In the latest episode of our Emerging Markets Equity podcast, David Smith joins Nick Robinson to take an in-depth look at how Chinese companies are addressing environmental, social and governance (ESG) issues. David gives his insight on how recent events – such as the Chinese government’s commitment to carbon neutrality – are causing businesses to change how they operate.
Nick Robinson: Hello everybody and welcome to the Aberdeen Standard Investments Emerging Markets Equity podcast, I’m Nick Robinson from the EM Equity team.
In this podcast series we explore the factors that underpin our thinking on Emerging Markets, from key individuals to evolving trends we seek to answer five W's – Who; What; Where; When and Why, that are shaping investment opportunities in the region.
In today's episode, we're going to revisit a topic we touched on in one of our earlier episodes when we explored Chinese technology companies and specifically how corporate governance of them has evolved today. I'm keen to broaden that topic out further and discuss in more depth how the environmental social and governance landscape has been evolving in China and the degree to which the Chinese government and owners of corporates are actually taking these ESG issues seriously as they run their businesses.
So helping me out today on this subject is our resident PHD in corporate governance and senior investment director based in Singapore, David Smith – David, welcome back to the podcast, it's great to have you - how are you doing?
David Smith: Hi Nick, I’m doing good thanks for having me, it's been a few months since I was on last but it's felt like a few years in terms of the news flow that we've seen.
Nick: Well yes, I was going to say. So the last time you were on the podcast we discussed the ANT IPO or the upcoming ANT IPO at that point, which ended up being cancelled much to all of our surprise. The US got a new president which was exciting and certainly changes the dynamic between the US and China and then I think you know one of the more interesting and quite surprising things at least for me has been China coming out and committing to a target of carbon neutrality by 2060.
So perhaps we could start there on the ‘E’ of ESG - the environment. My experience in investing outside of China, is the seriousness with which corporates take environmental issues often comes down to a founder or major shareholder of that company. In that the owner very much sets the agenda on sustainability and then that runs down through the organization, such that it's very clear which businesses are generally being run with sustainability in mind - you know, which ones are doing it for show and which ones not at all.
So with the Chinese government having made this commitment to carbon neutrality how important is the corporate sector to that target and when you personally speak to companies do you see a uniform willingness to meet this goal or is it quite varied.
David: Thanks, that's a good question. As you say the carbon neutrality statement from the Chinese government was perhaps the biggest piece of news that we've had in recent months and obviously that's going to require tremendous effort across the Chinese economy and including the corporate sector.
So if you think about how China is going to achieve this then there are three overlapping verticals really that we need to look at - the decarbonization of power; the decarbonization of industry; and the decarbonization of transport, and obviously the corporate sector plays a big role in all of those.
And we're gonna see China evolving the power mix so that's a greater role of renewables for example and a reduced role for fossil fuels and also the need to improve the energy efficiency of industry and transportation as well so, moving away from energy intensive business models, to business models that are far less energy intensive.
So if you look at what we'll see the government set the road map and the direction for decarbonization and the 14th five-year plan is a continuation directionally of the strategy we saw the 13th five-year plan but the government will set the regulatory roadmap the certain direction but the corporate sector is what needs to really deliver on some of these targets. But as you know the separation of State and industry in China is not as binary as we might see in other markets and so state-owned enterprises are actually playing a key role here in decarbonizing, particularly in the power segment where state-owned enterprises dominate but also in heavy industry around iron and steel and cement for example. So, this industry will play a key role there but many of these larger entities are linked to the government in some way.
When we speak to companies in China, I think there's a strong willingness to meet this goal of carbon neutrality and I think what you've seen over the last six months is a lot of companies released their targets for this and the roadmap for net zero and I think this is a continuation of what we tend to see in China that where the government sets a direction and a clear policy direction, then companies tend to align behind that and that's not necessarily just because it's an edict from the government, but also because it's good business sense that you'll see regulatory support for business models and businesses that play a key role in this and I think you'll see increasing regulatory scrutiny and regulatory tightening of business models that don't play a role in carbon neutrality or will get in the way and I think you're seeing that uh in the power sector and I think you're seeing that in things like the data centre as well.
So, I think when we speak to companies, we tend to get positive feedback, we tend to get a positive momentum and a positive direction of travel and of course that's presenting lots of really interesting opportunities for investors as well - not just around the folks that make solar and wind components but also in the companies that are playing a role here in terms of energy efficient solutions for industry as well - so it's an interesting time to be looking at China.
Yes, thanks and certainly a previous guest I had on a podcast, really highlighted some of those investment opportunities which do seem particularly exciting. Perhaps if we move on to some of the kind of social aspects of ESG, there's been a lot of concern recently about labour practices at some companies in China and specifically in the Xinjiang province.
As investors, can we get comfort that labour practices of companies that we invest in and indeed those businesses in their supply chain, are in line with standards we would expect globally and do you see companies doing anything proactively to help us on that issue?
David: Yeah, it's a really important question. As you might imagine, it's been a big part of our work over - well over the longer term - but certainly in the last few years, it's a part of our work that has ramped up incredibly on these topics, but also more broadly.
So, I think we've seen a lot of engagement with companies not just in China but also across this region on supply chain and supply chain management. You've mentioned China but issues around forced labour and recruitment of workers is also an issue across the rest of this region - particularly in parts of Southeast Asia around rubber and palm plantations and associated products.
I think the way we've looked at this is to go really quite granular with companies around the way they manage their supply chain, so asking quite pointed questions. The way they're looking at these different issues are getting quite granular in terms of the people that we speak to as well, so moving away from sort of IR or C-suite and towards folks who are directly involved in procurement and understanding the way that they're looking at things.
I think what's helped us is the way that we've looked at change as well so being able to ask companies you know, what's changed over the last few years, where are you doing more work on supply chain management and how are you working with your clients there. But also triangulating this because one of the interesting parts of our role in Asia, is that we're looking at companies who in many cases feed into a broader global supply chain, so we may own garment manufacturers, we may own component assemblers, we may own plantations and these feed into a supply chain that may end up with a company in the US or Europe, who are also grappling with the same issue but from the other side of supply chain.
So, I think what's worked well for us is triangulating through speaking to the companies we own there and internally - me speaking to my colleagues in these regions, to understand the way that these companies are working with the companies in our region.
So the challenge for us is whether you will be able to get to true verification on some of these, but we can certainly ask the way that companies are managing things, the way that they're working with their own supply chain, the way that they're working with their own clients in a way that clients are putting pressure on them or increased oversight of them of their supply chain management. So it's been a constant focus and one that we've put a lot of effort to in the last few years to go really granular and it's been quite pleasing that a lot of the companies we speak to - including in China - have been very keen to speak to us on this in order to help us understand the way they're managing that that supply chain. So we've got really good access recently, where companies have been quite keen to discuss this issue with us.
Nick: I know well that's reassuring that, you know, companies being a bit more proactive on that issue and I would imagine third party verification as well plays quite an important role in that - is that the case?
David: Yeah, you're right and that's something that we're asking a lot is around this third-party verification and as I said, we're getting quite granular around the way that audits are done down the supply chain - whether those audits are planned or sort of ad hoc or surprise audience if you like the way that third parties are brought in to verify this - so we're getting quite granular to get to the uh to get to the information that we need.
Nick: Great thanks, then, moving on to governance. You know I mentioned at the start of the podcast the cancelled ANT IPO which appeared to catalyse a whole raft of regulatory action across the tech sector. Where do you see the government going with this regulatory action and what do you think they've been trying to achieve?
David: Yeah, it's an interesting question isn't it. It's one of those issues that's been sort of lingering or hanging over the technology sector in China. But I think you know, if you, if you step back a little bit this approach to regulatory enforcement or the work on anti-monopoly in China - it's not really restricted to China- it's something that we're seeing in other markets as well. So we're seeing the global tech giants under scrutiny in the US and Europe, we've seen a number of these companies being called before parliaments or equivalent in the last few years to give testimonies on these kind of issues, so this is not really unique to China. And in part it’s because of the growth of their businesses over the last decade - or more actually if you think back to the origins of these businesses - but also the novelty of their business models and the way these different verticals work together which is a bit unlike the businesses we've seen before.
So if you look at the work of someone like Lena Khan who's now at Columbia Law, on Amazon, and the reframing of monopoly and antitrust law philosophy, I think that's indicative of the debate within many countries as they grapple with these new types of business models.
So, if you look back to China and you look at the context, I think what's happening over the last maybe five years, 10 years, is China's trying to put in stronger foundations for sustainable economic growth. So, over the last few years we've seen China addressing - amongst other things - supply-side reform, shadow banking and improving long-term technological competitiveness for example. And now with Covid relatively under control in China - and that's another issue that China's dealt relatively well with in terms of getting Covid under control – I think we're seeing China return to this focus on these strengths and their foundations and now the focus is on the digital economy, which is a very large part of the economy and has been the fastest growing part of the economy.
If you look at what the intentions are, I don't think it's the government's goal to - quote unquote – ‘nationalize’ this part of the economy, and I don't think the government is out to destroy innovation. I think the government understands that they need private companies to be commercially and competitively run so as to drive the economy forward and the government's aware of the limitations of leaving that purely to state-owned enterprises. But I do think the government is trying to achieve two things. I think they're trying to achieve consumer protection; I think that's consistent with what we've seen from governments elsewhere around the world but also sustainability of economic growth and corporate growth by addressing, in part, the leverage that can come from the growth of internet and Fintech sector.
So those have been the two key thrusts that we've seen in China and as I mentioned earlier, this is a catch-up in terms of the regulation, where the pace of growth of the the internet or the technology sector has outpaced regulations and that's brought regulatory challenges in China and as I said this is happening elsewhere around the world.
Now having said that, whilst I think these regulations and this focus is well intentioned, the pace of regulatory announcements in what's been a relatively short period of time, has perhaps surprised some and has weighed on the sector. But ultimately, I think it's our view that this is a little bit of short-term paying in exchange for longer quality of growth with some well-intentioned regulatory focus on businesses. And so, if anything, it highlights the importance of stock picking and identifying the business models that are really long-term winners, and sustainable long-term winners, that can evolve along with this changing business and regulatory environment in a resilient way.
So we're using this as an opportunity to really think hard and focus on business models that we think are sustainable leaders and will come out of the other side stronger for this.
Nick: And would that have any implications in terms of the size of investments you'd be looking at in terms of the market cap of some of these companies so, yeah, it seems very clear at the moment that the government has been very much focused on the mega cap Chinese companies - so perhaps there's more opportunity in the smaller companies? Would you agree with that or do you think actually it's the case that, the mega cap companies will end up paying their fines and then move on and their business models will still work perfectly well?
David: Yeah, it's an interesting point, I guess we'll have to see. I mean, I guess there's a correlation - I wouldn't want to say causality- but a correlation between the complexity of businesses and the number of verticals you operate across and the market cap or size of the company. So maybe that's why some of that attention has been focused on the larger companies.
But I think that, you know, as you say, the smaller companies present an interesting opportunity given there's potentially less complexity in terms of verticals. But you know I do think some of the larger companies, it could be a case where there's iteration of regulatory approaches, there may be some fines - but the question is, what the business model looks like coming out of the other side and if there's a, if there's a scenario whereby business models come out the other side relatively intact then of course these could be interesting opportunities as well.
Nick: Great okay, so final question. In Emerging markets, we've always been you know, very active as you well know in terms of engaging with corporates to try and improve their standing on various ESG issues and I think we've been recently successful over the years but you know, one thing I've always felt, you know, sitting in either London or Sao Paulo is you know feeling your team had a pretty tough time in China, in that, it's a market where engaging has often been a bit more challenging. Firstly hopefully that perception's correct - but is it- and do you get a sense that those challenges are becoming less over time, that companies are more willing to engage on these issues?
David: Yeh, I think things are changing. I mean if I look back - I mean I first started covering China, 15 or so years ago, I think that was a very different, very different place then to paraphrase – ‘the past is a different country and they do things differently there’, I suppose, and engagement is different.
If you look at the economic makeup of China, if you look at the sector makeup of China, if you look at the ownership makeup of Chinese companies. For example, if you take the Chinese index from 15 years ago, you would see a landscape that's dominated by heavy industry, that's dominated by capital intense industries and that's dominated by state-owned enterprises and maybe to an extent that's informed the type of engagement that you have and also potentially the degree of success you've had with engagements.
I think if you look at the market now, you've seen a transition to one that's more focused on the knowledge economy. If you look at the largest companies within China, you have the large technology companies who are competing for talent, you see more private ownership of companies or hybrid ownership of companies, so the largest companies now are entrepreneur or privately held companies - and so maybe that informs the engagement success that you have. And also I think what's changed is, capital flows, you know China's economy has opened up relatively over the last 15 years. You're seeing more foreign investment through things like Stock Connect and QFII quotas and I think that's exposing Chinese companies to a global investor base who are asking these kind of questions, and at the same time, onshore asset managers are increasingly asking these kind of questions around ESG.
So, the dynamic of the engagement landscape if you like has evolved but also your engagement with Chinese companies - as can be the case in a number of Emerging markets as you may agree - it does take time, it's a market where it's important to build relations with companies and build that trust with companies, to demonstrate that this is not a, this is not a zero-sum game whereby we as shareholders win but the company loses if you like.
This is a situation, or this is a practice whereby you spend a lot of time working with companies to explain our perspective on things and the way that implementing certain practices or disclosing more about practices relating to ESG is actually beneficial to the company. And this can be as simple as illustrating valuation multiples or differentials between companies listed in different markets, it could be around highlighting the scores that a company gets from a third party ESG scorer for example and the disparities there, and then putting a lot of work in to explain just where we think the companies can improve on on practice or on disclosures.
I think it's one thing you know, to send a letter and say - ‘we think you should do better on this or that, yours sincerely’ - it's quite another thing to put in a lot of work and get quite granular with companies about where we think changes and improvements can be made and also support that with evidence and perspectives. And I think over time companies have come to appreciate that from us, that we're willing to put in that hard work as a long-term shareholder and I think that also has led to better outcomes in terms of engagement and certainly you know this is, this is, non-linear if you like - so we're seeing an accelerated success I guess if you like on the back of what had been more difficult maybe 15 years ago.
We're seeing a more accelerated success recently where we've had a lot of good momentum in our engagement with Chinese companies, so certainly positive and encouraging at the moment.
Nick: Well great, I mean that is very encouraging and certainly completely agree with the point that some of the more significant engagements I've been in, have been, you know, very much multi-year efforts which really have started out very slowly and then only gained momentum in later years when companies actually began to trust us more and take our requests a bit more seriously.
So well great you know, on that optimistic note I think that feels like a good place to draw the podcast to a close. So thanks very much David for your time today, it's very much appreciated
David: Thanks for having me, always good to be here
Nick: And thank you everyone today who took the time to listen in. If you enjoyed today then please download our other podcasts from our website or wherever you normally get your podcasts watch out for the next episode and tune in.