By Therese Niklasson, Global Head of ESG and Wenchang Ma Assistant Portfolio Manager, All China Equity
Active ownership in a maturing market
Being an active owner is one of the cornerstones of our investment philosophy. We have learned that engaging with companies and participating in dialogues with regulators is an important and effective way to influence positive change in maturing financial markets. It is also an effective way to get a sense of which organisations exert the most influence in ESG matters.
Key insights from China
- An active governance debate has started in China, and the winds of change are finally being felt. However, change itself is likely to be slow but steady.
- Government attention on ESG is increasing, especially around environmental issues, but disclosure remains a challenge – there is a desire to understand how foreign investors would use the disclosed data.
- State-owned enterprise (SOE) reform continues apace, however, many obstacles remain, including structural ones and how to manage overcapacity.
- Stock exchanges are evolving their approach to governance in a positive way – with the Shenzhen stock exchange showing the greatest interest.
- The current governance code is being revised by the China Securities Regulatory Commission (CSRC). Whether it will become regulation or a normative measure remains to be seen, but ideally it will result in broader reform that moves away from a ‘minimum standard' mentality.
Improving corporate governance
Corporate governance has improved since the early days of the Chinese stock market in the 1990s. It has been modernised, in terms of both the legal and regulatory frameworks, in line with its increasingly open markets. And we believe it will continue to evolve as economic development ramps up. Overall, Chinese corporate governance scores (as represented by companies in the MSCI China Index) tend to cluster around the average global score (as represented by companies in the MSCI All-Country World index and shown in Figure 1).
Figure 1: Corporate governance score distribution
Source: MSCI – Corporate Governance in China, September, 2017, based on the 149 constituents of the MSCI China Index as at 11.09.17.
MSCI, in its 2017 corporate governance report, highlighted that concerns related mainly to remuneration and board issues – especially the lack of an independent chair or board majority, conflicts relating to a controlling shareholder and related party transactions, and limited shareholder protection rights.1
Hong Kong listed companies are a good indicator of the improvements that have been made in corporate governance with over 60% reporting more than the minimum ESG requirements. Hong Kong Exchanges and Clearing, which operates the stock exchange, made ESG policy disclosure mandatory in 2015.
ESG standards, disclosure and engagement receiving attention
The Chinese government has made it clear that the management of environmental issues is important to its five-year plan, yet there is currently no mandate for companies in China to report on ESG.
From our interactions with other Chinese managers it appears as if they look for inclusion in a leading sustainability standard, such as the Dow Jones Sustainability Index. Overall, it appears that Chinese companies prefer to work towards a standard and regulation defined by a third party, rather than evolving voluntary standards themselves.
Bodies such as the stock exchanges and the Asset Management Association of China (AMAC) have started encouraging companies to disclose more ESG information. AMAC represents the mutual fund industry in China and has developed a policy that promotes ESG integration.
On the topic of ESG engagement we expect progress to be slower than on providing access to ESG data. Chinese companies are still unfamiliar with the idea of engaging with stakeholders, such as institutional investors. Any form of engagement is currently managed by the investor relations team, which controls the content.
SOE reform and impact on boards
A combination of overcapacity and slowing economic growth has resulted in a renewed appetite to reform the SOEs to make them internationally competitive, financially successful, and less corrupt.
The Chinese president has stated that the government expects SOEs to follow the governance code (see below), the same as privately held companies. This sounds encouraging, but the continuing presence of embedded political elements in the SOEs' leadership remains an obstacle to shareholder-friendly reforms.
Only a minority of boards contain a majority of independent members (Figure 2). The government has indicated that this round of SOE reform will aim to enhance efficiency by changing the ownership mix and implementing performance-related pay.
This is not the first time the government has tried to reform the SOEs – but previously the issues around labour management created too many issues for it to proceed. This continues to be a problem and the question is whether the government pays off the workers that cannot be retrained, or creates some other form of compensation arrangement. We have seen only limited progress so far.
Figure 2: Board leadership at SOEs
Source: MSCI ESG Research, as at 27.07.17.
Stock exchanges evolving their approach to governance
Stock exchanges are important organisations when it comes to governance standards and transparency. Both the Shanghai and Shenzhen exchanges were established in 1990 and are governed by the China Securities Regulatory Commission (CSRC). The Shenzhen stock exchange appears to be evolving quite well. It has seen the largest number of IPOs in the world and has over 236 million active accounts, illustrating the retail nature of its stock market.
The Shenzen exchange continues to have open and productive conversations with foreign market participants, such as ourselves, about the challenges around disclosure, fundamental governance standards and its role versus the regulator. The exchange has responded to the concerns by foreign investors regarding English translations and has launched a platform called EASY IR providing translations for investors.
The suspension rules were tightened in 2016 to a maximum three months for companies involved in a major asset restructuring and to one month for companies conducting private placements after they were widely criticised by international investors for being applied too broadly and undermining the importance of markets to correct themselves. In 2015 foreign investors, including ourselves, raised concerns over the long suspension period (five months) and the exemption rules which many felt were too widely abused. The measures have had limited effect and the CSRC has said that Chinese regulators are working to further improve the suspension rules.
Reviewing the current governance code: hope for progress
The CSRC released its current governance code in 2002. This code set a fairly high bar for Chinese companies, based on the Organisation for Economic Co-operation and Development (OECD) guidelines. These standards focus on investor protection, basic code of conduct, and professional ethics that should be observed by executives, directors, supervisors and managers of Chinese-listed companies. This was followed in 2006 by a new Company Law and Securities Law that further developed the governance framework in China. It was an important step in providing further protection through increased transparency, legal responsibilities on controlling shareholders, as well as a securities investor protection fund. Together these set ambitious standards, which Chinese companies struggle to attain.
The governance code is currently under review by the CSRC. This is partly to address some of the shortcomings in the application of the code over the years, as well as to strengthen specific areas. Chinese companies and organisations would generally like the code to be brought more in line with the rest of the world.
The effort to ensure that any updated code is acceptable to the rest of the world appears to be more important than protecting minority shareholders, creating a level playing field or reforming Chinese boards. That will require a much deeper cultural shift.
International investors, for their part, would like to see regulators address the lack of a takeover code. Too many companies simply amend their articles of association themselves, effectively designing their own shareholder rights plan.
Finally, a critical point of the new code will be its legal status: will it simply establish new norms, or will CSRC be given official regulatory power. Foreign investors are hoping for better enforcement of the code and a greater degree of regulation around reporting and transparency by companies.
Engagement outlook, slow but optimistic
Engagement and advocacy work in China is much more challenging than in other markets. However, we are experiencing a real interest from companies and other investment organisations (including domestic managers) to better understand what ESG data is relevant, which standard we seek, and how we use the analysis.
We are also getting a more positive response and traction in our meetings with other domestic managers and investors. Moreover they seem open to collaborations with foreign investors in the interests of shareholders. Domestic and foreign investors collaborating in the interests of all shareholders is a powerful force for change.
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1 Source: MSCI – Corporate Governance in China, September, 2017.