Grappling with governance in China to find green transition opportunities

ESG investors will not get far without knowing the nuances of the market, regulation and companies themselves, say asset managers

China is known for having both the largest carbon footprint of all nations as well as for its ambitious decarbonisation targets of reaching peak carbon emissions by 2030, and to be carbon neutral by 2060.

But with the traditionally poor corporate governance standards in China, some investors will think twice about backing the companies at the heart of this green transition.

The crisis around China’s second-largest property developer Evergrande, which seems to have clawed its way back from the brink of bankruptcy, brought renewed focus on this topic as ratings agencies cited concerns about the company’s disclosure and governance practices.

Paul Milon, head of stewardship, Asia Pacific at BNP Paribas, said though the energy transition poses a huge opportunity, there is no cutting the G out of ESG.

“We have a financing gap today; it is estimated that all the way to 2050, investment to fulfil the energy transition towards 1.5°C could amount to a total of over $100trn. So, this is a massive investment opportunity. 

“However, it is not only about investing in something which is green if it then has a very negative impact on local communities or if it has very poor governance that means that you may have some risk of corruption… That might not be the best investment although it may help to meet the climate goals,” said Milon.

Calibrated approach

David Smith, senior investment director at Abrdn, said when it comes to investing in corporate governance in China there are some challenges which need to be put in context.

“In some markets, in the UK for example, maybe you would want a board which is majority independent with 75% women, and you’d want high quality disclosures around the directors, and would want the chairman to be thoughtful about how independent directors are recruited to the board. 

“In China we may not get 50% board independence, or may not get that sort of skills matrix-based, thoughtful approach to the board composition. 

“For some of the structural issues we have to calibrate our approach because this is an emerging market versus investing somewhere like the UK,” said Smith.

However, he stressed, there are also non-negotiables: “The structural issues around the quality of management, whether they will treat you well as minority investor, whether they are going to waste money on unrelated diversification, whether they are going to tunnel money out through these abusive related-party transactions, whether the money is real frankly – which used to be a concern in China – those are non-negotiable.” 

Encouraging disclosures

According to Smith, corporate governance in China is improving but there is still a wide spectrum. Knowing the market and putting in the leg work to get to know management teams and their strategies and capital allocation all pays dividends, he said.

Likewise, Smith noted corporate disclosures may not be where investors want them, but this would only be a barrier for those who do not know the market. In fact, said Smith, some of the best structural opportunities in the Chinese market are where companies’ disclosures are lacking.

On speaking to companies they own and asking about things such as supply chain management and environmental management his team found the companies were doing interesting things, while not disclosing them.

“We have had really good conversations with Chinese companies we own over the last six months-to-one year on things around supply chain management, animal testing, organic beauty treatments  where the behaviour and operations are on a par with what you would see in western markets. It is just not being disclosed

“Perhaps the easiest opportunity is just to say ‘you should be disclosing this’,” he said.

Smith said companies in China have been receptive to engagement and have improved corporate governance practices, but it is not a quick process and takes a lot of patience and trust. He said in the process of engagement it can be effective to have a conversation with a business about how their competitors within Asia are looking at areas of governance like board composition and disclosures.

Knowing the nuances

Kiran Nandra, head of emerging markets equities at Pictet Asset Management, noted when it comes to corporate governance, the regulatory criteria in China – for companies and active investors – does mean a shift towards pursuing positive ESG practices when engaging with companies. 

She said there are important differences in where the stocks are listed: “Chinese companies that are also listed in Hong Kong or New York – traded as H-shares or American Depository Receipts – have to meet strict governance rules.

“By contrast, minority shareholders on the mainland have weaker legal protection which is why it’s important to have the ability to sift through the gradations,” said Nandra.

However, with signs things are improving, Nandra has a preference for engaging with companies on corporate governance.

“MSCI’s decision to start incorporating China’s domestically-listed equities in its emerging market benchmarks from 2019 was encouraging as it points to increasing transparency and openness in the system. Other than for ‘entry level’ or ‘baseline’ exclusions, we have a strong preference for dialogue and engagement,” she said.

ESG investment opportunities off the back the momentum behind China’s green transition will undoubtedly continue to abound. But the governance challenges of those prospects will not necessarily be easy to navigate for those unacquainted with, or unwilling to take the time to get to know, the Chinese market.