China Shows Early signs of ESG Progress

Jerry Goh, Investment Analyst Equities, Asia

Regulatory change and gradual improvements in disclosures and engagement provide grounds for investor optimism.

China has some of the world’s most polluted cities, including its capital. So it seems ironic that the Asian Corporate Governance Association hand-picked Beijing as destination of choice for its recent annual conference on environmental, social and governance issues (ESG).

I was among those caught in the human squeeze at the event, which was chock-full of local and foreign asset managers, banks, brokers, board directors, company representatives and non-profit organisations. The bustle reflects how awareness of ESG is picking up.

Discussions on engagement and corporate governance dominated proceedings, with the association showcasing its first governance report dedicated to China and tackling issues unique to the mainland.

Quickly it became clear as each session progressed that investors and asset owners in China still have much learning to do when it comes to integrating ESG factors into their investment decision-making.

For a start the domestic stock market comprises predominantly retail investors who are nonchalant about actively engaging with companies on ESG matters. Institutional managers in China can be similarly indifferent.

That should come as little surprise given how ESG issues barely receive a mention at the numerous local investor forums. The vast majority freeload off of active ESG engagement carried out by a tiny minority of investors, typically long-only foreign fund firms.

Moreover, there are several China-centric hurdles to overcome. For one there is the lack of a supportive domestic eco-system, such as a formal regulatory framework, to guide investors and asset owners on how to integrate ESG into their investment decisions.

For many Chinese firms, ESG reporting remains a box-ticking, compliance-driven exercise, with scant appreciation of how it can add meaningfully to risk management due diligence or contribute to improvements in corporate performance over the long term.

Share ownership in China can also be as concentrated as it is complicated, involving partnership structures and cross shareholdings where firms hold shares in companies that hold shares in them – raising doubts about conflict of interest. Further, China’s legal system is immature relative to developed markets when it comes to protecting minority shareholder interests.

From a global perspective, it also doesn’t help that there is a dearth of reliable data on ESG considerations such as labour turnover rates and intensity ratios for emissions and water use.

The two major data providers are MSCI and Sustainalytics and their ESG scores for the same companies often bear almost no correlation. That leaves already sceptical investors questioning the subjectiveness of such ratings.

Silver linings

However, we see some silver linings. In April this year the China Securities Regulatory Commission (CSRC) announced changes to corporate governance rules. They include tighter regulation surrounding dividends and information disclosure, enhanced protections for small investors and more formalised roles and responsibilities for boards of directors.

Encouragingly, the Shanghai Stock Exchange had already instructed listed firms to follow some of these practices even before the CSRC’s official announcement.

The bourse’s progress on corporate governance over the years gives us grounds for optimism. The proportion of a company’s stock held by the largest shareholders in SSE-listed firms has fallen steadily over the past few years from 40% to 30% by mid-November, SSE representatives at the conference confirmed based on internal data analysis. This points to a positive trend of diversifying share ownership.

Over the same period they noted that the number of independent directors sitting on SSE-listed company boards had increased substantially to 33% on average, and in many cases is a good deal higher.

Additionally we can see that the international experience and relevant skill-sets of independent directors are improving. The representatives said that close to 60% of SSE-listed companies now used share incentive schemes, which serve to better align management and employee interests.

Dividends have improved, too, as firms have moved to include formal payout policies where they had none previously. In the five financial years to March 2017, dividend payout ratios have risen to 30% and above for blue-chip companies, the representatives noted.

SSE-listed companies are also improving their disclosures, aware of growing global momentum behind ESG investing. The SSE representatives explained that some 500-600 Chinese firms now published corporate social responsibility reports, where they outline their thinking on sustainability, their aspirations to reduce their carbon footprint and the frameworks they have in place to negate ESG-related risks.

“Growing appreciation that we are not in China for the short term is helping to improve the dialogues we are having with our investee companies.”

While these are still nascent steps, we see them as signs of progress that bode well for the future. We are finding companies more willing to engage with us and listen to our interests as a shareholder. Their growing appreciation that we are not in China for the short term is helping to improve the dialogues we are having with our investee companies. That is tangible evidence of positive market progress.

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.