Investor Opportunities and Corporate Risks: China’s Emerging ESG Framework

When examining official Chinese state policy regulations, one would not expect to see text in English, yet the Latin letters “E,” “S,” and “G,” stand out in pages full of Mandarin text in the “Plan to Improve the Quality of State-Owned Listed Companies.” The plan is representative of the larger complicated nature of ESG (Environmental, Social, and Governance) in China. When incorporating ESG in its markets, industries, and regulations, China is attempting to adopt some Western ESG concepts to attract investment while adapting others to fit China’s unique context.

China, SASAC. Plan to Improve the Quality of State-Owned Listed Companies, May 27, 2022. http://www.gov.cn/xinwen/2022-05/27/content_5692621.htm.

The global emergence of ESG metrics has sparked heated discussions in government ministries and corporate boardrooms. Investors primarily use ESG metrics to determine the environmental, social, and governance impacts of companies. Rather than purely analyzing profits, corporate leaders are now expected to consider whether their ventures harm the environment, have human rights implications, or are led by responsible corporate governance structures.

At this stage, however, most global discussions around ESG disclosures still lack sufficient clarity, with policymakers and investors disagreeing over who, what, and how to disclose. As the second largest economy in the world, China has been promoting information disclosures in the three ESG dimensions for over two decades, starting with the release of the “Announcement on the Disclosure of Corporate Environmental Information” in 2003. Yet these requirements are significantly different from those promulgated in other parts of the world. Investors and policymakers need to have a firm understanding of China’s ESG framework, lest they make ill-founded decisions. To attract new investments, China must improve its ESG standards.

The most important question regarding environmental metrics is: How green are we really? In May 2021, China’s Ministry of Ecology and Environment (MEE) released the Reform Plan for the Legal Disclosure of Environmental Information, which outlines corporate environmental disclosure requirements. China’s framework largely mirrored those of the rest of the world regarding who should disclose environmental information and how. Yet the most critical question remains: What business activities qualify as sufficiently green?

As of 2021, China’s Green Bond Endorsed Projects Catalogue no longer designates coal as a green energy source. However, Chinese regulators still count nuclear energy and natural gas as green energy sources. In other regions, such as the European Union (EU), activists are fiercely fighting to declassify these sources as sustainable.

Beyond energy sources, the International Platform on Sustainable Finance’s (IPSF) Common Ground Taxonomy highlighted that China and the EU bear striking similarities in most green regulations, with one notable exception. In the EU, “green” usually only refers to energy sources, production, or manufacturing activities. China also considers services to support green endeavors, such as consulting and other professional services, as “green.” This expanded definition opens up new opportunities for international green investment. The EU and U.S. should take note of these standards and their potential to turbocharge green investments.

Applying grand ideas to practical changes poses a major dilemma for social metrics in China. Unlike countries in the West, China’s regulations regarding the promotion of social responsibility place particular emphasis on state-owned enterprises (SOEs). In 2016, the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC) released “Guiding Opinions on Better Performance of Social Responsibilities by State-Owned Enterprises,” highlighting that SOEs should clarify social responsibility issues, integrate social responsibility into business operations and establish a social responsibility indicator system.

These regulations also require companies to respond to some grand yet vague political narratives frequently espoused by the Chinese Communist Party (CCP), such as classifying “lucid waters and lush mountains” as invaluable assets, and other state goals like alleviating poverty, promoting common prosperity, and aligning with the government’s global development program, the Belt and Road Initiative (BRI). These declarations are ambiguous and subjective, as they are more of an ill-defined philosophical manifesto derived from Xi Jinping’s political speeches than the basis of a practical regulatory code. This makes it difficult to gauge how Chinese companies are implementing the rules. Since not all companies have the bandwidth to support these grand narratives as well as their standard business operations, social obligations can be an undue financial burden.

In terms of governance metrics, corporate responsibility and party ties stand out. In March 2021, Chinese regulators revised the “Administrative Measures for Information Disclosure of Listed Companies,” which improved the basic requirements for information disclosure, the reporting/disclosure management system, and legal oversight of corporate governance disclosures.

Despite this recent report, mainland China is still at an early stage in the process of figuring out how listed companies should disclose information and has yet to clarify precisely what information to disclose. In contrast, the EU, United Kingdom, and Hong Kong have all codified corporate governance codes for boards of directors and shareholders and have promulgated detailed rules on governance disclosure requirements and reporting mechanisms.

There is one special governance requirement in China that investors must heed. In 2018, the “Governance Guidelines for Listed Companies” required all mainland listed companies to set up Communist Party branches, which are basic units of the CCP to monitor companies from the inside. In theory, companies with CCP branches are seen as less politically risky by the Chinese government and are more attractive to state-owned capital. However, CCP branches can influence a company’s management and decision-making processes, making them more complicated and unpredictable, and raising the specter of party or political influence over corporate decisions. Companies will also bear additional costs in workforce, money, and time to maintain the operation of a CCP branch.

China’s emphasis on expanding green certification in businesses expands opportunities for environmentally conscious initiatives. At the same time, multinational companies should be wary of the disparities in the definition of green energy in different countries, lest their global public image be tarnished by supporting green energy sources in China that are not considered green elsewhere. Investors must also recognize that social responsibility requirements have unique Chinese characteristics tied to political considerations and must decide if these goals align with their values. Finally, regarding governance metrics, the political significance of establishing a party branch is far greater than its economic significance, which raises a dilemma for global investors, since the impact of CCP branches on corporate governance is too unclear to be a reliable criterion for investment decisions.

China is at a critical stage of synthesizing environmental, social, and governance metrics into a unified concept of ESG. In May 2022, SASAC released the “Plan to Improve the Quality of State-Owned Listed Companies,” proposing to strive for full coverage of ESG reporting in all state-owned listed companies by 2023, which demonstrates China’s determination to develop a mature ESG disclosure system.

In developing this system, China could take several steps to better attract ESG-savvy investors. First, China could lean into and promote its green services regulations, which may be an attractive way for investors to diversify their portfolios. Second, China must clarify its social requirements and distill its grand narratives into clear, specific, and actionable steps to enable corporate compliance and disclosures. And third, China must continue to clarify its governance requirements while ensuring that the CCP branch requirements do not scare off foreign investors.

With these adjustments, China could improve the credibility and comparability of quantitative ESG rating systems, enabling companies to be comprehensively evaluated on a standardized scale. Taking these steps will not only help China become a global ESG leader, but can also help facilitate even greater investment, economic growth, and prosperity.