Funds Europe – What are some of the top ESG risks facing China from an asset allocation and distribution perspective, and how are you mitigating them?
Patel – As a manager of a number of UK pension funds and with a parent organisation that is Dutch, ESG and responsible investing are extremely important to us, and it’s actually been the single biggest hurdle for us to overcome when considering China. Identifying a strategy for Chinese equity or fixed income that’s perfectly able to live up to our internal ESG policies and guidelines is challenging, and I imagine that will be true of any responsible investor, or anyone who claims to be.
It’s not just about the environmental risks; those are actually the easiest ones to manage and are familiar territory for everyone, and there are lots of consistent data points. There are a whole range of additional risks with China, even more so and magnified when compared to other emerging markets.
You’ve got hyper-specific issues like forced labour and human rights abuses of the Uighur Muslim population (and that, by the way, isn’t contained to Chinese equity and fixed income markets, there are large global ICT companies that have questions to answer here).
You’ve got the issue of state-owned enterprises [SOEs] which make up around 50% of the A-share index; you’re seeing some reform and improvements in governance and you have to make a distinction between companies operating in strategic and non-strategic sectors, because clearly that will impact how the Chinese government treats and allows them to perform.
ESG reporting is not mandatory in China, engagement efforts more often than not are neglected by companies, there’s a very high degree of state interference in ESG matters of policy, and there’s a huge discrepancy between the interest of the Chinese government and both shareholder and stakeholder interests. There’s a limited degree of governance, transparency and shareholder protection, and this last one is very important.
If you take all that together, a very high proportion of the listed market public debt and equity in China scores very poorly on ESG matters. Now, despite those challenges, foreign capital is still flowing, and it is speeding up some of the improvements, but it’s speeding up from glacial to merely slow.
In terms of how you deal with ESG risks, asset managers can add value. We tend to think that active managers are the only way that you can really incorporate ESG meaningfully in the onshore China markets. It’s still in its infancy and therefore finding an asset manager who is more aligned to EU, UK or US norms is better able to express those ESG views, and they can also take into account very poor data quality on ESG issues in listed onshore Chinese markets.
Finally, just one level up from ESG on the actual underlying companies and issuers, the ownership structures of Chinese asset managers is also worth looking at, and it can be very complicated, again with significant ownership by local government entities. We’re finding, whilst they’re taking a lot of measures to improve governance structures, for example through much more increased employee share ownership, it’s still just not going fast enough. So, you’ve still got underlying problems with the actual listed stocks and bonds, you’ve got problems with the potential owners of the asset management companies, and then a very slow pace of improvement. As an investor, you have to find a way to operate through these issues or compromise the way you implement your ESG framework in China.
Wang – From an on-the-ground perspective where we operate in China, the key starting point is that we have to realise the uniqueness of the overall structure of China. The government is everywhere and can have a big role in the overall economy – nowhere else can you see the role government is playing, so that causes lots of the challenges when bringing ESG into China. If you want to have a good-quality data collection and all these reporting mechanisms, the government should encourage lots of things, otherwise the quality of things could be diluted. For ESG, you need to have the consensus in the overall understanding of the ESG framework and endorsement from the Chinese government. Without that, you have to live with non-satisfactory results, because if we need local input but the government discourages it, then you won’t find data equality – that’s ESG data in terms of the coverage. If you look at MSCI and all the providers, the coverage of China A-shares and the onshore bond market is quite limited and that is a big challenge for global investors coming to the Chinese market.
On the positive side, China is quite keen to try and live up to a lot of those things with the 2060 zero-carbon commitment and so on. I agree on the environmental points that Nikesh made, the government needs to find a solution in terms of how to bring China’s local things into the global framework. But some of the issues – human rights and so on – are really on a very different trajectory. With more participation from the global investors in the China market, I am still quite confident that things will be improving.
At this point, if you want to engage a local manager to live up to ESG, that will be a big challenge for us as a company operating in China. Domestically it takes time to move the overall understanding of ESG in China. It takes a long time and also needs official endorsement from the government in order to do it properly and consistently. The government is everywhere, so for a lot of the local managers you always see government influence. Ultimately, that will be an issue and that’s where you have to take the uniqueness of Chinese economic structure into place, and hopefully the government will be on the same page in terms of ESG and moving forward together.
Amstad – The perception of ESG standards in China absolutely and relatively to other countries is that China is very poor. The reality on the ground in our experience, though, is very different to that perception. We’ve been going to China since 1988, and the stock exchange only reopened in 1990, so initially most of our China-related investments were through Hong Kong. Our investment style, if I had to sum it up in one word, is ‘engagist’. Now, if you take an ‘engagist’ approach to stock selection, of course to engage you need to have a counterparty on the other side to engage with, and we can’t force any company to engage with us on any matter. If you look back at the history of our Asia-Pacific portfolios over the years, one of the key components of these portfolios is this massive underweight to Chinese equities that was made up for to a large extent with some overweight positions to Hong Kong.
What has happened over the last five or six years, though, is that we have massively increased our holdings in Chinese equities, and that is because when it comes to ESG, on all three factors we are noticing dramatic improvements in China. Not at all companies, absolutely, and you mentioned the problem of state-owned enterprises. The first change is the willingness of companies to engage and it’s all part of this shift in China away from the quantity of growth to the quality of growth, it’s all part of President Xi’s commitment to taking China to carbon neutrality by 2060. ESG is something that many management teams at companies now get because they see the rewards of having higher ESG scores, it means you get a higher valuation in terms of the price/earnings ratio, so the willingness to learn is just growing exponentially.
It’s not so much the point about where China is at now, it’s about the direction of travel, and the direction of travel to us is very clear. Romil, to answer your question about how you deal with it, it is that you go active. If there’s one market that rewards you for going active, it’s the Chinese stock markets. I can think of half a dozen – there are probably more – managers who have been able to generate double-digit alpha year in, year out in this market, because these inefficiencies in the market are beginning to rise to the surface. We have literally dozens of examples of companies where, because we actively engage with them, standards of ESG are getting better. And actually, when it comes to the rating agencies and disclosure, it is poor because the reality on the ground is that many companies do far more for ESG than they actually disclose in their annual reports, it runs both ways.
On the ‘S’ issue, which is the trickiest one to address, clients do raise this, and again the way to address that issue is not to deny issues that exist but just to point out that over the last couple of decades, the Chinese government have lifted 800 million people out of poverty. Forty years ago, life expectancy was under 40, today it’s over 75, GDP per capita was US$100, it’s now $10,000 and it’s $20,000 if you live in a Tier 1 city like Shanghai. When you multiply these numbers by 1.3 billion people, and in that context you put China into a comparison with certain other countries where inequality is going through the roof, and without naming countries, one particular country where now tens of millions of people are living on food stamps and can’t earn enough to pay a living wage, then actually China is not in such a weak position as is portrayed.
One thing that China is not particularly good at is PR, and their attempts there are sometimes rather crude, but when we look at the direction of travel, allocation to China is something that I think is worthy of merit, but as you say, on an active rather than on an index or a passive basis.
Shukla – Clearly everything has two angles – whilst I agree that China offers a very unique and diversifying investment opportunity, it would be wrong to approach investing in China with blind optimism and faith that what worked in the past would continue to do so in future. It is important to think not just about opportunity but also about the risk, including ESG, and I see many, including some that could be quite unconventional and potentially difficult to quantify. The only way to mitigate many of these risks would be through active management and diversification by asset types, names, sectors and growth drivers.
