds by supranational issuers such as the European Investment Bank or World Bank could be an alternative, said Kirschner. “These bonds are compliant with global green bond standards, offer a triple A rating and greater levels of transparency on the use of proceeds,” he added.
For Inderst, China is now too big to be ignored. But the gap in ESG standards means that investors should continue to approach it with caution. “Solid bottom-up research and transparency and dynamism in decision making remain crucial,” he said. A mere reliance on ESG indices, which feature significant concentration risks will be insufficient, Inderst said.