China Fails to Pass ESG Test

Emerging-markets ESG filters help investors to align their asset allocation with their values, but they also create large unintended country bets.

The UBS MSCI Emerging Markets SRI ETF (UC79) and the iShares MSCI Emerging Markets SRI ETF (SUSM) provide exposure to emerging-markets firms that have a limited negative impact on the environment; promote diversity and have good relationships with key stakeholders, including employees; and strong corporate governance systems. They also exclude companies in certain lines of business such as tobacco, alcohol, and gambling.

This means that Emerging Markets SRI ETFs are underweight in their exposure to China and Russia, but overweight in South Africa, South Korea and Taiwan, relative to the MSCI Emerging Markets Index. The largest deviation is in China, which comprises more than a quarter of the MSCI Emerging Markets Index, but only represents 3%-4% of the total weight in each SRI portfolio.

Why Does China Fail to Make the Cut?

In a paper titled “Bridging the Gaps: Effectively Addressing ESG Risks in Emerging Markets,” the Sustainalytics research team examines the ESG environmental, social and governance – landscape across different emerging-markets countries and explains why China trails behind its peers across environmental, social and governance factors.

Country weights of MSCI Emerging Markets SRI

It’s not surprising that China’s economic expansion and rapid population growth has heavily contributed to environmental pollution. In fact, company-level research indicates that Chinese firms receive the lowest environmental scores of all emerging-markets firms.

Meanwhile on the social front, China lacks adequate labour standards and policies. As a result, on the job employee accidents occur more frequently in China relative to other BRICs. For example, Foxconn Technology, the world’s largest contract electronics manufacturer, whose clients include Apple, Hewlett-Packard and Dell, suffered reputational damage after several deaths and attempted suicides were reported at its Chinese facilities. These incidents had a material impact on the company’s stock price.

When it comes to corporate governance, Chinese companies’ poor financial and operational disclosures make it difficult for foreign investors to assess security risk. Opaque business environments also foster corruption and bribery. Additionally, most listed companies are government controlled entities. State owned enterprise are particularly vulnerable to conflicts of interest between the government and minority shareholders. For example, during the past 10 years, the Chinese government unexpectedly swapped CEOs between its three largest telecommunications companies, China Mobile, China Unicorn and China Telecom, to spread knowledge and see more parity in the industry.

Highest ESG Scoring Emerging Markets

India and South Africa are among the most overrepresented countries in emerging-markets SRI ETFs, with overweights of 6%-7% relative to the MSCI Emerging Markets Index. In their article, “IT Firms Give India an ESG Boost,” authors Jon Hale and Archit Jain argue that India’s large IT sector is responsible for raising the country’s overall ESG profile. Because large Indian IT companies like Tata Consultancy Services derive most of their revenue from Europe and the United States, they must adhere to western ESG practices.

While India’s rapid population growth has taxed the environment, the government has implemented several policies to reduce carbon emissions, promote energy efficiency and prevent climate change. That said, Indian companies have a history of child labour, employee discrimination and corruption.

Under the King III code, South Africa requires its companies to report on their ESG practices. This greater level of transparency makes South Africa stand out among other emerging and also many developed markets. Controversies mainly concern the mining sector, which has contributed to environmental pollution, as well as human rights infringements.

Interestingly, Taiwan is overweight in the MSCI Emerging Markets SRI Index by approximately 11% relative to the MSCI Emerging Markets Index, while the MSCI Emerging Markets SRI 5% Issuer Capped Index is in line with the parent benchmark. This is because Taiwan Semiconductors MFG accounts for nearly 16% of the MSCI Emerging Markets SRI Index. In comparison, the stock represents only 3.50% of the MSCI EM Index.

Aside from China, emerging-markets SRI ETFs are underweight in their exposure to Russia by approximately 1%-2% relative to the MSCI Emerging Markets Index, for very similar reasons as they are underweight in China. Russian companies have failed to establish solid environmental, social, and governance systems. They are also among the least transparent in the emerging markets.
Russia’s contributions toward environmental pollution began during its Soviet-era expansion. The country’s infrastructure is also archaic and has led to several employee health and safety incidents. Meanwhile, state-owned enterprises continue to cultivate antitrust practices and corruption.

Trade-Off Between China and ESG

Ultimately, with the current ETF offering, socially conscious investors looking to invest in emerging-markets equities need to make a trade-off between their exposure to environmental, social, and governance risks and their exposure to China.

Heavily underweighting the world’s second largest economy represents a risk that investors with global portfolios need to consider seriously.

Socially responsible investors wanting a larger China allocation may look to several index funds tracking the MSCI Emerging Markets ESG Index, or a customised version of it. But these come with less stringent ESG requirements.

Hopefully, with time, as Chinese companies continue to operate on a global scale, their ESG practices will converge with those in developed markets. Consequently, investors will be able to access socially responsible emerging-markets equities with a representative China allocation. For now, a compromise between one or the other must be made.

Source: Morningstar. Monika Dutt

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