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Revisiting ESG in China: Has company performance improved?

Posted on May 30, 2018

Frank Pan
Frank Pan
Manager, Asia-Pacific Research

China’s growing economic power, continuous reforms and liberalizations have made it increasingly important to global capital markets. In 2017, MSCI announced it would add around 230 “A-Shares” to its Emerging Markets and All Country World Index indices in June and September 2018. Due to the large amount of passive-strategy funds worldwide, it is estimated that a total of USD 20 billion, and as much as USD 300 billion at full inclusion, will flow into A-Shares market.

With environmental, social and governance (ESG) investing moving from the margins to the mainstream in many of the world’s financial markets, we expect investors to pay much greater attention to the ESG performance of the companies in their investment portfolio, including companies in China.

In this analysis of Sustainalytics’ historical data we find that, despite some improvements, on average the ESG performance of Chinese companies still lags behind their global peers. We suggest some of the drivers of improvement as well as the reasons hindering performance and formulate some expectations for ESG in China in the coming years.

Historical ESG performance of Chinese companies

In our 2012 report, Bridging the Gaps – Effectively Addressing ESG Risks in Emerging Markets we found that despite some Chinese companies starting to respond to investors’ ESG and transparency concerns, there was still much room for improvement. At that time, Chinese companies had the lowest overall scores among BRICS (Brazilian, Russian, Chinese and South African) companies and ranked consistently low across most ESG indicators.

In recent years, Chinese authorities and companies have made efforts to promote ESG awareness. For example, China has introduced its own sustainability reporting standards, such as the CASS-CSR 3.0 reporting guidelines. In 2016, the People’s Bank of China along with six other government agencies jointly issued Guidelines for Establishing the Green Financial System, which provide an essential first step for accelerating the pace of ESG programs in the country. Directed by the Guidelines, the China Securities Regulatory Commission has been promoting the ESG disclosure of listed companies, and has introduced new requirements that, by 2020, will mandate all listed companies to disclose key environmental information in their annual or semi-annual reports. The Shanghai and the Shenzhen Stock exchanges have joined the UN Sustainable Stock Exchanges initiative and are committed to supporting the development of green and transparent markets in China.

To gauge the effects of these developments, we studied Sustainalytics’ historical ESG assessment data of the Chinese companies in our coverage over the past six years.

Despite the ESG-related initiatives launched in China, companies’ average overall ESG score still lags other regions, with the gap having widened slightly since 2012. Chinese companies’ average ESG scores have remained stable while other regions have seen marginal improvements in their average scores.

Regional Trends in Total ESG Scores from 2012 to 2017

Source: Sustainalytics ESG Research & Ratings

When looking at Environmental, Social and Governance scores separately, we found an improvement in Chinese companies’ performance on environmental issues, from 43 to 46 points on average (an almost 7% increase). This improvement is consistent with China’s environmental efforts, such as the strengthening of regulation enforcement, the phasing out of high-cost, high-energy and high-pollution factories or industries, and the promoting of renewable energy and electric vehicles through industrial policies and massive subsidies.

Chinese companies' ESG scores by category

Source: Sustainalytics ESG Research & Ratings

However, Chinese companies’ improvement on environmental issues is offset by the deterioration of their social and governance performance, which leads to the overall average ESG score remaining stable. While the reasons behind this drop in performance are unclear, an underlying cause may be the strengthening of media scrutiny in China, and the increasing role of the internet in public scrutiny, bringing more controversial practices involving Chinese companies to light. The chart below shows the growing number of incidents involving Chinese companies that we have recorded through our Controversy Research.

Number of ESG incidents at Chinese companies captured by Sustainalytcs

Source: Sustainalytics ESG Research & Ratings

A closer look at the leaders

The same pattern emerges when we eliminate the impact of industrial imbalance between different regions and compare Chinese companies with industry peers. Only 7% of Chinese companies are above industry average in terms of overall ESG score, and only about one in 10 companies outperforms peers on E and S pillars, and one in 20 on G.

Percentage of companies above the average sub-industry score

Source: Sustainalytics ESG Research & Ratings

Although China’s relative performance on corporate governance worsened during this period, we had expected the government’s nationwide anti-corruption campaign, conducted in 2012, to lead to improvements in this area at the company level. Chinese companies’ improvement on Whistleblower Programs echoes our expectation, although the average score remains low. Company performance on Bribery and Corruption Policy remains mixed, since it is still not a common practice to publicly disclose a code of conduct in China.

Chinese company whistleblower programs scores

Source: Sustainalytics ESG Research & Ratings

Overall, Chinese companies have not made significant improvement on their ESG performance, but some companies, such as China Oilfield Services, China Eastern Airlines and BYD, have stood out by making considerable progress on ESG issues. For example, China Oilfield Services exhibits decreasing injury rates among employees, China Eastern Airlines maintains a certified quality management system, while BYD is among the world’s top manufacturers of electric vehicles.

Looking ahead: more focus on materiality for more informed decisions

Despite noticeable improvements on environmental performance, Chinese companies have not yet managed to narrow the gap in ESG performance with other regions. In our view, the ESG performance gap is driven by two main factors: lagging disclosure and a focus on corporate social activities rather than managing ESG issues.

Chinese companies’ disclosure on ESG issues remains relatively limited compared to industry peers. Although more companies are publishing CSR reports, Sustainability reporting essentially remains voluntary in China. Moreover, despite referencing GRI G4 guidelines in their CSR reports, few CSR reports from Chinese companies self-declare compliance with GRI G4 standards. The reports generally lack detailed information on material ESG issues, and disclosure on management structures of company ESG programmes and tend to not include quantitative metrics such as detailed workforce data and carbon emissions data. Chinese companies are also less willing to disclose their internal policies relating to business ethics and human rights issues, for example.

Additionally, Chinese companies still seem more focused on philanthropic activities and put relatively less effort into managing the material ESG risks and opportunities of their own operations, products and business models. While philanthropic activities are certainly positive, material ESG issues are more relevant to a company’s long-term sustainable development strategy. For example, few Chinese companies discuss the impact of their operations on local communities, or the measures taken to mitigate the risks their products and services may pose to customers. Lack of information on the management of some of the most material ESG risks and opportunities drags down the average overall ESG performance of Chinese companies in our rating.

With increasing awareness of ESG in China and the opening up of China’s capital market to international investors, we expect Chinese companies to experience more pressure to improve their ESG performance in the coming years. Mandatory reporting requirements, government intervention, increasing management awareness of ESG and shifting consumer behaviour will be strong drives for change. Considering the increasing importance of China’s economy and capital market, global investors may want to pay closer attention to the ESG performance of Chinese companies. In doing so they can manage portfolio risk and exposure and identify firms better positioned to cope with an increasingly complex business environment, while simultaneously contributing to global sustainable development.

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