Will index inclusion raise China’s ESG standards?

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Robeco argues that the increasing internationalisation of China’s stock markets will force Chinese companies to take ESG seriously.

“But for now, the quality of ESG disclosure varies and most companies are still just box-ticking,” Jie Lu, Robeco’s head of research told FSA.

However, as he argues in recent paper on ESG and A-shares, co-authored with Victoria Mio, CIO China, ESG standards will improve eventually.

This is partly because China’s authorities are pushing them to adopt better practices for the national interest, and perhaps more importantly, because China’s stock markets are opening more to foreign investors, the report said.

During the past 12 months, MSCI and FTSE Russell have raised the level of A-share inclusion into their mainstream indices, which means that more foreign institutional investors with high ESG principles are likely to buy A-shares – and hence put pressure on Chinese companies to raise their standards by subjecting them to greater scrutiny.

The main difficulty in assessing ESG standards in corporate China is, ironically, a critical red flag that signals poor ESG practices: a lack of transparency

Moreover, Lu is encouraged by the Chinese regulators’ moves to restrict share suspensions and a general recognition that companies’ governance standards must improve.

Good ESG practices typically translate into better, sustainable financial performance, according to Lu.

“Robeco’s ESG analysis is part of the investment case, juts like valuation, and technical and fundamental analysis. We use a ‘material factor’ approach to focus on the factors that have most impact on a company’s value, and they vary across industries,” he said.

The firm claims to have ESG profile coverage for 100% for its portfolio holdings and for more than 70% for its broader Chinese stock universe.

ESG difficulties

Mio and Lu argue that using financially-material ESG information in their investment process leads to better-informed investment decisions, contributing to superior risk-adjusted returns in the long run. They cite academic studies to support their view.

However, “the key to success is to focus only on those ESG factors that are financially material – they have a direct impact on the bottom line,” said Lu.

The main difficulty in assessing ESG standards in corporate China is, ironically, a critical red flag that signals poor ESG practices: a lack of transparency.

The leading ESG rating providers who partly base their assessment on company disclosures tend to score Chinese A-share companies lower than their counterparts in developed markets because of their opacity, note Mio and Lu in their paper.

Even based on the limited assessments of the ESG performance of Chinese companies by Robeco, “it is no surprise to find that on average, Chinese companies score lower on all aspects of sustainability than their global peers,” they write.

They identify four further deficiencies:

First, listed Chinese companies have a low awareness of the ESG concept, and a limited appreciation of the importance of sustainability to their business operations.

Second, most Chinese companies that submit sustainability or corporate social responsibility reports treat them as a box- ticking exercise

Third, there is lack of a comprehensive regulatory framework to promote sustainability investing.

Finally, the community of investors in Chinese companies does not have a collective body to demand more ESG-oriented management and disclosures.

“For our Chinese A-share equities strategy, we base our ESG-integrated investment analysis on Robeco’s global framework, and strengthen it by incorporating characteristics exhibited by the Chinese capital market,” said Lu.

Robeco’s A-shares strategy takes a “deep-dive into company’s value drivers, including such things as the sustainability of growth in its industry, the company’s competitive advantage and market share”.

“We believe that in the long run there is relationship between stock price performance and a high ESG score in China,” said Lu.

“However, we don’t screen base selections on ESG scores in isolation, which mean that sometimes we invest in companies with low ESG scores, and do a valuation discount to make sure we loweer risk,” he added.


Robeco Chinese Equities Fund vs the benchmark and sector average

 

Source: FE Analytics. Three-year cumulative performance in US dollars.

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