Policy Brief: The Negative Influence of Low ESG Scores in China 

By Saamiya Laroia and Yidi Zeng 

Introduction

Green Finance refers to structured financial activities that promote sustainable development. The People's Bank of China (PBOC) defines green finance as "financial services provided for economic activities that are supportive of environmental improvement, climate change mitigation, and more efficient resource utilization."(Wu, 2022). Environmental Social Governance (ESG) was coined by 20 financial institutions across the globe as a response to a request from Kofi Annan, the then Secretary-General of the United Nations. It refers to how firms and investors incorporate environmental, social, and governance considerations into their business strategies. The ESG framework encourages benefiting stakeholders through data transparency in the three fields of Environment (e.g., carbon emissions), Social (e.g., labor standards), and Governance (e.g., Audit Committee Structure) (Fleming 2022). In this brief, we will discuss ESG scores in China and their influence on foreign investment in Chinese companies.

Background 

The demand for ESG ratings is continually growing, with rating companies such as Sustainalytics generating revenue of $76.8 million USD (White and Leo, 2023). However, the current state of ESG development in China falls short with a low ESG score compared to other regions like the US, Europe, and other Emerging Markets (see figure 1 below). Sustainalytics recently downgraded industry giants Tencent, Weibo, and Baidu to the classification of "non-compliant with UN principles," signaling to the broader industry that Chinese transparency frameworks may be incompatible with Western expectations of ESG goals(White and Leo, 2023). This incompatibility may negatively impact foreign investment in China, as foreign investors are increasingly concerned with sustainable investing.

Figure 1

Source: MSCI, J.P. Morgan Asset Management

Reasons for Low ESG Scores

Government policy is closely intertwined with ESG scores, as almost 75% of Chinese companies on the Fortune Global 500 list are state-owned enterprises (CSIS, 2019). However, compared to the EU, the UK, and the US, Mainland China has been slow in terms of ESG policy-making. It was not until 2018, when the China Securities Regulatory Commission (CSRC) promulgated the Code of Governance for Listed Companies, that China entered a period of policy acceleration. The basic framework for national ESG disclosure is now largely in place. Prior to this policy acceleration period, China only issued policies for a single aspect - environmental, which imposed mandatory environmental disclosure requirements on key emission units but had less discussion of social or corporate governance issues.

Adequate disclosure of ESG information by enterprises and financial institutions is also a crucial foundation for the financial system to direct capital towards green industries. However, China does not possess a unified standard for disclosing information on climate and environmental social responsibility, nor has it made it mandatory for companies to disclose ESG-related information. Although the relevant authorities and institutions in China have provided policy guidance on ESG disclosure, voluntary disclosure remains the norm, and there is no strict supervision and assessment of institutional fund investment and benefits generated. According to Everbright Securities (2021), Chinese enterprises are quick to respond to the introduction of mandatory policies but show a low degree of response to non-mandatory policies. Therefore, accelerating the introduction of mandatory policies on ESG information disclosure would be an important tool to improve the level of information disclosure in China in the future.

Reasons for Foreign Investment Drifting Away

Foreign investment in China recently slumped to an 18-year low. Exacerbated by the US-China trade war, foreign investors are losing faith in China’s economy dominated by State-owned enterprises (SOEs) which lead to a lack of competition, inefficient resource allocation, and potential conflicts of interest (Chen & Xu, 2021), along with raising concerns  about how the  government's role in corporate decision-making and the lack of independent oversight raise affect the accountability of Chinese firms (Hale, 2020).

The growing emphasis on ESG performance among investors is one significant reason for the gradual drift of foreign investment away from China. ESG analysis has become a crucial aspect of decision-making for investors as it serves as an indicator of a company's long-term sustainability and profitability (Friede, Busch, & Bassen, 2015). As China has consistently received low ESG scores, investors are becoming increasingly cautious of the potential risks associated with investing in the country. Furthermore, the global investment community has been shifting its focus towards sustainable and responsible investment strategies, incorporating ESG criteria into their portfolios (GSIA, 2020). This trend has led investors to seek out opportunities in countries with higher ESG scores as they believe such investments are more likely to yield long-term value and minimize potential risks. In a PRI and Syntao investor poll on ESG disclosure in China conducted in May 2020, 98% of respondents agreed that conformity with international standards and indicators was critical. 63% of investors stated they would be more willing to invest in mainland China if Chinese firms increased their ESG disclosure. 80% of investors stated they would be more willing to make long-term investments in China （PRI, 2020).

Environmental concerns are a major issue in China due to problems such as air pollution, water scarcity, and waste management. Investors are aware of these challenges and understand that investing in companies that contribute to or ignore these problems can have negative implications (Hale, 2020). Businesses that don't prioritize environmental stewardship may face regulatory penalties, reputational damage, or operational disruptions, ultimately affecting their profitability. China has been performing well in terms of environmental disclosure, however, while the environment is important, it is also of vital importance to disclose social and governance performance. Particularly, improvements in governance in China have been slow (PRI, 2020).

Social factors, including labor rights, income inequality, and overall working conditions, are also important in determining a company's ESG performance. Nevertheless, most ESG reports in China have been criticized for lacking substantive data, such as the frequency of health and safety accidents. “Most of the time”, one of the investors from the ESG poll (PRI, 2020) said, “Chinese enterprises merely reveal the number of safety training sessions held, which actually  does not tell us anything”. China has historically faced challenges in these areas, with instances of labor rights violations, inadequate wages, and occupational safety concerns (Chan, 2013). Investors worry that companies operating in China may be exposed to social risks, which could result in boycotts, lawsuits, or negative press, ultimately affecting their bottom line.

Reasons for ineffective resource mobilization of China's green finance market

In recent years, China's green finance market has witnessed significant growth, with the government implementing various policies and regulations to encourage investment in environmentally friendly industries. Green financial tools, such as green bonds, are designed to mobilize capital for environmentally friendly projects, ultimately contributing to a low-carbon economy. However, the effectiveness of China's green finance market has been severely hampered by the phenomenon of greenwashing, which involves companies portraying themselves as more environmentally responsible than they truly are (Zhang, 2022).

Greenwashing has plagued China's green finance market, hindering the objectives of green financial tools from being achieved. A significant proportion of funds raised through green bonds are misallocated to projects that do not meet the required environmental standards (Zhang, 2020). This undermines the purpose of green bonds, which are intended to channel capital towards projects with genuine environmental benefits. Furthermore, greenwashing reduces investor confidence in the green finance market, as they are unable to distinguish between genuine green projects and those that only appear to be environmentally friendly (Liu, Qi and Wan, 2022).

The lack of transparency and effective regulation in China's green finance market exacerbates the problem of greenwashing. For instance, companies often use vague or misleading criteria to label their projects as "green," resulting in the misallocation of funds (Zhang, 2022). To counter this issue, it is essential for the Chinese government to establish clear, comprehensive, and enforceable guidelines for the green finance market (Liu, Qi and Wan, 2022). These should include standardized definitions of "green" projects, mandatory disclosure of environmental impact data, and stricter supervision of green bond issuances. By addressing the greenwashing issue, China's green finance market can become a more effective mechanism for promoting environmentally sustainable growth.

Recommendations

To attract foreign investment and improve the effectiveness of resource mobilization within China's green finance market, it is crucial to address the issue of low ESG scores. Policymakers should focus on enhancing the regulatory environment, fostering greater transparency, and promoting the adoption of international best practices in environmental, social, and governance criteria (Zhang, 2020). This would not only improve the credibility and attractiveness of Chinese companies but also instill confidence in investors, thereby facilitating more significant resource mobilization within the green finance market.

Conclusion

There is going to be an international trend towards more stringent disclosure of climate-related financial information by companies and financial institutions under the carbon neutrality target. There is an urgent need for China to establish disclosure standards that are in line with international standards and meet Chinese characteristics since low ESG ratings reflect negatively to foreign investors looking to invest in China’s green finance market. The Chinese government needs to formulate a disclosure policy with more international values.  It is imperative for China to make ESG disclosure mandatory and have a comprehensive and universal ESG disclosure and rating mechanism on par with established systems in developed countries if it wants to play a role as a leader in green finance. 

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