As China’s carbon neutrality target implements, the ESG investment trend has been emerging from foreign financial markets to China in recent years. Especially since this year, major financial forums have been talking about ESG investment. Despite increasing attention from domestic financial markets, Chinese companies still lag behind their developed-market peers who has been developed for 40-50 years in ESG investment. At present, ESG investment is developing, but its supporting measures such as investment strategies and evaluation criteria are at the initial stage of being explored and established.
ESG is the acronym for Environmental, Social, and (Corporate) Governance. A number of interviewed industry insiders told the Securities Times that the ESG investment trend currently emerging in China began in the green investment for environmental protection because a quantifiable assessment system for green finance is easier to build. But the real ESG investment has a richer connotation. There is not much exploration in China for the “S” (social) and “G” (corporate governance) investment objectives. It is even more difficult to build a quantifiable investment evaluation system.
Some scholars point out that from the perspective of empirical research, ESG investment does not have excessive financial returns in the traditional sense. It is supported by values behind, which are limited by cultural differences. Therefore, the ESG investment evaluation criteria in Europe and the United States are not fully suitable for China. So, we need to explore ESG investment strategy and evaluation system in China.
From Two-dimensional to Three-dimensional Investment
The ESG was first introduced at the turn of the century in 2004 by the UNEP Finance Initiative, which set three bottom lines for quantifying non-financial risks: environmental, social and governance. However, the core of ESG investing is similar to socially responsible investing (SRI), which emerged earlier around the 1970s, and impact investing and sustainable investing, which were proposed later. In recent reports released by the China Academy of Inclusive Finance (CAFI) of Renmin University of China, scholars have combined these concepts into SRI in the context of Chinese investment practices.
ESG investments have received increasing attention from large international asset managers and sovereign funds in recent years, which have incorporated ESG into their investment decisions and risk management. The latest research by Invesco has tracked a significant increase in the incorporation of ESG principles into sovereign and central banks portfolios since 2017. In just four years the proportion of respondents adopting an ESG policy at the organizational level has increased dramatically, rising from 46 per cent to 64 per cent among sovereigns and from 11 per cent to 38 per cent among central banks. The Covid-19 pandemic broadly acted as a catalyst for sovereigns and central banks to prioritize ESG; nearly a quarter of sovereigns and 45 per cent of central banks increased their focus on ESG as a result of the pandemic.
Whether it is ESG investment or SRI proposed by Chinese scholars, the goal of investment is to expand from the traditional 2D financial return that focuses only on risk and return to a 3D perspective that also focuses on social responsibility.
In an interview with the Securities Times, Duoguang Bei, President of CAFI said that the core of SRI is to refocus the business from pursuing financial returns to pursuing both financial returns and social effects. In China, the current SRI is more focused on the green and low-carbon economy for environmental protection, mainly because the environmental protection effect achieved by the investment is easier to evaluate with quantitative indicators. There is a huge investment demand for the targets of peak carbon dioxide emissions and carbon neutrality in China in the next few decades and China has already issued large-scale green credit and green bonds. So, it is easier to win a consensus by starting with the environmental protection sector.
Tzu Kuan Chiu, Professor of Shanghai Advanced Institute of Finance (SAIF) of Shanghai Jiao Tong University, also told the Securities Times that ESG investment is a 3D investment. While 2D investment is about risk and return, ESG investment introduces a third dimension - ESG impact. ESG investment has been developed in Europe and the United States for almost half a century, but it has only been introduced to China for a few years.
According to Duoguang Bei, SRI is highly compatible with China’s transformation and development in the 14th Five-Year Plan period. In addition to low-carbon transformation and environmental pollution control, China needs to invest in healthcare, rural revitalization, education, inclusive finance and cultural construction, which are also covered by ESG investment.
Three Challenges of ESG Investment
While ESG investing has a promising future, there are many challenges for its practice. According to Tzu Kuan Chiu, there are three challenges of ESG investing.
First, ESG investment has a conceptual threshold, and ESG investment concepts in Europe and the United States may not be applied in China.
A senior manager of a foreign asset management company in Shanghai also told the reporter that the headquarter of his company has already developed a set of ESG investment strategies which has been applied in the European and American markets for many years. But many of the investment criteria do not match the actuality of the Chinese market and will be unsuitable for investment decisions in China. Therefore, the company is currently working on a set of criteria suitable for the Chinese market when investing in China’s ESG.
Second, as empirical studies show that ESG investments do not offer excess return, we need to look for investors’non-financial motives. In addition, ESG investing needs database, which is a huge challenge.
“It has been almost 40 years since people built the first ESG rating database in 1983. There are two solutions: one traditional method is to obtain data through ESG ratings, which have been developed for 40 years. But it can’t solve the root problem of data.” Tzu Kuan Chiu stated.
Chiu added that the fundamental problem in addressing data lies in the role that companies play in society. “We can no longer look at the value created by companies from a traditional ‘shareholder capitalism’ standpoint, namely, to look only at financial statements. Otherwise, we will never get the data we really want.
Therefore, Chiu suggests that we should look beyond ESG ratings and focus on “impact-weighted financial statements”. It is a very long chain of cause and effect in business operation, from production inputs to output to the results and impact created by the product. Traditional financial statements only show the front end of the chain to investors, such as how many electric cars Tesla has built, but not the back end.
However, it is not easy to obtain ESG impact data as suggested above. In addition to the accurate identification of cause and effect, a greater difficulty lies in the measurement of ESG impact. The ESG rating involves several dimensions with different units of measurement, which are difficult to add up together.
“The ideal way to unify measure units is to make them into units of measure that we are familiar with, that is, monetary unit. By doing so, we can eventually combine them with traditional financial statements. Through a modified version of traditional financial statements, that is, impact-weighted financial statements, we can integrate the two types of information (financial information and non-financial information) into one. In this way, we take a more holistic view of the value that companies bring to our society.” According to Chiu, if you just advertise that your financial products are ESG investments without database, it’s just “ESG washing”, i.e. using ESG as a window dressing.
In the wake of the ESG investment frenzy, Europe and the United States have also begun to rethink the standards for ESG investments in recent years. In March 2021, the European Union introduced the Sustainable Financial Disclosure Regulation (SFDR), known as the anti-greenwashing rule, which requires fund managers to assess and disclose the environmental, social and corporate governance characteristics of their financial products. The European market for sustainable investments contracted by $2 trillion between 2018 and 2020 following the policy’s tightening of standards for what can be considered responsible investment, according to data from the Global Sustainable Investment Alliance（GSIA）.
China’s ESG Investment Needs Improvements
In Duoguang Bei’s view, ESG investment in China will gradually move from margin to mainstream in investment decisions in the future. But it still needs improvements in the process of moving to “center stage”.
“ESG investment practice is still a marginal activity in China, facing many problems. For example, asset holders focus too much on financial returns and mainstream capital management institutions do not issue enough products. In addition, information disclosure and ratings are not well, and the government doesn’t give sufficient promotion and facilitation.” Bei said.
Deyun Cao, Executive Vice President of Insurance Asset Management Association of China (IAMAC), recently revealed at the 2021 International Forum for China Impact Investment (IFCII) that, according to the IAMAC research, most insurance institutions have a certain understanding of ESG investment, but the understanding is shallow. In their investment philosophy, they have not regarded it as an important element that can be integrated into the company’s investment culture. At the same time, many institutions say that there are still many obstacles in practicing ESG investment in China, including the lack of effective database for decision-making, inadequate corporate information disclosure, unclear definition of ESG investment and other related concepts, insufficient supply of green financial products, and the lack of unified or recognized ESG investment standards and evaluation mechanisms.
To address the above problems, Cao suggested that the financial industry should explore and do more research on ESG investment to establish ESG investment standards and enrich the supply of green underlying assets and ESG investment tools. They should also strengthen information disclosure to build a standardized data disclosure platform for ESG investment so that ESG investment information disclosure can be institutional and regular with database.
Bei hold that the development and growth of SRI in China would not be possible without the leading role of the government. By formulating development goals and strategies, the government can promote SRI to implement the new development philosophy. It can also mobilize all parties to recognize, advocate and support SRI, to enhance the efficiency of social participation in ESG investment. By defining a management and coordination body for SRI, the government can maintain its strategic support for SRI through policies of SRI development.
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