Why Belt-Road is China’s debt-trap diplomacy
BELT & ROAD ONLINE
The projects that China is supporting are often in...
Over the Lunar New Year holiday, air pollution in Beijing reached its second highest level in five years, as the smoke from fireworks exacerbated China’s underlying air pollution problems. This is just one example of the challenges facing Asia which have given rise to the growth of Environmental, Social and Governance concerns (ESG) among investors in the region.
Far from being a due diligence hoop to jump through, ESG should be a core part of the investment process. Small differences in the integrity of management, and how a company interacts with the world and community around it, compounded over years, are likely to have a tangible impact on financial statements.
These efforts are being seen more in mature Asian markets, driven by stock exchanges, securities regulators and major assets owners, which are encouraging the region’s investors to integrate ESG strategies into their investing plans. For example, Hong Kong’s stock exchange (HKEX), the Singapore Exchange (SGX) and Bursa Malaysia have all included ESG standards and reporting as part of their listing rules.
The weaker link remains in Asia’s emerging markets (EM). Over 1,600 companies globally have signed up with the United Nations Principles for Responsible Investing (UN PRI), which aims to establish a global ESG platform. Only 38 of those are based in Asia ex-Japan, with even fewer from EM markets. For EM specifically, the greater opacity and instability of the political and macroeconomic environment can make ESG deviations even more impactful.
ESG development in Asia EM
The concept of ESG is simple; investors identify companies with strong efforts to meet their environmental, social and governance responsibilities. In many cases, the ‘G’ (governance) of EM companies can mean that the all-too-common potential for catastrophic losses can be alleviated by a thorough analysis of whether the company’s business is sustained by market forces or by precarious relationships. Over-reliance on an autocratic regime, for example, might bring years of supernormal profits that evaporate the moment the administration in question is overthrown. Many monopolistic rent seekers that benefitted from cozy connections with a particular regime would have turned into bad investments if they were still held when their political patrons were removed from office. Indeed, even if the regime maintains power, there is often very little impediment about it changing its mind –as Mikhail Khodorkovsky, once the richest man in Russia, discovered when Yukos, his previously state-sanctioned oil production business, was effectively nationalized in December 2004.
As far as the ‘E’ (environment) goes, we often notice how little a company is penalized for the environmental externalities which go along with its business. We are all aware of the environmental degradation which has been part and parcel of commodity exploitation across the emerging world, as well as the polluting effects of China’s industrialization. Yet it is quite unusual to find an EM regime which attempts to put a price on a company’s environmental footprint, as the EU has attempted to do with carbon taxes. For an investor who expects to still hold their shares in a polluting EM company in a decade’s time, this is a horizon over which this ‘free lunch’ could start to become expensive. Indeed, it is striking how much local communities and pressure groups have started to make their voices heard around resituating plants and other initiatives.
The same goes for the often cavalier attitude to health and safety and community welfare (the ‘S’ or ‘social’ element). Attitudes are changing across the emerging world, meaning it is increasingly essential to have some quantifiable framework through which to assess the downside risks associated with these issues, particularly when considering long-term investments.
Quantifying ESG for long-term investments
However, in EM conducting an ESG analysis which can give forewarning of these deficiencies is not simple. There are a number of systems which can help with the process, and providers such as Sustainalytics, ISS-Ethix and TruCost are a useful starting point. Yet in EM, such tools will only take you part of the way, as they are generally designed for developed markets companies and place a very high premium on levels of disclosure.
This automatically puts EM companies on the back foot, given that they will rarely have the fully fledged Investor Relations apparatus to properly communicate ESG activities in which they are involved. Added to this, media coverage can be lacking; with frontier markets, China A-shares and EM small-caps receiving only sporadic attention.
From a more holistic perspective, an over-reliance on hard numbers alone can be inappropriate. EM managers need to remember that one of their core functions is to efficiently connect DM capital with EM needs. There will be some circumstances where this role conflicts with the theoretical best practice as defined by traditional ESG metrics.
For example, if you were to apply TruCost’s environmental impact calculation to Coal India, it would take up 120% of its EBITDA. We believe, however, that a more nuanced view is necessary. India’s coal consumption today is the same as that of the US in around 1850. It is therefore hard for Western investors to lecture on environmental sustainability to a country where around 300 million people still lack access to reliable electricity. This makes the point that it is more important to be concerned with ‘ESG alpha’ than beta. In other words, an Indian mining company may be an environmental laggard on a global, absolute basis, but within the context of a more applicable peer group, its ESG record could be far more comparatively impressive.
More generally, it is important to note that, whilst ratings data does provide useful information about a company’s position, it is fundamentally backward looking and does not tell us much about trajectory. Whilst analyzing the past is an important part of ESG in EM, engaging with the future is even more so. By ensuring ongoing dialogue with management teams, investors can encourage EM businesses to move toward a more sustainable destination. Shareholders should use their voting rights responsibly to ensure that management recognize that they are active and engaged.
The Path Forward
We believe that the peculiar environment of Asia’s EM will mean that ESG investing cannot be boiled down to a potted off-the-peg process. Instead, a more intelligent approach is necessary, one which uses the conventional tools that are available, but also has the flexibility to deal with numerous situations which do not fit the playbook. Awareness of past ESG performance is important and should certainly be a part of the process by which a company’s intrinsic value is determined, but this does not go far enough. Engagement is even more important, and is the path investors must take to most efficiently and ethically steward capital.
Simon Pickard and Edward Cole are portfolio managers of Man Investments
16 Feb 2017