Bridging the ESG Gap in ChinaFranklin Templeton Investments
Environmental, social and governance (ESG) factors have become increasingly important to many investors—including those in emerging markets. Franklin Templeton Emerging Markets Equity’s Michael Lai examines challenges facing ESG investing and reporting in China—and how it’s likely to continue to evolve.
Environmental, social and governance (ESG) screening factors are transitioning from important to essential for a growing number of investors. The COVID-19 pandemic exposed a divergence in ESG capabilities across markets—including emerging markets—and has put a spotlight on China in particular.
Institutional and high-net-worth investors are boosting the demand for ESG investing in China,1 and they have been doing so for some time. Capital flows into ESG-themed exchange-traded funds (ETFs) in China for example increased 464% between 2018 and 2019. At the same time, we’ve also seen a boom in a wider range of “pure ESG” products made available to investors, evidence that sustainable investing has already become mainstream. As more international investors look to China’s capital market for opportunities, it has also raised awareness and interest in ESG investment principles. Increased availability of data will help investors distinguish between companies that are ESG compliant. However, challenges remain in China’s overall development in this area.
Despite increased attention from both foreign and domestic investors, China generally lags developed markets with ESG best practices. Chinese companies operate according to local norms and requirements from local regulators, and we have found many are doing more than what is required in many areas. When compared to Western peers, the overall perception may feel like Chinese companies are falling short. While in general it may seem that way, as regulation in China evolves, many companies will likely progress in becoming more accountable for the wider stakeholder.
Is China’s 2060 Net-Zero Goal Realistic?
The latest five-year plan sets out China’s longer-term climate goals, notably with the introduction of a cap on carbon dioxide emissions for the first time. China’s target to achieve carbon neutrality by 2060 reflects several ambitions for the country. China is currently responsible for 28% of the world’s carbon dioxide, more than the United States and the European Union combined. Practically becoming “carbon neutral” means that China will have to reduce its carbon emissions by as much as 90% (based on 2019 data), and offset the rest through natural systems or technologies that absorb more carbon from the atmosphere than they emit. This is a huge undertaking, especially as there is still a dependency on fossil fuels. The share of coal consumption in the energy mix will be crucial to this balancing act, in addition to the importance of maintaining energy security.
The first target is to reach peak carbon emissions before 2030. That will be a key milestone, in our view. On the flip side, China leads on clean technology globally through electric vehicles, batteries, solar panels and wind turbines. Electric vehicles have a lead role in the “Made in China 2025” industrial masterplan—Beijing wants 20% of all new cars hitting the streets to be electric vehicles by 2024. The United States had five times as many electric vehicles as China in 2013, but now China has twice as many as the United States, cementing China’s dominant position in the electric vehicle global market.2 There’s been a turnaround on wind and solar energy between the United States and China too—by 2019, China had taken the lead and deployed twice as much wind, and three times as much solar energy than the United States.3
As price gets to parity or cheaper than alternatives, we would expect green energy to take off further. But, the success of China’s carbon-neutral goal is dependent on whether there is sufficient capital to fund this switch to clean energy. Balancing the energy mix to also ensure energy security will be crucial, in my view.
Raising the Bar
China in general is considered to be more of a regulatory-driven market, and companies generally don’t act unless or until asked to. This has proved tricky in some circumstances when third-party ESG assessors rely solely on public disclosures to conduct assessments. In our experience, management teams are willing to share this information with us; however, there is still a lack clarity on what information should be supplied to the public.
In general, we have found that Chinese companies remain proactive in ESG measures and remain dedicated to either learning more from what investors want to see from an ESG perspective, or setting out agendas in disclosing how sustainability features in their long-term strategies. Our on-the-ground presence in China allows us to guide these conversations where companies are keen to improve their ESG disclosure and implementation. For example, we recently held a meeting with a prominent Chinese bank which was keen to improve its ESG disclosure and implementation. That presented an opportunity for us to guide the conversation toward the appropriate disclosure that investors use to measure ESG standards.
Overall, ESG in China is a mixed bag but seems to be headed in a positive direction. Many companies have very robust reporting, where investors can see exactly how sustainability fits in their overall strategy, and how the company and management teams take account of ESG risks. While China’s capital market has opened up and the barriers are coming down for international investors, Chinese regulators are set to improve ESG reporting processes further through mandatory disclosures for listed companies by the end of 2021. We believe these steps will pave the way for Chinese companies to truly be in line with their Western counterparts.
What Are the Risks?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks. Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values-based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.
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- Source: Ping An, ESG Investment in China, November 2020.
- Source: International Energy Agency, Global EV Outlook 2020, June 2020.
- Source: International Renewable Energy Agency, Renewable Capacity Statistics 2020, March 2020.
Article by Michael Lai, CFA, Portfolio Manager, China Equities, Franklin Templeton Emerging Markets Equity – Franklin Templeton Investments