By: Faisal Rafi FIA, Head of Research, RisCura
When investors think about China, they don’t normally think about sustainable investing. On the contrary, they know that China’s carbon footprint has been increasing for decades, now overtaking the US. However, Chinese fund managers have, in fact, been taking ESG factors into consideration and are increasingly developing documented ESG policies, explicitly accounting for them in their investment process and communicating the impact on their decision-making.
China’s poor air quality came to global attention during the 2008 Olympics. The Chinese government needed to act, and it did, reforming polluting industries such as coal power stations and steel. As a result, air quality has improved substantially over recent years.
The Communist Party included the environment as one of its seven objectives in its 13th Five-Year Plan for economic and social development, with key performance indicators ranging from CO2 emissions to forest growth. It remains committed to the Paris Agreement, even though the US pulled out.
Action has followed policy. Fossil fuel remains the main source of energy, but renewables are rising. In 2017, renewables generated 26.4% of total electric power. The goal is to reduce fossil sources to below 50% by 2030. Meanwhile, China has become the largest producer of photovoltaic panels and wind turbines and has the largest installed capacity of both (about 30% of the global total in 2018).
The manufacturing industry is reforming across the board. Tougher emission standards for electricity generation meant the steel sector replaced coal power as the biggest polluting industrial sector in 2017. New ultra-low steel emission standards were introduced in 2019; the goal is for 60% of plant compliance within a year and 80% by 2025. Whilst there may be challenges with enforcement, the direction of intent is clear.
Since establishing a Green Finance Committee and Environmental Protection Law in 2015, we have seen rapid expansion and improvement in Chinese green finance. Data from the Climate Bonds Initiative shows China’s global ranking of green bonds issuance rose from 8th in 2015 (less than USD1 billion) to 2nd in 2019 (USD31.3 billion).
Bad practitioners can run but can’t hide – at least not in China!
Rapid changes in democracies are rare. Change requires approvals by elected parliaments and congresses, with checks and balances, but also lobbying, manipulation and the desire to be re-elected. In the meantime, a company can continue to enjoy higher share prices as long as it can deliver earnings regardless of its impact on climate unless asset owners explicitly take climate change into consideration.
This is not the case in China. A fund manager explained that ‘getting caught in China doesn’t just mean a hefty fine but could lead to prison for a long, long time’. China is a command economy that can introduce overnight changes leading to radical shifts in the fortunes of companies and entire industries. Skillful Chinese fund managers are compelled to consider the environmental impact of a company as a main course of their due diligence because it could directly impact its financial future.
Cement is a good example
Cement was a cyclical growth story up to the 2008 Olympics followed by a spectacular crash that slowly recovered by 2011. Throughout two business cycles, there was not much differentiation between share prices in the sector. Things changed after the government took concrete steps to clamp down on the most polluting sites and then reducing excess capacity in 2013. For example, between late 2013 and early 2014, Yi’an, a district built on cement production, shut down 30 plants, losing thousands of jobs.
Despite the shutdowns, aggregate demand for cement plateaued in 2014 and never crashed. This created the opportunity for better, cleaner manufacturers to increase market share. Anhui Conch, a portfolio holding across many of our managers, is one such company. Its fortunes have parted ways from its peers CNBM and Jidong substantially since 2015, achieving cumulative growth in its share price of over 260%, whereas CNBM and Jidong achieved less than 75%.
While there are differences in each company’s fundamentals, one contributing factor to Anhui Conch’s outperformance has been its continuous investment into technology and equipment upgrades to stay efficient and compliant with more stringent environmental regulations.
Fund managers and their ESG policies
Understanding the environmental impact of a company and how it compares to its peers is a fundamental question for Chinese managers seeking sustainable long-term investments. Environmental impact can have a material impact on financial performance so there is no compromise between financial return and ESG.
Overall, it is still early days and there will be environmental setbacks. For example, coal power curbs were reduced to stimulate economic growth after Covid-19. Regardless, the intention is clear, and measures could materially impact companies bringing both challenges and opportunities.