China’s New Era of ESG

By Emily Chew, Xiaoshu Wang 14 July, 2015

MSCI's Chew & Wang on changes in China that mean ESG factors will play bigger role in investing

Things are changing in China which indicate that environment, social & corporate governance factors (known as ESG) will play a more crucial role for the country’s growth. Such changes include the new Environmental Protection Law that came into force at the beginning of the year and various more stringent regulations and action plans that prioritize these three factors (more on this below). Given this new direction, the question on many peoples’ minds is what does this mean for investors?

ESG factors previously secondary to economic growth now hold considerably more weight

China’s economy is slowing down and converging with challenges arising from ESG factors. These challenges were previously secondary to economic growth targets but now hold considerably more weight than before, for example, in the area of natural resources management. Actually, natural resource scarcity due to overuse and to industrial pollution is emerging as one of the restricting factors for China’s economic development. Another challenge is the social alarm arising from environmental pollution. Further to this is widespread corruption, which reflects weaknesses in corporate governance at Chinese companies.

Clearly there will be some difficult policy choices for President Xi Jinping’s administration, especially given the 13^th Five Year Plan will start next year. By all indications, pursuit of economic transformation in China will enhance the materiality of ESG factors for investors.
Below are some of these key factors that we highlight in the MSCI ESG Research thematic report, “China’s Economic Transformation: A New Era of ESG Opportunity”. The full report is only available to MSCI clients but a summary report can be publically access here (or by clicking on the image right).

Environmental law reforms: setting a price on pollution

Environmental reforms will introduce more costs for polluters, which is a particular concern for environmentally impactful State Owned Enterprises (SOEs) that historically show 3x higher average values of penalties, and 4% lower average net margins, than private sector peers.

Number of violations being penalized or resulting in stop production orders doubled over 2011-14

We analyzed over 700 records of pollution violations and controversial polluting behavior among MSCI China Index companies and their known subsidiaries, drawn from local government records collated by the Institute for Public and Environmental Affairs, and MSCI ESG Research’s controversy database (see chart below). There has been clear upward momentum in the pollution incidents being recorded by local environmental protection offices (134% increase 2011-14), and the number of violations being penalized or resulting in stop production orders (doubling over 2011-14).

Red flags: MSCI analysis shows a higher rate of penalties imposed on SOEs in environmentally intensive industries

Our analysis also highlights a higher rate of penalties imposed on SOEs in environmentally intensive industries¹ – companies that tend to underperform other SOE peers and non-SOEs on key financial metrics. Taken together with the strengthening of regulatory oversight over pollution across China at this time, these indicators represent a red flag: Companies that can least afford extra costs, are likely to be the most impacted by the environmental reforms.

In addition to a concerted push to better protect the environment, a parallel anti-corruption crackdown is underway, which is significant as corruption has been linked with overlooking environmental transgressions in the past.

Anti-corruption investigations

In the last three years, the strength of private sector companies’ anti-corruption strategies has improved, whereas that of SOEs has remained flat, suggesting that the ‘crackdown’ is having limited impact on the structural causes of SOE corruption, such as monopolies, lack of transparency, and weak prevention policies and mechanisms.

Chinese  large- & mid-cap corruption controversies more than doubled between 2012-2013 & likely to double again in 2015

Driven by President Xi’s anti-corruption campaign, the number of corruption controversies among Chinese large- and mid-cap companies has more than doubled between 2012 and 2013, and will likely double again in 2015 with a new round of the campaign.
Over the last three years, we have tracked the anti-corruption management policies and programs for companies in industries facing high risks of corruption, such as energy, real estate, and telecoms.
The average corruption management score (where 0 represents weak management and 10 represents best-in-class management by global standards – see chart below) highlights that non-SOEs have shown the greatest enhancements in their performance to address corruption issues in the past three years, whereas the SOEs trend has been virtually flat. While Chinese SOEs under investigation might experience rotation of key personnel and reputational damage in the short term, their more structural anti-corruption prevention measures remain weak.

In the last 3 years non-SOEs have shown greatest improvement in addressing corruption, meanwhile SOEs remained flat

In terms of more structural adjustments to Chinese corporate governance, the SOE reform agenda aims to improve SOE efficiency and align their commercial goals with China’s modern development plans. Addressing weak corporate governance norms is key.

Mixed ownership and privatization reforms among Chinese SOEs

Around 63% of Chinese companies have a controlling shareholder – much higher than the emerging markets average of 48%. The new round of SOE reform in China aims to enhance corporate structure and corporate efficient, impacting around 60% of large/mid-Cap Chinese companies.
SOEs represent 60% of the Chinese constituents of the MSCI Emerging Markets Index.² Our data indicates that around 63% of Chinese companies have a controlling shareholder, much higher than the developed and emerging markets averages (Figure 4). The Chinese government and its agencies serve as the controlling shareholder for a large number of SOEs, also reflected in the very low proportion of Chinese companies with an independent board majority.

“around 63% of Chinese companies have a controlling shareholder, much higher than the developed & emerging markets averages”

In late 2014, the Chinese government launched a new round of mixed ownership reforms: partial privatization in some sectors, while maintaining government control of SOEs central to the economy and national security. Significant pay reforms are also being introduced to incentivize a new generation of professional managers, seeing the introduction of employee share ownership schemes at some of China’s largest SOEs.
Despite varying reform approaches for different types of SOEs, the purpose is the same: enhancing SOE operational efficiency via reducing political interference. The new round of SOE reform in 2015 will target the structural corporate governance weaknesses of Chinese SOEs, aiming to narrow the gap between Chinese and developed market corporate governance norms.

It’s clear long-term investors increasingly need to incorporate ESG factors

It’s clear from the above – higher pollution fines, a continued crackdown on corruption and SOE reform – that ESG will play a more important role for investing in China. Long-term investors increasingly need to be prepared to incorporate ESG factors into their China-related investment decisions.