Integrating ESG Issues in China’s Top-Down Economy
Why does this distinction matter for investors? Because once we acknowledge the systemic difference between a Chinese government-owned power plant and a private plant, we can ask the right questions about how companies fit into China’s carbon-neutrality plans. Beyond the example above, the SOE framework is found in many other areas and industries that will participate in China’s green reforms.
Investors must realize that much of the impetus for environmental efforts in China comes from a top-down approach that starts with its political leadership. As a result, analyzing the green credentials of Chinese companies requires a different ESG approach than investors typically apply to Western companies.
For example, consider corporate governance. Standard ESG ratings tend to give Chinese SOE companies low scores on governance. Most boards aren’t composed of 50% independent directors. Compensation isn’t usually disclosed. Related-party transactions—because of the SOE ecosystem—are commonplace.
Government control of companies also means that top-down policy changes on environmental issues can have a profound effect on business decisions. We believe that China is serious about the long-term need to address climate change because its own economy and population will benefit. Listening closely to the policy noises in China can provide important clues about how companies will behave.
Investors can discover how this is playing out by engaging with company management teams. AB’s China Equities team has found that SOEs are often more comfortable talking about climate goals than private companies are. Private companies in China are also subject to a degree of government influence (a relationship that has fluctuated over time), yet they are driven by profit motives similar to those of their Western peers. Some have not yet embraced the idea that going green is good for shareholders.
Engaging with Management: SOEs Are Listening
As active managers, AB’s China Equity team routinely engages with company management. These efforts help us gain insight on a company’s ESG commitment, behavior and impact on the business. In part, given the weight of the government shareholder, it’s harder to influence the managements of Chinese SOEs than publicly traded Western peers’. However, private investors (both equity and debt) do have a role to play.
First, Chinese SOEs—and their government shareholders—are generally keen to attract foreign investment and increase their share prices; they want to hear what shareholders have to say. Second, in the Chinese corporate and finance system, SOEs are meant to be responsive to capital markets where possible; this includes considering international private capital as a prospective source of funding. Third, engaging with management can help investors learn which companies are more conscious of ESG issues in their operations and how to distinguish between good and bad ESG actors.
Through these engagements, AB has discovered that responsible companies don’t neatly align with the SOE or non-SOE labels, or with the preconception that SOEs might be laggards on ESG issues. For example, we recently engaged with one very large, privately held technology company and found that it was far behind the curve, devoting few resources to ESG.
In contrast, China Yangtze Power, a large SOE, is quite proactive on sustainability issues. The company is best-known for its Three Gorges Dam, the world’s largest hydroelectric power–generating facility. In our conversations with management, we discovered that even though the company is a hydroelectric generator, it produces CO2 emissions and is working on plans to improve transparency and disclosures on environmental issues. The company has also taken significant biodiversity initiatives, including the establishment of an institute to help protect Chinese river sturgeons. Though China Yangtze is an SOE, it is attuned to investors’ ESG concerns and, of course, reputational issues for itself and its shareholder, the government.
Companies like these are vital to China’s decarbonization efforts. They also offer investors a window into how the government will navigate decarbonization challenges over time. While the government has pledged to combat climate change, it’s balancing a precarious macroeconomic agenda and the need to foster domestic GDP growth, so there will be ebbs and tides in policy implementation.
Can the Climate Agenda Succeed?
Success, in particular within the broader international capital market context, will depend on several factors. First, investors and energy policymakers must acknowledge that China’s economic structure warrants a different approach. Free-market incentives such as emissions-trading systems and carbon taxes are less effective at delivering results in China, in our view.
Second, China needs a climate policy toolkit that is appropriate for its reality. Shadow carbon pricing, for example, which incorporates environmental costs into the analysis of energy and industrial projects, is well suited to SOEs that need to navigate the broad economic goals of their government shareholder with their own corporate-level financial objectives and could help persuade decision-makers to opt for green projects.
Third, more research is needed in areas such as the impact of growing affluence on energy and emissions and, by extension, on SOEs that have remained critical strategic actors in the government’s economic growth strategy. This in turn has implications on how SOEs can finance their low-carbon transition. Gauging the true costs of power and stranded-assets risk can also support sound green decision-making by government owners.
With the right policy guidance and financing, we believe that SOEs can help China make progress on the road to carbon neutrality. Investors who apply an ESG mindset and independent research to China’s unique circumstances will be able to identify companies driving change that stand to benefit as efforts to combat climate change gather momentum.