By Therese Niklasson, Global Head of ESG and Wenchang Ma Assistant Portfolio Manager, All China Equity
Whilst engagement and advocacy work in China remains relatively more challenging than in other markets, we are witnessing a real interest from companies and other investment organisations, including domestic managers, to better understand which ESG data is relevant, which standards international investors are seeking, and how analysis is used. We also receive a more positive response and greater traction in our meetings with other domestic managers and investors, and have encountered an openness 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, and we believe that there are four themes driving this. First, government attention on ESG is increasing, especially around environmental issues. Second, state-owned enterprise (SOE) reform continues apace, though obstacles remain, including structural issues and how to manage overcapacity. Third, stock exchanges are evolving their approach to governance in a positive way – these are important organisations when it comes to governance standards and transparency; a case study here is the Shenzhen stock exchange which is currently showing the greatest interest in governance issues. Finally, 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.
Below, we expand on these four themes which we believe are behind the winds of change.
1) Improving corporate governance ESG standards, disclosure and engagement receiving attention
Corporate governance has improved since the early days of the Chinese stock market in the 1990s having been modernised in line with its increasingly open markets in terms of both legal and regulatory frameworks. 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.
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 rights1. Yet Hong Kong listed companies are a good indicator of the improvements that have been made in corporate governance. Hong Kong Exchanges and Clearing, which operates the stock exchange, made ESG policy disclosure mandatory in 2015, and over 60% of companies now report more than the minimum ESG requirements2.
Whilst the Chinese government has made it clear that the management of environmental issues is important to its five-year plan, as yet, there is currently no mandate for companies in China to report on ESG. 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. Further to this, industry bodies such as the stock exchanges and the Asset Management Association of China (AMAC) have started encouraging companies to disclose more ESG information. For example, AMAC, which represents the mutual fund industry in China, has developed a policy that promotes ESG integration.
2) SOE reform and impact on boards
A combination of overcapacity and slowing economic growth has resulted in a renewed appetite to reform SOEs to make them internationally competitive, financially successful, and safeguard against any corruption. China’s president has stated that the government expects SOEs to follow the governance code in the same way as privately held companies. Whilst this sounds encouraging, the continuing presence of embedded political elements in SOEs' leadership structures remains an obstacle to shareholder-friendly reforms.
Given that only a minority of boards contain a majority of independent members, 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 SOEs, but previously issues around labour management created too many concerns for progress to be made. As this continues to be a problem, we will continue to observe the progress in this area which is slowly being made.
3) Stock exchanges are evolving their approach to governance
Stock exchanges are important organisations when it comes to governance standards and transparency, in our view. 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 fast, seeing the largest number of IPOs in the world and with over 236 million active accounts, illustrating the retail nature of its stock market. It 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 in relation to regulators. An example of one element of progress is the launch of a platform called EASY IR, providing English translations for investors in response to concerns by foreign investors.
4) Reviewing the current governance code: hope for progress
The CSRC released its current governance code in 2002, setting a relatively high bar for Chinese companies based on Organisation for Economic Co-operation and Development (OECD) guidelines. These standards focus on investor protection, basic codes 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.
This governance code is currently under review by the CSRC, partly to address shortcomings in its application over the years, as well as to strengthen specific areas. There is a desire by Chinese companies and organisations in general to have the code brought more in line with internationally acceptable standards, in turn creating a level playing field or reforming Chinese boards – though in our view this will require a deeper cultural shift. For example international investors, for their part, would like to see regulators address the lack of a takeover code, given that 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.
1 Source: MSCI – Corporate Governance in China, September, 2017.
2 Source: MSCI ESG Research, as at 27.07.17.