China ESG reckoning looms for investors

Foreign investors in Chinese equities have a problem. China’s growth offers the hope of big returns over the coming decade, but on environmental, social and governance ratings, its companies rank lower not only than western nations, but also below most emerging markets.

The combination of the world’s biggest consumer market with fast-growing technology and services sectors has attracted global investors willing to look the other way on censorship, surveillance, environmental, labour and other human rights abuses.

However, there are signs an ESG reckoning is looming for Chinese companies and those investing in them. ESG ratings are increasingly important for international investors, but the sustainability rules and standards common in western jurisdictions are at odds with realities on the ground in China.

In a move signalling the challenge ahead, Sustainalytics, a sustainable rating agency owned by research house Morningstar, in October downgraded three Chinese tech darlings on its watchlist — Tencent, Weibo and Baidu — to the category of “non-compliant with UN principles”.

“It seemed to our team that internet censorship in China was increasing — Tencent, Baidu and Weibo are playing a significant part in that,” Simon MacMahon, global head of ESG research at Sustainalytics, told the Financial Times.

“There was evidence of censorship and surveillance related to religion, related to LGBT rights, to the war in Ukraine, to Covid-19,” MacMahon said. “The scope and scale of the censorship and surveillance appeared to be increasing.”

In the case of Tencent, the internet group has 1.3bn monthly active accounts held by individuals and businesses and its WeChat super app is considered indispensable for navigating daily life across not just messaging but also shopping, banking, taxis, food delivery and paying for utilities.

Its shares have been hammered over the past 18 months by concerns about Beijing’s regulatory crackdown on the tech sector. But the company still accounts for a sizeable chunk of foreign institutional investors’ China portfolios, and Sustainalytics’s downgrade shocked some ESG-focused investors.

Liqian Ren, who manages China investments at WisdomTree Asset Management, a US-based fund, said she was among those obliged to drop the companies, a move that resulted in a turnover of more than a quarter of its main China index.

“[If the companies] become non-compliant, by our process we have to sell — unless we just don’t claim this fund as ESG,” she said. “It’s a big part of the portfolio. But on the other hand, this is indeed an area that people do care about . . . and the whole point of ESG is people taking a stance on some issues.”

Such experiences may become more common for investors in an increasingly authoritarian China as Xi Jinping, the country’s most powerful leader since Mao Zedong, embarks on an unprecedented third term in power. Some have already been debating whether China is too risky given the unpredictability of Xi’s administration in recent years.

Some experts have said that the trend towards a greater role for ESG in investment decisions has weakened in the wake of Russia’s invasion of Ukraine, amid complaints that sustainability considerations have fuelled the rise in energy costs and inhibited resource development.

However, Fitch, the ratings group, believes the hit to ESG has been a “short-term reaction to challenging conditions” and that the longer term outlook remains for increased allocation of public and private capital to sustainability initiatives.

Demand for ESG rating services is booming. Sustainalytics reported revenue of $76.8mn in the first nine months of the year, up 36 per cent year on year.

And while scrutiny of Chinese companies is intensifying, the ESG reckoning is embroiling multinationals and posing questions for their investors too.

Hong Kong Watch, a UK-based group that researches investment and human rights issues in China, said in a report in November that many of the biggest asset management, state pension and sovereign wealth funds were passively invested in companies allegedly involved in the repression of Uyghur Muslims in north-west China’s Xinjiang region.

The report found three major stock indices provided by index publisher MSCI include at least 13 companies that have allegedly used forced labour or have profited from China’s construction of internment camps and surveillance apparatus in Xinjiang.

MSCI said the only filters for inclusion in its global indices were “accessibility and investability” and that it had other ESG-focused indices.

Foxconn, which makes iPhones and other devices for Apple, was among the companies Hong Kong Watch said allegedly used Uyghur workers obtained through state-sponsored transfers.

The Taiwan-based company denied the allegations and in a response to the FT said researchers had been inconsistent in analysing their operations. It said that in response to forced labour allegations in recent months, it had submitted proprietary documents and information to Sustainalytics and to MSCI’s in-house research group.

“Despite reviewing the same information, each returned with opposite assessments in November 2022 about Foxconn’s ESG efforts,” the company said.

Human rights experts are unlikely to accept such denials because China has severed access to Xinjiang, making due diligence on them near impossible.

Chinese companies are also less likely to engage on ESG issues than western counterparts, researchers and investors said. About 60 per cent of the companies Sustainalytics rates respond to its queries, but in China, the number is “quite a bit lower”, MacMahon said.

While tech groups have been a focus in 2022, the auto sector appears likely to attract increasing attention heading into 2023.

In December, Sheffield Hallam University’s Helena Kennedy Centre released the results of a six-month investigation into links between western car brands and human rights abuses of Uyghur Muslims.

The researchers said they had documented engagement with forced labour transfer programmes by 38 companies involved in the supply chain for western auto brands. The companies were involved in sectors across mining, processing, and manufacturing, they said.

“The auto industry cannot wait another day to trace their supply chains back to the raw materials. To do anything short of full tracing would be an enormous legal, ethical, and reputational risk,” said Laura Murphy, lead researcher.