When U.S. investors think about sustainable investing, few consider China as a natural fit. Investors voice concerns about the economy being controlled from Beijing as well as human rights, environmental and privacy issues. But does that make investing in China antithetical to an increased focus on environmental, social and governance considerations and the fight against climate change?
The answer to that question is a resounding "no." But we need to unpack that answer as a crucial step toward deciding where and how to invest sustainably in China.
First, there's no arguing against the fact that China ranks as one of the world's bad actors when it comes to some ESG considerations. For example, it is the world's largest emitter of greenhouse gases, accounting for more than a quarter of total global emissions — more than the U.S. and Europe combined. And to make matters worse, China plans to build enough new coal-fired plants this decade to match the entire existing capacity of the European Union, although this push is primarily to secure its own energy security.
But that's only part of the story.
In other (often overlooked) ways, China today might represent the ideal sustainable investing environment.
For starters, the country's powerful central government has declared sustainability a priority. Although progress toward a more sustainable future likely will be erratic, and investors must deal with opaque corporate practices, the government's sustainability agenda virtually guarantees that the long-term trend in China will be green. We believe that local, on-the-ground research will be a key differentiator in separating the early movers from the laggards.
Meanwhile, China is on target to meet its commitments under the Paris Agreement two years early.
Since Beijing set specific targets for carbon emissions, energy consumption and pollution, China has become the world's leading renewable energy producer and maker of solar panels, wind turbines, electric vehicles and batteries. According to the United Nation's Environment Program, China invested about $758 billion in renewable energy between 2010 and 2019 — more than any other country. By comparison, the U.S. was second with $356 billion invested; Europe as a whole invested $698 billion in renewables. China's progress has been "underpinned by tighter environmental regulations and massive green investments, including in renewable energy and electric vehicle infrastructure," according to a recent report the Brookings Institution. "This in turn is driving green innovation."
Highlighting how quickly the Chinese economy can mobilize once Beijing makes something a priority, China has built more than 18,000 miles of high-speed rail lines since 2008, the world's largest such network, serving 1.7 billion passengers annually. High-speed rail produces significantly less carbon dioxide emissions than air travel. Meanwhile, the first U.S. high-speed rail, only 520 miles between Los Angeles and San Francisco, is estimated to be completed by 2033.
China's mixed environment record is due partly to the difficult balance of transitioning to greener energy without disrupting the country's rapid economic growth. China's economy needs lots of fuel in the short term while building a green infrastructure for the future. As a result, some Chinese industries are moving quickly, some are moving slowly, and some (such as coal) are still moving in the wrong direction entirely. The differences are even more extreme among individual companies.
However, these disparities create opportunities. First, investors can make an impact. By supporting companies with superior environmental practices, investors can hasten China's transition to a low-carbon, sustainable economy. This is important. While there is no way to stop China from building new coal plants, investors can contribute capital to Chinese companies laying the groundwork for the future green economy, while withholding capital from firms that ignore ESG concerns.
Second, China's mix of environmentally progressive and regressive companies offers a fertile field for investors to potentially outperform by targeting ESG standouts. Research by my colleagues shows that globally, companies with higher ESG ratings enjoy a lower cost of capital and deliver higher shareholder value . Those findings suggest that integrating ESG factors into stock selection may reduce portfolio risk and volatility, potentially improving long-term risk-adjusted returns.
However, finding ESG standouts in China is no easy task because the country's corporate governance approach is haphazard, notable for relatively weaker accounting standards that make corporate disclosures unreliable. According to a CFA Institute report, a lack of historical data, company culture and a limited understanding of the role of sustainability are by far the largest obstacles to greater integration of ESG standards. About one-third of Chinese companies issue corporate social responsibility reports, but without set standards most reports contain a significant amount of non-material information. (The Chinese Securities Regulatory Commission is expected to unveil a formal plan this year, requiring greater ESG disclosures from A-share companies.)
The good news is that, in such an inefficient market, investors willing to conduct their own proprietary, on-the-ground intensive research can unveil significant opportunities and mitigate risk, perhaps more so than in any other country.
For example, internal research might determine that a worst-in-class ESG rating from a third-party ESG rating provider for a Chinese consumer staples company (over its pollution and water use) was unwarranted. On that basis, an asset manager would maintain its investment. Similarly, an asset managers' ESG research into a Chinese water company could uncover significant governance tail risks related to board independence. If the asset manager then pressed management of the water company to make changes but was rebuffed, it would make sense to sell its holdings.
These examples illustrate the potential for dedicated ESG investors both to mitigate risk and improve long-term investment returns by uncovering otherwise material, unrecognized risks.
In this light, investing in China not only fits the mindset of higher ESG awareness and focus, it also presents a unique opportunity for investors to influence — and potentially profit from — the world's second-largest economy's journey toward a more sustainable future.
Christian McCormick is a director at Allianz Global Investors and a senior product and sustainability specialist responsible both for China equity and sustainable investing, based in Denver. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.