ESG News HOW SUSTAINABLE IS YOUR CHINESE FUND?
For emerging market investors, China is hard to avoid and so, it seems, are its low ESG standards. Mona Dohle reports.
At first glance, China appears to offer plenty of green invest- ments. In 2021, it reported record inflows of $46.7bn (£41.1bn) into climate funds, according to Morningstar, a 150% increase year-on-year. While demand for Chinese funds dropped in 2022, investor appetite for China has made a comeback. For investors replicating an index, China remains hard to ignore. About a third of the MSCI Emerging Market is repre- sented by Chinese firms and the country also dominates emerging market bond indices. But a series of ESG scandals illustrate that investors might want to approach some Chinese ESG funds with caution. One example is a report that major Chinese firms are bene- fiting from forced labour of the Uyghurs. This applies to at least 13 firms included in global equity indices such as the MSCI Emerging Market and Morgan Stanley’s All World index. Institutional investors with passive exposure to China might therefore be inadvertently complicit in human rights violations.
The E, the S and the G
Another factor to consider is the discrepancy between the stand alone environmental, social and governance (ESG) factors. Some firms perform reasonably well on environmental met- rics but less so when it comes to the S and G. This includes Tencent, which has relatively low carbon emissions and accounts for more than a quarter of MSCI’s China ESG Lead- ers index. Another prominent index constituent is micro blog- ging service Baidu. But Tencent and Baidu have been downgraded by Morningstar Sustainalytics. As a result, Wisdom Tree has removed them from its China Ex State Owned index, which resulted in an adjustment of 28% of the overall index. Neither Tencent nor Baidu are state-owned, but in a state capi- talist economy, the distinction between state and the private sector is far from straightforward. One decisive factor that motivated the Morningstar downgrade is that Tencent and Baidu have violated UN Global Compact Guidelines. “While we are primarily known for our ESG risk ratings, which focus on financial and material risk factors, we also have a team which analyses firms based on the UN Global Compact Principles, such as respecting human rights,” said Remco Slim, manager of product strategy and development at Morn- ingstar Sustainalytics. These UN Global Compact assessments are based on reports in the media, including in China, supported by a team of Man-
darin speaking researchers. “We noticed that firms like Ten- cent are increasingly playing a role in the oppression of free- dom of speech and their data is also frequently used in court cases against dissidents,” Slim said. Human rights violations are an exclusion criterion for some investors. This includes Capitulum Asset Management, a Ber- lin-based boutique advising on fixed income strategies. “When it comes to Chinese bonds, the distinction between state and private sector remains almost impossible,” said Ernst Theodor Kirschner, a fund manager at the boutique.
“The majority of green bond issuers in China are state-owned banks which are closely connected to the Chinese govern- ment,” Kirschner added. “This is why we are sceptical of these issuers from a social and governance perspective, even if they have been labelled as green bonds by some of the major rating agencies. We have opted not to invest in local issuers, despite the fact that China’s share in bond indices has been growing significantly over the last few years.”
Green bonds: Dodgy definitions Another factor to consider is that up until last year, the Chinese definition of green bonds was less stringent, with up to 50% of the proceeds could be spent on general projects. This included fossil fuel producers and even “clean coal” mining. The Cli- mate Bond Initiative has seen this as a reason to exclude more than 60% of Chinese green bonds from its database. But green bond standards in China are evolving, said Georg Inderst, who advises pension funds. Indeed, the Chinese Green Bonds Standards Committee published a set of princi- ples in July which obliges issuers to dedicate all of their pro- ceeds to sustainable projects. China has also signed a Common Ground Taxonomy with the EU last year. While China had “a lot of catching up to do”, excluding it entirely means abandoning some significant opportunities, particularly in green technology, Inderst warned. Another factor to consider is China’s growing contribution to global carbon emissions. The People’s Republic now generates almost a third of such harmful gases. Tackling climate change without China would be impossible. Nevertheless, the question remains how investors can gain exposure without being complicit in human rights violations. Some are focusing on firms which operate in China but are not listed there. For fixed income investors, yuan denominated green and social bonds issued by supranationals, such as the European Investment Bank or World Bank, could be an alter- native. “These bonds are compliant with global green bond standards and offer AAA rating and greater levels of transpar- ency on the use of proceeds,” Kirschner said. For Inderst, China is too big to ignore. But the gap in ESG standards means investors should approach it with caution.
Issue 121 | March 2023 | portfolio institutional | 27
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