The unstoppable rise of environmental, social and governance (ESG) investing since the signing of the 2015 Paris Agreement has been largely about climate. Then, with the start of the Covid crisis last year, social issues came to the fore.
However, for veteran emerging market fund manager Karine Hirn, it is the G that is by far the most important of the three letters.
“Everything starts with governance,” she says. “If governance is bad, then the chances are that the environmental and social sides will be bad as well.”
Hirn has had plenty of experience of sketchy corporate governance. East Capital, the investment firm she co-founded in 1997, was one of the first Western equity funds to offer retail investors exposure to the former Soviet Union.
More recently, she has shifted her focus further east. In 2010, she moved to Shanghai to head up East Capital’s expansion into Asia. Now based in Hong Kong, she is also responsible for coordinating the firm’s approach to ESG, having taken on the newly created role of chief sustainability officer in 2019.
On the face of it, China seems a more natural venue for a CSO. While eastern Europe has lagged the West on climate, China has emerged as a global leader, encouraging the development of green technology and a green bond market, and pledging in October to achieve net-zero emissions by 2060.
On the social side, the picture is less positive. Quite apart from obvious concerns relating to human rights and labour law, Hirn notes that data privacy and data ownership by tech companies are also key issues for investors in China.
Governance concerns
However, the area where most work needs to be done, she says, is governance. Indeed, here she contrasts China unfavourably with East Capital’s original markets, particularly when it comes to the quality and role of corporate boards.
“In eastern Europe, there is a culture of having independent directors that are accountable and boards that work,” she says. “Not all of them work perfectly – and the poorer-quality ones are probably those of companies we wouldn’t want to invest in – but everywhere you can work with boards, you can have communication with directors, you can help nominate directors, etc.”
Hirn acknowledges that there is a difference between East Capital’s position in central and eastern Europe, where it is one of the largest international fund managers, and in China – but notes that even large asset managers with extensive resources say they “find it impossible” to work with Chinese boards.
Only 13% of all directors are women – which is hard to understand
Karine Hirn, East Capital
The choice of independent directors is a particular bugbear.
“With Chinese boards, they are very often academics or retired people,” says Hirn. “Are they really likely to be the ones standing up for the rights of minority shareholders?”
She also notes that, even in larger and supposedly more sophisticated companies, independent directors can have worked for the same firm for as much as 15 years.
“For us, that is a red flag,” she says. “You have to rotate your independent directors. How can anyone be independent if they’ve been handsomely remunerated for so long from one company?”
Then there is the question of gender diversity on boards. Clearly, this is a global problem, and one that is often more prominent in emerging than developed markets – but even by these standards, says Hirn, China’s record is weak.
“They are progressing, but still only 13% of all directors are women – which is hard to understand because there are a lot of very competent women involved in the management of Chinese companies,” she says.
She notes that the largest company in China with no women on the board is liquor producer Kweichow Moutai, which has a market capitalization of around $450 billion.
Even in the tech sector, Tencent only acquired its first female director in 2019, while electronics firm Xiaomi – along with nearly a third of all Chinese companies in the MSCI index – still has an all-male board.
“Hong-Kong listed companies are even worse than the A-shares,” adds Hirn.
Chinese boards also lack expertise on climate change – although again, as Hirn acknowledges, this is not unique to either the country or the region.
The European Commission is looking at introducing requirements for board sustainability expertise as part of new proposals on corporate governance due to be published this year.
While supportive of the idea of improving board responsibility on climate change, Hirn says it is unrealistic to expect all firms to be able to find and recruit climate-competent directors.
“There simply aren’t that many climate specialists available,” she says.
For this reason, East Capital is supportive of initiatives such as Chapter Zero, which focus on working with companies to educate existing directors.
“It is very useful for shareholders such as ourselves to be able to recommend this to the companies we invest in,” she says.
ESG disclosure
East Capital also actively encourages the companies it invests in to improve their ESG disclosure. The fund is particularly keen to push firms to follow the protocols of CDP – formerly the Carbon Disclosure Project – to provide details of greenhouse-gas emissions.
“Whenever we add a company to our portfolio, we send them a letter about our expectations as a shareholder and we refer them to CDP because we believe it’s important,” says Hirn.
She admits, however, that so far engagement by the emerging-market firms that make up the bulk of East Capital’s holdings has been limited.
“Less than 30% of the companies we hold currently disclose to CDP, so making assessments is still a bit of a guessing game,” she says.
The situation is exacerbated by the fact that coverage by ESG data providers is low in emerging markets generally, and particularly so in some of East Capital’s key markets, including Russia and domestic China.
Even where there is coverage, Hirn says the methodology favoured by ESG rating agencies is often unsuited to emerging markets.
China is really the only market that has been producing at scale interesting companies in the green economy space
Karine Hirn, East Capital
“The majority of ESG ratings relate to policies rather than practices,” she says. “This favours larger companies and those in developed markets that have a better understanding of what is expected from them and more resources to dedicate to it.”
To fill the gap, East Capital has developed its own ESG scorecards. Predictably, these put a premium on governance, as does the firm’s global emerging market sustainable fund. Hirn says this has sometimes raised eyebrows among potential investors.
“We have had questions about whether that means we don’t care enough about the E and S of ESG,” she says. “But we also include under governance things like how the Sustainable Development Goals (SDGs) are incorporated in the strategy, controversies related to social issues and board diversity – which for us means not only gender but also having a good mix of skills and perspectives.
“Similarly, when it comes to remuneration for executives and for the board, we want to see links to environmental and social KPIs [key performance indicators]. So, the E and the S are very much part of our focus on G.”
Again, though, Hirn acknowledges that in all these areas Chinese firms still have a long way to go – despite increasing efforts by local regulators, particularly in Hong Kong, to step up the pressure on sustainability.
“The way companies report on their ESG efforts or contribution to the SDGs is still in the very early stages,” she says.
Similarly, she notes that the enthusiasm of Chinese policymakers for sustainability – particularly on the environmental side – has yet to translate into widespread action by domestic investors.
“In China, so far there has been more push than pull on ESG,” she says. “Most of the movement has come from regulators rather than investors.”
Chinese asset owners have been particularly slow off the mark. While 40 investment managers in China have signed up to the Principles for Responsible Investment, just two asset owners – Ping An Insurance and Wu Capital – have so far followed suit.
“That’s important because when large asset owners take the lead, others will follow – as we’ve seen in Japan with the Government Pension Investment Fund (GPIF),” says Hirn. “But in China, so far we’ve seen very little interest in ESG from large asset owners.”
Environmental issues
Nevertheless, she sees signs that awareness of environmental issues in particular is rising in among China’s investors and consumers.
“It is no secret that the fast growth of the last 30 years in China has come at a heavy cost in terms of environment and sustainability for the population,” says Hirn.
“As a result, we are starting to see a shift. Chinese consumers are taking more interest in the environmental impact of the products they buy; and that’s matched by a rapid increase in the number of ESG funds available.”
As Hirn notes, climate change is also a topic that resonates in China, where many of the big coastal cities are at risk from rising sea levels and where the effects are already being felt by neighbouring countries.
“Climate change is a much more urgent issue in Asia than it is in Europe, for investors and for societies,” she says. “I have family in Finland, and for them it means not having a white Christmas last year. That’s depressing in the middle of winter – but at the same time people in Bangladesh and the Philippines were experiencing disastrous floods with loss of homes and loss of life.”
Certainly, an increasing number of Chinese asset managers are signing up to Climate Action 100+, a group of global investors committed to ensuring the world’s largest greenhouse-gas emitters take action on climate change.
For the moment, though, Hirn says the biggest pressure on Chinese companies to up their sustainability game will likely come from the foreign asset managers who are starting to access mainland markets.
“Part of our investment case for China is that the nature of the investor base is changing,” she says. “For a long time, Chinese domestic markets were dominated by domestic investors, but now that markets are gradually opening up, foreign institutional investors are becoming increasingly influential, and clearly for most of them ESG is a priority.
“That in turn is changing the way that both Chinese corporates and investors think about the topic.”
Hirn also notes that, for emerging investors with a sustainability focus, China offers unique opportunities.
“If you look at emerging market equities, China is really the only market that has been producing at scale interesting companies in the green economy space,” she says. “Whether it’s cleantech, renewable energy or electric vehicles, there isn’t really an alternative to China.”
And while the challenges of obtaining reliable data on Chinese companies are unlikely to be fixed in the near term, Hirn says that can play to the strengths of funds such as East Capital.
“It’s why emerging markets are exciting,” she says. “When there is less information available, you have to do your own homework, which is why it remains a great opportunity for active managers.”
