ESG and alpha: ESG integration in China

The integration of ESG issues into investment practice and decision making is an increasingly standard part of the regulatory and legal requirements for institutional investors around the world.  In China, two key drivers have recently prompted interest in responsible investment: a government effort to promote green finance, and the increasing globalisation of China’s investment market.  New research by the PRI shows there is a third driver for responsible investment in China: that ESG integration is a source of investment value.

Two years ago, the PRI published the first report on ESG and alpha for the US market. Based on a time series of 15 years of ESG data from developed markets, the report showed that ESG information offers an alpha advantage in the construction of equities portfolios. While ESG data in China does not offer the same depth and history as the one used in the US study, preliminary analysis led with MSCI ESG data in China and emerging markets, and case studies by local and international investors, similarly suggest that ESG is a source of alpha in China.

Why this matters in China

China is seeking to align economic and environmental performance and build a green financial system. This transformation started in 2016, with a government-backed surge in green bonds, green credit and lending. Greening investments has followed suit, with the first guidelines published by the Asset Management Association of China (AMAC) in 2018. ESG integration has become a known investment concept to many market participants, while only recently market participants were linking that topic with philanthropy.

Over the past two years, the number of PRI signatories in China has increased from seven to 37, with most of these new signatories being asset managers and services providers. One key motivation for asset owners to step up their responsible investment strategies is the efficacy of ESG investment.

Two main drivers for responsible investment: regulation and globalisation

Since the release of the Guidelines for Establishing a Green Financial System in 2016, Chinese regulators and policymakers have made great efforts to promote green finance and sustainable development. China is a world-leading green bond issuer, with $31.2 billion green bond issuance in 2018. The central bank added green credit into the macro-prudence assessment framework in 2017. The National Development and Reform Commission updated the national industrial catalogue to clarify standards for green industry and green projects. In 2020, securities regulators and stock exchanges are expected to establish a mandatory ESG disclosure framework for listed companies.

At the same time, the Chinese investment market is opening up to global investors. In 2019, the State Council of China released a series of policy measures aiming to lower the barriers for global investors to invest in China and for Chinese investors to invest abroad. This policy reform implies that domestic investors need to be familiar with concepts of ESG integration, climate change, the Sustainable Development Goals (SDGs), which are now key topics, and evaluation criteria for global institutional investors and asset owners.

To embrace the opportunities and challenges from ESG regulations and the influence of global asset owners, financial institutions in China need to be prepared. AMAC has conducted an investor survey for Chinese asset managers in 2018, which found although more than half (58.2 per cent) of the surveyed asset managers are considering ESG issues in investment processes, only 1.2% have already established a responsible investment strategy at a firm level. However, 94 per cent of the managers surveyed agree that ESG considerations are important to improving investment returns, and 68 per cent view ESG integration as an alpha-generation method.

ESG and alpha

The quantitative analyses in our new report, ESG and alpha in China, are based on MSCI China ESG Leaders, MSCI China ESG Universal, MSCI Emerging Markets ESG Leaders, and MSCI Emerging Markets ESG Universal indexes, and use available data from June 2013 to June 2019. Analysis indicates that both best-in-class and tilting strategies using ESG scores deliver alpha and relatively lower maximum drawdowns over their respective benchmarks. In addition, the efficacy of ESG factors in delivering stronger risk-adjusted returns is more pronounced in the MSCI China universe than in wider emerging markets.

The limitations of current A-share ESG data does not stop investors’ exploration on ESG incorporation strategies in China. Some asset managers already incorporate ESG factors into their investment processes, and some are using active engagement as a tool to better understand companies they invested in. The report presents concrete examples from investors in China (China Asset Management, E Fund Management, Harvest Fund Management, Hwabao Fund Management and BNP Paribas), illustrating how ESG issues and data are analysed and integrated into investment research when investing in Chinese companies.

The key message from this research is that it makes sense financially for Chinese investors to incorporate ESG issues in investment decisions. It also makes sense for asset owners to mandate ESG incorporation with their managers as markets are opening up and ESG risks and opportunities affect corporate performance in China and abroad. It is, after all, their fiduciary duty to take account of all value drivers, including ESG issues, in investment decision making.

From a policy perspective, the main message is that with better data, investment managers can make better investment decisions and generate better returns for their clients. A standardised, mandatory ESG disclosure framework is key to mainstreaming responsible investment in China.

Margarita Pirovska is head of Fiduciary Duty in the 21st Century, PRI