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.

Decarbonisation 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; over the standards of corporate governance and perceptions that Chinese firms are not always run for the benefit of all shareholders; and over 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?

In our experience, China is a market where investors need to be active, not just in stock selection but across the investment process – 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 will 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 recognise 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 behaviour are strengthening. There’s much better dialogue between companies and investors than there was 5-10 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. Whilst 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 analyse companies’ labour and supply chain issues, including around forced labour and modern slavery. We have made clear to companies – and continue to make clear – our zero tolerance for forced labour in supply chains. Where we identify risks around human rights, it’s our number one priority to ensure that our portfolio companies are not involved, either directly though their operations or indirectly through their supply chains. If our due diligence or engagement progress is unsatisfactory, we will not buy or own the company. This 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 ask companies about the structures, processes and checks and balances they have in place when it comes to supply chains. We speak to subject matter experts, including supply chain managers and procurement managers. But we don’t rely solely on what companies tell us. We engage across a company’s ecosystem – suppliers, customers, competitors and industry experts. We encourage all companies to put 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 recognise 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.

As investors we need to be aware of the risks and how to manage them. Our due diligence process always starts with the controlling shareholder. We check their backgrounds to understand alignment of interests, what connections they retain to privately held vehicles and the way these interests compete. We assess the competence and commitment of company boards and management teams.

We also examine transactions in detail to appreciate rationale and pricing fully. We aim to understand if a transaction was in the normal course of business, why a counter-party was sought, and how pricing was determined. We look to understand the governance process, board members responsible and the checks and balances in place. This work is critical to our investment approach.

Climate and the environment

China is both the largest single emitter of CO2 globally1 and the world’s top investor in renewable energy.2 That said, when it comes to manufacturing, China accounts for 28% of global output, which is in line with its share of global emissions.3

China has funded research into renewables for decades, enabling it to set ambitious targets for decarbonisation. This creates investment opportunities, both in the context of the domestic market and because Chinese renewables firms are industry leaders and central to decarbonisation globally.

Chinese companies have become increasingly conscious about their carbon footprint. When we carry out research we look for companies that maximise their energy efficiency, minimise 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 is our starting point for engagement. We speak 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

We engage with companies collaboratively and work constructively to raise standards and increase disclosure. We share best practices, including what peers in other markets are doing. Typically, these are multi-year engagements.

While China is a market that offers clear investment opportunities, there are also ESG challenges. But we believe investors can manage these risks with an appropriate investment process. 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 need to be 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:

Those that do will find rewards through long-term growth opportunities.