
China ESG: Societal shift
China’s ESG compliance drive reflects a long structural change for financial markets and an evolutionary process for local business culture. Many investment variables are unique
Smog-draped skylines and anti-corruption crackdowns have become the daily currency of an impassioned public debate about the progress of China’s modernization during the past decade. But perhaps no single event has stoked momentum for improved environmental, social, and governance (ESG) norms with as much emotion as the 2008 melamine scandal.
At least six infants were killed and more than 50,000 hospitalized after consuming poisoned formula produced by about 20 different companies. It is alleged that the contamination was an intentional ploy to help substandard milk pass nutrition tests. Ten years on, the aftershocks are still being felt by investors, cementing China’s standing as possibly the most complex and challenging ESG compliance jurisdiction in the world.
Partners Group knows the intricacies of this landscape better than most. In 2015, the private equity firm invested in mother-and-baby retailer Aiyingshi after confirming the company was not connected to any of the offending suppliers from 2008. A dedicated in-house ESG team pored over the qualifications of third-party partners and the process for building the supply chain. Domestic safety specifications were considered, but only conditionally.
“Some regional brands have had issues historically, so we check local regulations and standards for quality control, but we cannot fully rely on that,” says Sheng Liu, a senior vice president and head of China for Partners Group. “We also need to do our own work and meet our own internal policies about quality control. It’s the only way for us to be sure before we put something on the shelves.”
For global players accustomed to best-practice risk management and due diligence, China’s groundswell in ESG awareness is making business easier. Government and social pressure around issues such as environmental protection, labor rights, and food safety have introduced new data pools to the assessment process. For smaller GPs, the movement often translates into a cumbersome and unfamiliar workstream.
Enlightened investors know that when it comes to ESG, short-term pain begets a long-term gain. And in China, as with any market, uptake of ESG practices will largely be a matter of corporate reluctance offset by a demonstration effect – when it works, it gets repeated. In a private equity context, international stakeholders with high sustainability standards to maintain, including many critical LPs, will add to the impetus.
Early movers
For China, the difference is in the scale of the economic growth story. ESG traditionally balances a dispassionate profile of practical risk management with the more human work of protecting public welfare. But heretofore, this approach has never been needed to count the cost of dominating numerous global manufacturing chains in a single generation while bringing hundreds of millions of people into the middle class.
Concerns around compliance in China began growing in the early 2000s with accession to the WTO and vague signals from the government about fostering an “ecological civilization” ahead of the Olympic Games in 2008. In the following decade, high-level policy direction appeared more concrete. Government performance priorities shifted from breakneck GDP growth at any cost to a more holistic financial and industrial institutionalization agenda.
Standout efforts in this vein include an amended Environmental Protection Law in 2016 that emboldens non-governmental organizations to sue polluters and the establishment of a green finance industry framework by seven ministries in 2016. There is also an ongoing anti-corruption campaign that culminated last year with the launch of a new supra-agency known as the National Supervision Commission.
In the investment world, the Asset Management Association of China has outlined its ESG guidelines for private fund managers, but the most visible part of the iceberg has been in the pubic markets. The China Securities Regulatory Commission has mandated that by 2020, it will require all listed companies to disclose the ESG risks associated with their operations. The key outcome here is the creation of general ESG datasets, which will be needed to increase compliance traction across the board.
“The difficult part of implementing ESG practices in private equity is the availability of ESG data, which is much stronger in the public markets,” says Nan Luo, head of China at Principles for Responsible Investment (PRI), a UN-backed group with 21 Chinese signatories, about a third of which are PE firms. “ESG is still a very new concept and far from becoming common practice for Chinese PE firms. International investors are the major driver for implementing ESG principles at the moment, but things are changing with increased awareness and understanding.”
The headline-level guidance from regulators in recent years has aimed to improve this lack of awareness, but in a strictly legal sense, it is generally agreed the climate has neither changed significantly nor departed from international norms. The difference has been in enforcement rigor. Plant shutdowns, forced upgrades, imprisonments, fines, and rigid licensing administration have become meaningful trends only in the past two years.
Social security offers a good example. A sound system has been in place since the early 2000s, but many employers have been able to shirk payroll levies due to weak enforcement. Last year, Beijing ordered local governments to tighten up compliance by closing loopholes and enacting reforms that are likely to include tax hikes significant enough to dent national GDP growth by 0.6%.
Environmental checks, meanwhile, have been far more noticeable. More than 15,000 people were arrested for pollution-related crimes in 2018, up 51% versus the prior year. In the past two years alone, hundreds of pharmaceuticals factories are estimated to have been shuttered by the state to put a stop to the practice of releasing untreated effluent into natural waterbodies.
“What makes ESG in China unique compared to other developing markets is the top-down decisiveness of the government to enforce regulations tightly and do it overnight,” says Vikram Raju, an executive director at Morgan Stanley Investment Management. “That’s not a deterrent, it’s creating a more level playing field. But if you’re willing to ride it out in the gray zone in terms of compliance, you’re playing a very high-stakes game, because China has made a strong statement that these rules are not just on paper anymore.”
Heavy vs light
GPs are advised to understand how ESG policies fit their target industries, upskill accordingly, and engage with investees on developing sustainability improvement plans that consider the profile of investments at the time of exit. In heavier industries such as manufacturing, equipment investments and workplace improvements will be part of the equation, but in sectors with less obvious ESG connotations, a subtler operations playbook is needed.
Chinese healthcare, for example, has long struggled with hospital operators allowing underpaid staff to receive kickbacks from pharmaceutical suppliers. FountainVest Partners tackled this problem with one investee business in the hospital space by helping it centralize procurement and pay its doctors a market standard rate.
“A lot of the companies we’ve done due diligence on recently have been told by our advisors they need to get licenses that they were not even aware of. But even if there are lapses in compliance, we do find that local management is more than happy to discuss coming up with a workable solution,” says Brian Lee, general counsel at FountainVest. “We always require our portfolio companies change their auditor to one of the big four and, where appropriate, influence local management to appoint a chief compliance or risk officer to enhance their risk management and internal controls.”
Environmental issues are often the clearest area for investors to find an entry or value-add angle. There is a long, investable technology supply chain waiting to service companies that can no longer discreetly emit atmospheric particulates above official limitations. Likewise, government targets such as a plan to make one-fifth of nationwide car sales electric by 2025 have opened up entire new industries.
The ESG implications of asset-light segments such as customer-facing software are comparably less understood. As China transitions from export and investment-driven economy to one built on domestic consumption, the nature of the workforce is changing, and social issues related to business innovations such as automation are coming increasingly to the fore. This category of risk is harder to read.
China’s move up the value chain has also coincided with the dawn of social media, which entails distinct reputational risks for transgressing an evolving set of ESG expectations. Viral public relations crises have become common in many developing markets, but the effect is amplified in China due to government encouragement of public debate on environmental and labor issues. At the same time, Chinese leadership in bringing artificial intelligence to communications is expected make online firestorms even harder to water down.
“When we talk about social risk with internet companies, it’s not just a reputation issue or a legal issue, it’s something in between,” says Peiyuan Guo, chairman of SynTao Green Finance, a due diligence services provider. “It can be quite difficult to justify that content, privacy or copyright violations are illegal, but the market and regulators in China are increasingly concerned about whether new technologies are creating negative impacts on society.”
The governance facet of ESG in China could be murkier still. For institutional investors, the most serious concerns revolve around a lack of transparency in domestic business structures such as the party committee system, which ties boardroom decision-making at private companies to the central government.
There are no formal rules obliging foreign-owned companies to include a party committee in business decisions, but pressure to this effect is now said to be increasing. In a survey published last year by the Asian Corporate Governance Association, about 60% of foreign fund managers in China said they did not see the role of party committees in listed companies as clear and accountable.
“It’s important for foreign investors to understand the nature of the specificities of China and how the country works,” says Francois Perrin, a China-focused portfolio manager for Sweden-headquartered East Capital. “You can see the Chinese government and companies starting to make the journey with ESG, but they’re trying to figure out how to benefit from it in a Chinese way. Things are moving forward in terms of corporate party committee governance, but it will always be a governance of Chinese conduct.”
Foreign incursions
Industry participants report less evidence that foreign entities tied to global governance and sustainability expectations are playing on a different field than their local competitors. But to some extent, a more stringent ESG environment will require non-Chinese operators to cope with new disadvantages.
In part, this is because some ESG-relevant datasets may ultimately be considered too sensitive to justify foreign access, and tougher compliance enforcement implies more involvement with unfamiliar authorities and business culture norms. The only prescription for mitigating this effect is going as local as possible with the right talent.
“Whenever private equity firms consider an investment in China these days, they have to be able to nominate board members with ESG skills,” Perrin adds. “If you’re not on the ground or visiting on a very regular basis, you’re at a huge disadvantage. China has to be almost like your own home country to understand the local ESG aspects.”
Foreign integration efforts can present unique challenges outside of the most cosmopolitan areas. Not being under the direct nose of the central government, tier-three and tier-four cities are often characterized as having more opaque and entrenched bureaucracies, where corruption problems linger more prominently.
This reputation is fading fast, however. Anecdotes of bribery and pushback on pollution controls from sub-national authorities are increasingly being framed in the rearview mirror. Corporate players in the regions are often said to be amenable to shaping up their affairs, if they’re not already compliant in their own informal way. ESG might not be erasing the quirks of the provinces, but it seems to be toning them down.
“Regional administrators will enforce the rules according to their own standards, but that doesn’t mean it’s a relationship thing,” says one foreign investor with industrial assets in the country. “You can’t wine and dine your way out of anything, and they’re not interested if you’ve hired somebody’s son.”
The penetration of a cultural trend outside the main capitals of power and influence is an important turning point, and in the case of ESG, it can suggest a demonstration effect is taking hold. For China, this could be where the whole idea takes on its promised role as an opportunity set of incentives, untapped industries and new financing options, rather than just another rulebook.
“The biggest issue with ESG in China is not the changing regulations, it’s the government push with the local green finance industry,” says James Pearson, CEO at Pacific Risk Advisors. “Those investors and companies that are not on that bandwagon are going to miss enormous opportunities either inside their businesses or down their supply chains. If they’re complaining that ESG is becoming harder, they’re just not seeing the big picture.”
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