China drives towards ESG integration

China's emphasis on environmental issues may be a relief to Trump's climate change denials, but is there a disconnect between state rhetoric and the practices of its firms?

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Against a backdrop of the US’ withdrawal from the 2015 Paris agreement and Donald Trump’s promise to bring back coal, China is emerging as an unlikely champion of the environment. But as the planet’s largest polluter responsible for about 30% of global greenhouse gas emissions, its critics would argue it is about time China took a more prominent role in addressing the climate challenge.

It would be fair to say China’s motives serve its own interest, as well as the rest of the world. First, poor air quality may have been responsible for about a million premature deaths in China per year, or a quarter of the total worldwide, so addressing the nation’s environmental health hazards is a political necessity.

Second, energy security is among the administration’s top priorities and a push towards renewables will help diversify its energy sources.

Third, China is heavily investing to transition away from an “old” export-driven economy that relies on cheap manufacturing to a higher-income model, powered by innovation and technology in sectors such as renewables, electric cars and batteries.

Unsurprisingly, China’s corporate environmental credentials have risen faster than its overall social or governance scores since 2015. At a time when shares listed in the mainland account for an increasing portion of key equity benchmarks, this is good news. But how sustainable are these improvements for investors looking to benefit from the greening of China?

The Chinese government has done a lot to move environmental issues up the agenda, with a heavier emphasis on air quality but also water pollution. China plans to invest US$360 billion in renewable energy and has pledged to increase the share of renewables to 15% of the total energy mix by 2020. Meanwhile, it is reducing the number of new coal plants while capping energy consumption from coal during the same period.

Specific targets to reduce pollution are enforced at local and regional levels. Highly-polluting plants may risk shutdown, tougher penalties and stricter lending conditions. To change consumer behaviours, subsidies such as those supportive of electric cars were made available since vehicle emissions are a major cause of pollution in China. To reduce pollution from disposing recycled materials, China abruptly announced a severe reduction in the amount of waste it was accepting from other regions, including Europe.

Arguably, these initiatives to mitigate climate change risks are happening faster than anticipated, which is why it has been such a surprise that these policies have affected global markets to such an extent. It is increasingly apparent that the government can be very effective at driving progress when it sets its mind to something, in this case, the environment.

Given that China is the world’s second-largest economy and the biggest contributor to greenhouse gas emissions, any efforts to mitigate global climate change will require major shifts in the environmental practices of Chinese companies.

For investors, stocks in companies listed in mainland China will become a larger component of global portfolios. Chinese A-Shares were added to major MSCI emerging market benchmarks for the first time in 2018 and will also be included in key FTSE Russell emerging market indices from June. The government’s environmental reforms are no doubt a necessity for China to meet its goals under the Paris Agreement, and for investors, they also present opportunities.

Investors can benefit from changes in Chinese policy, and a good place to start is electric cars. However, it is also a very competitive sector, so investors need to be cautious. Policy risk is high and given the huge amount of incentives available, there could be some distortions around production and demand. Ultimately, it’s important to take a step back and analyze the ESG standards of a company on its own merits. Just because a company manufactures electric vehicles doesn’t necessarily suggest it is a good investment from an ESG perspective.

For other sectors such as steel, the government’s efforts to curb air pollution have really impacted capacity and iron ore prices. There are different levels of purity available when you buy iron ore – the lower the sulphur, the higher-purity the iron ore, which produces less pollution in the smelting process. The gap between the prices of higher-purity and lower-purity iron ore has widened dramatically as a direct result of China’s environmental policies. 

China’s environmental policies have reverberated globally, but it is not always positive.

One of the biggest policy changes occurred in December 2017, when China abruptly halted a large amount of recycled waste foreign countries sent to its shores for disposal. Up until that point, China had been the absolute centre for global recycling, with container ships taking products from China to the US and Europe, and returning with recycled waste. This specific change in policy has completely disrupted that system, and China’s stricter requirements for external waste resulted in millions of metric tons of displaced recycled plastic and paper with nowhere to go.

These limitations on foreign waste had a clear knock-on effect globally. The margins for processing recyclable waste have increased significantly, and investments are being made in recyclers worldwide to adapt. Recyclers are expanding their labour force and upgrading equipment, processes and technology, and an increasing share of the recycled materials is now going to other countries – especially in Asia such as Indonesia.

Ultimately, as countries like China become wealthier, living standards improve and the economic benefits of a cleaner environment increase. If a company is having a materially bad effect on its surrounding environment versus competitors, then it will need to do much more to catch up with market and regulatory trends. Under those circumstances, operational costs will increase with time. That needs to be built into the way we assess companies. 

Will Ballard is a portfolio manager, Emerging Markets and Asia Pacific Equities, Aviva Investors.

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Date

6 May 2019

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