ESG focus: China's green mission

China's recent emphasis on environmental issues may be a welcome relief to Trump's climate change denials, but is there a disconnect between state rhetoric and the practices of its companies?

4 minute read

Against a backdrop of a US withdrawal from the 2015 Paris agreement and Donald Trump’s promise to bring back coalChina is emerging as an unlikely champion of the environment. But as the planet’s largest polluter - responsible for about 30 per cent of global greenhouse gas emissions - its critics would say it is about time China took a more prominent role to tackle the climate challenge.

It would be fair to say China’s motives serve its own interest, as well as the rest of the world. First, poor air quality may have been responsible for about a million premature deaths per year,or a quarter of the total worldwide, so addressing the nation’s environmental health hazards is a political necessity. Second, energy security is among the administration’s top priorities and a push towards renewables will help diversify its energy sources. Third, China is heavily investing to transition away from an ‘old’ export-driven economy that relies on cheap manufacturing to a higher-income model, powered by innovation and technology in sectors such as renewables, electric cars and batteries.

Unsurprisingly, China’s corporate environmental credentials have risen faster than its overall social or governance scores since 2015. (See chart below.) At a time when shares listed in the mainland account for an increasing portion of key equity benchmarks, this is good news. But how sustainable are these improvements for investors looking to benefit from the greening of China? In the third instalment of our Q&A series focusing on ESG in emerging markets, Will Ballard, head of emerging market small-cap equities, discusses the investment consequences of China’s focus on the environment.

What are some of the main environmental issues being addressed by the Chinese government?

The government has done a lot to move environmental issues up the agenda, with a heavier emphasis on air quality but also water pollution. China plans to invest $360 billion in renewable energy and pledged to increase the share of renewables to 15 per cent of the total energy mix by 2020. Meanwhile, it is reducing the number of new coal plants while capping energy consumption from coal during the same period.3

Specific targets to reduce pollution are enforced at local and regional levels. Highly-polluting plants may risk shutdown, tougher penalties and stricter lending conditions. To change consumer behaviours, subsidies such as those supportive of electric cars were made available since vehicle emissions are a major cause of pollution in China. To reduce pollution from disposing recycled materials, China abruptly announced a severe reduction in the amount of waste it was accepting from other regions, including Europe.

Are these initiatives being implemented quickly enough to mitigate climate change risks?

I would argue that it is happening faster than anticipated; that’s why it has been such a surprise that these policies have affected global markets to such an extent. What is increasingly apparent is that the government can be very effective at driving progress when it sets its mind to something, in this case the environment.

Why is this important for investors?

China is the world’s second largest economy and the biggest contributor to greenhouse gas emissions, so any efforts to mitigate global climate change will require major shifts in the environmental practices of Chinese companies. For investors, stocks in companies listed in mainland China will become a larger component of global portfolios. Chinese A-Shares were added to major MSCI emerging market benchmarks for the first time in 2018 and will also be included in key FTSE Russell emerging market indices from June.

The government’s environmental reforms are no doubt a necessity for China to meet its goals under the Paris Agreement4, and for investors, they also present investment opportunities.

How can investors benefit from changes in Chinese policy?

A good place to start is electric cars. We are invested in one of the country’s largest EV manufacturers. It’s a very competitive sector, though, so investors need to be cautious. The policy risk is high and, given the huge amount of incentives available, there could be some distortions around production and demand.

It’s important to take a step back and analyse the ESG standards of a company on its own merits. Just because a company manufactures electric vehicles doesn’t necessarily mean it’s a good investment from an ESG perspective.

What about other sectors, such as steel?

There are a lot of steel manufacturers north of Beijing, and the government’s efforts to curb air pollution has really impacted capacity and iron ore prices. There are different levels of purity available when you buy iron ore – the lower the sulphur, the higher-purity the iron ore, which produces less pollution in the smelting process.

We can see quite clearly the pricing gap between higher-purity and lower-purity iron ore prices. That gap has widened dramatically, and it’s a direct result of the environmental policies. At the end of 2018, the spot price for iron ore with 62 per cent iron content was 39 per cent higher than that with 58 per cent iron content. (See chart below.)

How have China’s environmental policies reverberated globally?

It’s not always positive. One of the biggest changes in policy occurred in December 2017, when China abruptly halted a large amount of recycled waste foreign countries send to its shores for disposal.

Up until that point, container ships would take products from China to the US and Europe, and when they come back, they would come back with recycled waste. China had been the absolute centre for global recycling, so this very specific change in policy has completely disrupted that system. China’s much stricter requirements for external waste resulted in millions of metric tons of displaced recycled plastic and paper with nowhere to go.

Have these limitations on foreign waste affected companies in this sector, in China and elsewhere?

There’s a clear knock-on effect globally. The margins for processing recyclable waste have increased significantly, and investments are being made in recyclers worldwide to adapt. They’re expanding the labour force and upgrading equipment, processes and technology. More and more of the recycling is now going to other countries mostly in Asia, such as Indonesia. We’re looking at potentially investing in a paper processing mill in Indonesia because it is getting a large flow of the recycled materials that would have gone to China.

While China has been focusing on the ‘E’ (environmental), what about the ‘S’ (social) and the ‘G’ (governance) in ESG standards?

We don’t really break the components out quite as explicitly. At an individual company level, we want to know how that company compares with others in adapting to the changes in the overall industry. This helps us analyse how sustainable its returns are. And ESG is part of that.

As countries like China become wealthier, standards of living improve, and the economic benefit of a cleaner environment increases. If a company is having a materially bad effect on its surrounding environment versus its competitors, then it will need to do much more to catch up with market and regulatory trends. Under those circumstances, operational costs will increase with time. That needs to be built into the way we assess companies.

References:

  1. Donald Trump said his administration is putting “an end the war on coal” in 2017.  https://www.whitehouse.gov/briefings-statements/remarks-president-trump-signing-executive-order-create-energy-independence/
  2. State of Global Air/2018,’ Health Effects Institute, Institute for Health Metrics and Evaluation’s Global Burden of Disease Project. Estimates are based on 2016 data. https://www.stateofglobalair.org/sites/default/files/soga-2018-report.pdf
  3. China’s National Energy Administration announced its five-year plan for energy development on 5 January 2017: http://www.nea.gov.cn/2017-01/05/c_135956835.htm.
  4. The 2015 Paris Agreement aims to limit the increase in global average temperatures to well below two degrees Celsius above pre-industrial levels. https://unfccc.int/process-and-meetings/the-paris-agreement/what-is-the-paris-agreement

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