An outline of ESG investing in Chinese markets

At Blackrocks annual conference, Larry Fink, president and chairman, told the audience that the climate crisis will reshape financial markets. Blackrock will adapt to these market changes by implementing sustainable development goals in its portfolio construction with strengthened information transparency. Sustainable investments will become core for future investing, Fink said. We suggest that ESG liability investment is key to meeting these goals. In this article we analyze the main mechanism of ESG liability investments and put forward suggestion for stakeholders on how to align with these in the Chinese context.

The problem

According to the global risk report 2019 released by the World Economic Forum, climate change sits at the top of the risk-list for financial risks in the coming decades. Frequent occurrence of extreme weather events and the near collapse of ecosystems will force stakeholders to face the risk and uncertainty brought on by climate change.

On December 3, 2019, the World Meteorological Organization (WMO) issued its interim report on the global climate in 2019, which showed that the average temperature in the past ten years is the highest it has been in recent history. According to the mean value of the five data sets used in the analysis, the global average annual temperature in 2019 is 1.1 °C higher than in the pre industrial average. 2019 was the second warmest year on record.

UNEP's latest emission gap report 2019 points out that even if all the unconditional national independent contribution (NDCS) commitments in the Paris Agreement are fully implemented, the global carbon budget in the 1.5 °C target will be exhausted ahead of 2030. According to these calculations, even if national determined contributions under the Paris Agreement are fully implemented, the global temperature will rise 3.2 ℃ by 2100.

Financial risks

The financial risks stemming from climate change can be divided into two: first, the physical risks, namely, the financial and economic losses directly caused by issues such as extreme weather events and long-term ecological structures; second, the transformation risks: the policies and actions taken by governments and private institutions to control climate change.

Chen Yulu, vice president of the people's Bank of China, told an audience at the 2019 China Financial Forum that climate change is one of the major factors changing the economic and financial system. The physical and financial transformation risks caused by climate change will have a significant impact on the macro-economy and the financial variables through asset revaluation, balance sheet shifts, risk exposure, policy uncertainty and market volatility.

Methods for dealing with climate change financial risks

The fifth assessment report of the United Nations Intergovernmental Panel on climate change was issued in 2013. It pointed out that climate change is real, and the greenhouse gases caused by human activities are the main reason for its occurrence. The six greenhouse gases specified in the Kyoto Protocol: carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCS), perfluorocarbons (PFCs) and sulfur hexafluoride (SF6). For the asset management industry, Carbon Price Risk stress tests, a quantitative analysis based on climate risk analysis and management method, provides a decision matrix for asset managers on how to navigate in this world.

The Carbon Price Risk stress test, presented by the International Institute of Green Finance of the Central University of Finance and Economics in Beijing, uses asset pricing modelling to measure risk factors. VAR models are used to provide quantitative environmental risk, that is, VAR monetization. This methodology combines sensitivity analysis with scenario analysis. Sensitivity analysis seeks to find the sensitivity degree of quantitative relationship between environmental climate risk and return rate (for example, the corresponding change value of an assets return rate for every 1% increase of carbon price). Scenario analysis models predict the losses caused by various climate changes (such as extreme weather events).

By simulating the stock, bond and equity value changes that may occur in the scenario of small probability events (directly related to climate change, such as carbon price rise) the enterprises and stakeholders involved in the portfolio, can measure the impact of a carbon price rise on the investment return of the portfolio of the management companies and quantitatively analyze the carbon price risk to mitigate potential losses in the portfolio.

Carbon emission causes climate change. Therefore, when carrying out targeted risk warning, the environmental stress test of CFDA IIGF can quantify the specific profit and loss. Using the environmental stress test of carbon price risk of the CSI 300 index as an example, the empirical data show that a change of carbon price has a significant negative correlation on the value of the CSI 300 index.

If the carbon price increases three times, the average return rate of CSI 300 will decrease by 2.63%; if the carbon price increases one time, the market value of CSI 300 index will decrease by up to 2.6 trillion RMB. These preliminarily results show how the research and judgment of financial risks corresponding to climate change events is conducive to risk-hedging in the asset management industry.

Deploying ESG to deal with climate change risks

The concept of ESG, which sits at the centre of sustainable responsible investment, can maximize purpose driven sustainable investing. Traditional investment strategies take financial information disclosure, but fails to involve a more systemic analysis for the risk of stranded assets. These profit-maximizing goals are not conducive to the development of green industry, nor can it hedge the risk of potential asset impairment caused by climate change.

Uncertain climate change events such as extreme weather and natural disasters will impact the fundamentals of the financial market. In trying to manage climate change the value changes of high energy consumption and high pollution assets (such as oil, natural gas and coal reserves), politics will impair the valuation of any asset that causes climate change In the example of energy producing facilities, there is a real risk of ending up with stranded assets in the production line (such as power plants, energy transportation facilities, and the like. For asset managers, the stranded assets risk will dent the fundamental goal of "maximizing benefits".

In contrast to this, investment concepts with environment, society and corporate governance (ESG) at the core which focuses on non-financial information, including climate risk factors in the field of environment and corporate governance, approaches portfolio management with a more holistic, environmental focused agenda. Financial risks caused by climate change can not be eliminated outright, but the ESG investment methodology makes quantitative value prediction on the impact of climate risk by scenario analysis through multi-dimensional, indicator system and environmental stress testing. An investment strategy with ESG at the core involves real-time tracking of climate change in the development stage, and can effectively be reflected in the portfolio of asset risk and return.

Sustainable investment on a global scale

In 2006, UN PRI was launched at an event at the New York Stock Exchange. As an international investor network composed of asset owners, asset managers and service providers from all over the world, it is committed to the development of a more sustainable global financial system. PRI aims to publicize and promote the investment meaning of environmental, social and corporate governance (ESG) factors, support international investors to integrate ESG investment concept into investment and strategy formulation, and create a sustainable market environment. Thus, the sign up frequency for the UN PRI can be used to measure the development process of responsible investment in international financial markets. As of January 20, 2020, a total of 2861 organizations around the world have signed and joined UN PRI.

The rise and flow into ESG

In recent years, ESG liability investment has increased in popularity as an investment methodology. According to Morning Star, a rating agency, the size of ESG funds in 2012 were 655 billion USD, but reached 1050 billion USD in October 2018, a total increase of 60%.

According to aggregated global sustainable investment alliance data, as of 2018, we have seen an increase of 34% for funds managed under ESG goals compared with 2016, accounting for about 33% of the total global asset management. According to the latest calculation by Jon Hale, director of investment research of Morningstar ESG, at the end of September 2019, a total of US $13.5 billion USD were in ESG open-ended or ETF funds in the US market, and the inflow in the third quarter of 2019 exceeded $4 billion USD. By contrast, the total annual capital inflow in 2018 did not exceed 5.5 billion, and never exceeded $2 billion USD in a single quarter.

ESG necessity in China's asset management industry

ESG for high-quality economic and social development

At the environmental (E) level, the ESG investment philosophy meets the requirements of high-quality development and the battle against environmental pollution. At the 19th National Congress of the Communist Party of China the goals and requirements of high-quality development in China in the New Era, which is founded on the need to build an environment-friendly economy, strengthen ecological environmental protection in the process of economic development, effectively use natural resources, avoid excessive development, was put presented. ESG investment focuses on efficient investment in green industries, and realizes the development path of a green economy by directing funds to ecologically harmonious industries, thereby reducing climate pressure and enhancing climate resilience.

Next is the social (S) level. The ESG investment philosophy includes charity and poverty alleviation, which is fully in line with China's poverty alleviation campaign. The Central Committee and the State Councils plan to combat poverty in China was released on November 29, 2015, and it aims to alleviate the rural poor and eliminating rural poverty by 2020. On March 5, 2019, Premier Li Keqiang of the State Council presented the the "2019 Government Work Report" wherein he doubled down on the fight against against poverty. Eradicating poverty, improving people's livelihood, and gradually achieving common prosperity are the essential requirements of socialism. A lack of socially sustainable asset management behavior is detached from the national conditions with Chinese characteristics and cannot be sustained.

Finally, we have the corporate governance (G) level. The ESG concept include a financial risk prevention and control mechanism, that is, the micro-level implementation of the basic requirements for good governance. In 2019, the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions was published; in November 2019, the CSRC issued the Action Plan to Promote the Quality of Listed Companies. The successive release of various policy guidelines has presented stronger requirements for the high-quality development of enterprises and financial institutions, and has further strengthened the need for sustainable development.

ESG development as a path achieving the internationalization of the capital market

The pace of internationalization of China's capital market continues. Against the background of further strengthening the domestic capital market's interconnection with overseas markets, more and more international investors, especially long-term investors, can participate in China's capital market. At present, the development trend of ESG in the international market is obvious. Only by further strengthening the ESG concept can Chinese enterprises and financial institutions meet requirements for opening up the capital market to the outside world.

The capital market ecology is constantly changing, and the entry of international capital has gradually led to higher requirements for ESG development in China's capital market. Morgan Stanley Capital International (MSCI) announced in November 2019, that the weighting of all Chinese A shares will increase to 20%. FTSE Russell, a global index and data provider, announced on December 24, 2019 that it will expand its sustainable investment capabilities in the Asia-Pacific region, including with the expansion of the China A-share ESG rating and the main data model.

ESG investment can bring better returns

According to market practice analysis, ESG-themed asset management financial products are more likely to outperform the broader market. According to the statistics of IIGF, 10 ESG-themed public fund products were added in 2019, with total assets of 7.106 billion. Based on a comprehensive comparison of the market performance of the new ESG funds in 2019, the annual return of 70% of the new products is higher than that of the Shanghai Composite Index. Taking the Xingquan Fund, the first social responsibility theme fund, which was introduced in 2008, i presented a return of 44.33% in 2019, far exceeding the Shanghai and Shenzhen 300 in the same period (36.07%).

In terms of theoretical research, IIGF conducts regression model analysis based on our own methodologies. We have released the "Relationship Research between ESG Performance and Corporate Performance of Chinese Listed Companies", which tracks that the workings of the top 100 ESG scoring firms. We find that the companies’ returns on investment is positively correlated with ESG performance. Companies with better ESG performance can improve their financial performance through channels such as improving credit quality, enhancing anti-risk capabilities, and reducing financing costs. Comparing the outcome the CSI-China Finance CSI 100 ESG Leading Index, the CSI 300 Green Leading Index, and the CSI 300 Index, we find that the ESG investment philosophy has the ability to bring better returns to enterprises and financial institutions.

Future developments in ESG investment in China

At the institutionel level, it is vital to train the ESG capabilities inside the financial institution. The purpose of talent training is to form an ESG investment team to dig deeper and capture the benefits better, so as to achieve a win-win situation of sustainable development and maximum profit. In response to the cascading risks of climate change, the development of ESG responsible investment does not necessarily require a cleansing of existing investment products, but instead requires the flexibility to introduce new ones.

Taking Blackstone’s investment strategy as an example, most of its funds are currently being invested in passive index funds. It is not possible to simply sell stales in listed companies that do not meet the sustainability requirements. Therefore, Blackstone has deployed the strategy of setting up a new type of "active management fund" to select sustainable investment targets. At the same time, it will exclude fossil fuel companies from the newly opened passive funds to ensure the basic attributes of responsible investment.

Second, the self-regulatory mechanisms inside the asset management industry should adapt to market ecological practices and play a guiding and regulatory role in the ESG market by giving full play to the long-term value of ESG, and urge the asset management industry to conduct environmental stress tests and improve capital utilization mechanisms.

Taking the China Securities Investment Fund Industry Association as an example, the Association has formulated the "Green Investment Guidelines" for green investment and ESG investment. By organizing training courses, it encourages the industry to develop ESG investments and generate them within the industry. positive influence. Education and better guidelines is key to helping the industry understand the connotation of sustainable investment and the significance of addressing the risks.

Third-party intermediaries should combine the emerging trends in financial technology development, enrich environmental risks of stress testing, improve the empirical models and methodologies for stress testing, and make reasonable use of high-tech such as big data and cloud computing to make it more efficient and high-quality. Enhance the ESG certification capabilities of corporate entities, optimizing the selection of asset investment projects, improving the ESG assessment process, and build a comprehensive ESG database so that asset management agencies can help in the process of asset portfolio selection and formation.

Based on the relatively vigorous development trend of ESG responsible investment, it is recommended that third-party institutions build an ESG investment project management platform to better play the role of a think tank for information sharing and resource empowerment. The International Institute of Green Finance of the Central University of Finance and Economics is further improving its own carbon price risk environmental stress test model, which aims to cooperate with the central bank's green financial network (NGFS) and build a standardized methodological system for the industry, and gradually promote the global climate risk response mechanism and promote assets manager to develop sustainable portfolios.

Authors: Shi Yichen and Yang Chenhui

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