China’s commitment to net-zero is one example of how authorities are rebalancing the economy away from exports and carbon-heavy industries to rely on services and protecting the environment.
Decarbonization has become a strategic priority. China has pledged to hit peak carbon by 2030 and achieve carbon neutrality by 2060. Its companies today play leading roles in developing renewable energy globally, through both component manufacturing and the deployment of generating capacity.
But does it follow that investing in China is compatible with a focus on sustainability? After all, concerns linger over the impact of industries tied to years of strong economic expansion. These includes questions over the standards of corporate governance and perceptions that Chinese firms are not always run for the benefit of all shareholders and whether government intervention in various sectors of the economy.
The key question revolves around how to access China given both the opportunities and the risks. Can investors gain exposure to China’s growth without compromising on environmental, social and governance (ESG) commitments?
Decarbonization has become a strategic priority. China has pledged to hit peak carbon by 2030 and achieve carbon neutrality by 2060. Its companies today play leading roles in developing renewable energy globally, through both component manufacturing and the deployment of generating capacity.
But does it follow that investing in China is compatible with a focus on sustainability? After all, concerns linger over the impact of industries tied to years of strong economic expansion. These includes questions over the standards of corporate governance and perceptions that Chinese firms are not always run for the benefit of all shareholders and whether government intervention in various sectors of the economy.
The key question revolves around how to access China given both the opportunities and the risks. Can investors gain exposure to China’s growth without compromising on environmental, social and governance (ESG) commitments?
The key question revolves around how to access China given both the opportunities and the risks.
In our experience, China is a market where investors need to be active, not only in stock selection but across the investment process, but also in due diligence, portfolio management and engagement. The type of ESG analysis required to invest in China is deeper and more nuanced than for many other markets.
We expect heightened regulatory scrutiny to persist in segments such as education, technology, real estate and health care. But it doesn’t necessarily follow that investors must avoid these sectors.
Some stocks stand to benefit from “common prosperity” regulations, as do firms working to solve domestic challenges around access to health care, energy security and the transition to renewable energy. This is likely to create mispricing opportunities. Through detailed research and analysis at both a macro-economic and micro-economic level, we believe it’s possible to differentiate quality in China.
More Chinese firms are outlining their thinking on sustainability, aspirations to reduce their carbon footprint and putting frameworks in place to negate ESG-related risks. However, there’s still work to do. While disclosure standards are improving, often they lag behind what investors are looking for. Here’s the key ESG issues that we think about when investing in China, and how we respond to them.
We believe that it's important to ask companies about the structures, processes and checks and balances they have in place when it comes to supply chains. This could involve speaking to subject-matter experts, including supply-chain managers and procurement managers. But it's critical not to rely solely on what companies say about themselves. It's important to engage across a company’s ecosystem — suppliers, customers, competitors and industry experts. It's helpful if companies have structured disclosure practices in place, including on how they manage their supply chains.
It’s also important to recognize that not all SOEs are the same. Management teams differ in how entrepreneurial, professional and independent they are. Making these distinctions requires deep due diligence and a constructive approach in meetings with company management.
It's important to be aware of the risks and how to manage them. Prudent due diligence process should start with the controlling shareholder — checking their backgrounds to understand alignment of interests, what connections they retain to privately held vehicles and the way these interests compete. It's also helpful to assess the competence and commitment of company boards and management teams.
Investors could also benefit from examining transactions in detail to appreciate rationale and pricing fully. It's crucial to understand if a transaction was in the normal course of business, why a counter-party was sought and how pricing was determined. Understanding the governance process, board members responsible and the checks and balances in place is also useful.
China has funded research into renewables for decades, enabling it to set ambitious targets for decarbonization. This creates investment opportunities, both in the context of the domestic market and because Chinese renewables firms are industry leaders and central to decarbonization globally.
Chinese companies have become increasingly conscious about their carbon footprint. There are environmentally conscious companies in China that maximize their energy efficiency, minimize their carbon footprint and provide products or services that allow other companies to do the same. On the whole companies provide data on these issues.
This could be a starting point for engagement — speaking to companies to understand how they manage their carbon emissions, water and energy risks. But while Chinese firms are often willing to disclose snapshot statistics (current year water consumption, for example), they can be less willing to disclose targets publicly for fear of not achieving them. On the other hand, we’ve also found examples of companies doing more than they say they’re doing. Often it may appear that some companies are not acting, but in our experience they often are and are just not disclosing it.
1 China’s Role in Climate Change: The Biggest Carbon Emissions Polluters (bloomberg.com)
2 Global Trends in Renewable Energy Investment Report 2018 (unep.org)
3 World Bank, 2022.
Applying ESG and sustainability criteria in the investment process may result in the exclusion of securities within a fund's benchmark or universe of potential investments. The interpretation of ESG and sustainability criteria is subjective meaning that the fund may invest in companies which similar funds do not (and thus perform differently) and which do not align with the personal views of any individual investor.
We expect heightened regulatory scrutiny to persist in segments such as education, technology, real estate and health care. But it doesn’t necessarily follow that investors must avoid these sectors.
Some stocks stand to benefit from “common prosperity” regulations, as do firms working to solve domestic challenges around access to health care, energy security and the transition to renewable energy. This is likely to create mispricing opportunities. Through detailed research and analysis at both a macro-economic and micro-economic level, we believe it’s possible to differentiate quality in China.
Key ESG factors
It’s important to recognize the progress that Chinese firms have made on ESG, which is something that investors not directly engaged in China don't always appreciate. Standards are evolving, disclosure is improving and rules around social and environmental behavior are strengthening. There’s much better dialogue between companies and investors than there was five-10 years ago.More Chinese firms are outlining their thinking on sustainability, aspirations to reduce their carbon footprint and putting frameworks in place to negate ESG-related risks. However, there’s still work to do. While disclosure standards are improving, often they lag behind what investors are looking for. Here’s the key ESG issues that we think about when investing in China, and how we respond to them.
Supply chains
As part of our investment process, we research and analyze companies’ labor and supply chain issues, including around forced labor and modern slavery. We have made clear to companies — and continue to make clear — our zero tolerance for forced labor in supply chains. Risks surrounding human rights can be either directly through a company's operations or indirectly through its supply chains. Avoiding forced labor is non-negotiable for us, made possible by our active approach to investing, and we have in the past divested from companies due to concerns around human rights.We believe that it's important to ask companies about the structures, processes and checks and balances they have in place when it comes to supply chains. This could involve speaking to subject-matter experts, including supply-chain managers and procurement managers. But it's critical not to rely solely on what companies say about themselves. It's important to engage across a company’s ecosystem — suppliers, customers, competitors and industry experts. It's helpful if companies have structured disclosure practices in place, including on how they manage their supply chains.
State control
It’s a common misconception that China’s economy is dominated by state-owned enterprises (SOEs). In fact, the balance is tilted far more towards private companies today.It’s also important to recognize that not all SOEs are the same. Management teams differ in how entrepreneurial, professional and independent they are. Making these distinctions requires deep due diligence and a constructive approach in meetings with company management.
Related-party transactions
Share ownership in China can be concentrated, while controlling shareholders can have multiple public and private interests. Related-party transactions between a listed company and a connected party (shareholders, directors, sister companies, suppliers or others) can be a challenge. There are clear conflicts of interest. But such transactions are also part of the normal course of doing business in China.It's important to be aware of the risks and how to manage them. Prudent due diligence process should start with the controlling shareholder — checking their backgrounds to understand alignment of interests, what connections they retain to privately held vehicles and the way these interests compete. It's also helpful to assess the competence and commitment of company boards and management teams.
Investors could also benefit from examining transactions in detail to appreciate rationale and pricing fully. It's crucial to understand if a transaction was in the normal course of business, why a counter-party was sought and how pricing was determined. Understanding the governance process, board members responsible and the checks and balances in place is also useful.
Climate and the environment
China is both the largest single emitter of CO2 globally1 and the world’s top investor in renewable energy.2 This said, when it comes to manufacturing, China accounts for 28% of global output, which is in line with its share of global emissions.3China has funded research into renewables for decades, enabling it to set ambitious targets for decarbonization. This creates investment opportunities, both in the context of the domestic market and because Chinese renewables firms are industry leaders and central to decarbonization globally.
Chinese companies have become increasingly conscious about their carbon footprint. There are environmentally conscious companies in China that maximize their energy efficiency, minimize their carbon footprint and provide products or services that allow other companies to do the same. On the whole companies provide data on these issues.
This could be a starting point for engagement — speaking to companies to understand how they manage their carbon emissions, water and energy risks. But while Chinese firms are often willing to disclose snapshot statistics (current year water consumption, for example), they can be less willing to disclose targets publicly for fear of not achieving them. On the other hand, we’ve also found examples of companies doing more than they say they’re doing. Often it may appear that some companies are not acting, but in our experience they often are and are just not disclosing it.
Investment opportunities
While China is a market that offers clear investment opportunities, there are also ESG challenges. But we believe investors can manage these risks. Of course, China is a market that requires a long-term perspective. Investors are likely to experience volatility, but they should not lose faith and risk missing out on China’s long-term, structural growth opportunities.
In China, investors could benefit from active in stock selection and across the investment process – due diligence, portfolio management and engagement. To benefit from China’s long-term growth, we urge investors to:
- Understand all the issues and nuances
- Recognize and adapt to changes
- Conduct active due diligence
- Engage companies actively to drive change
1 China’s Role in Climate Change: The Biggest Carbon Emissions Polluters (bloomberg.com)
2 Global Trends in Renewable Energy Investment Report 2018 (unep.org)
3 World Bank, 2022.
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IMPORTANT INFORMATION
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.Applying ESG and sustainability criteria in the investment process may result in the exclusion of securities within a fund's benchmark or universe of potential investments. The interpretation of ESG and sustainability criteria is subjective meaning that the fund may invest in companies which similar funds do not (and thus perform differently) and which do not align with the personal views of any individual investor.
- understand all the issues and nuances;
- recognise and adapt to changes;
- conduct active due diligence;
- engage companies actively to drive change;
- trade around volatility to build exposure to long-term winners.
Those that do will find rewards through long-term growth opportunities.