RisCura believes that ESG and financial performance are integrally linked and especially so in emerging markets. Several recent examples have cost investors dearly, like furniture retailer Steinhoff International losing almost $10bn market cap when fraudulent accounting was exposed; or Chinese coffee chain Luckin’ Coffee collapsing shortly after listing on the NYSE when it was revealed ¼ of its sales were false.

What about Social?

Most people have an intuitive understanding of what ’Social’ means, but there is less guidance for investment professionals. The emphasis also differs by country and is shaped by current affairs. For example, gender and ethnic diversity are currently topical in developed markets, highlighted by movements like Black Lives Matter, as are worries about global internet companies using personal data. For investors into China, human rights are a concern.

There is no clear worldwide standard for many ‘Social’ issues. For example, attitudes to data privacy in Germany are very different to those in China, which is different again to the US. Some countries believe universal healthcare models are essential, others find the idea alien. Laws in one country prescribe child car seats, others don’t. Product safety standards are not harmonised. ‘Social’ standards may need to be adapted to different locations. In contrast, environmental factors are often fairly consistent.

A closer look at China

We suggest making a distinction between investing in a country and investing in companies. Investors may have little influence at the country level, but great influence at the company level.

China is one of the fastest growing economies and ignoring it because of controversies at the country level may come at a high opportunity cost. Rapidly developing countries also create jobs and products which improve local living conditions. However, if producers are facilitating human rights abuse, this is unacceptable.

Incidents like 2013’s clothing factory collapse in Bangladesh exposed unacceptable local working conditions, but we are disappointingly still largely unaware where many products come from and how they are made. Recent scandals in the Leicester garment trade remind us vividly of this.

But positive results can be achieved with engagement and co-ordination. Initiatives like Fairtrade Coffee show that we can achieve meaningful change through co-ordinated global efforts, particularly through changing consumer attitudes.

Adapting the ‘S’ to China

China is a communist country that is run very differently from western democracies. The state has a significant influence on society and the economy, and it can clamp down quickly and substantially on perceived malpractice. A clampdown could immediately overturn a company’s fortunes, including the possibility of a complete shutdown.

In contrast, there are companies in the US or Europe who have had poor environmental and social records for many years, sometimes despite media and regulatory attention, and frauds also occur in developed markets. The recent Wirecard scandal in Germany is a good example, where regulators sided with the company at length until evidence of the fraud became overwhelming.

There are multiple examples where the Chinese state has shut down malpractices. Polluting steel mills, overcharging for generic drugs, promoting aggressive personal lending: all have been targeted and often changes came into effect at short notice. Companies with unsustainable practices simply closed while good operators benefitted from the resulting reduced competition.

Chinese investment managers pay significant attention to unsustainable practices when researching companies, as missing something could have a direct and material impact on financial return. If not the threat of state shutdown, poor ESG practices may cause a loss of revenue as customer attitudes change.

But we need to respect that the way of life in China is different from ours. For example, as in many Asian countries, the Chinese have a somewhat relaxed attitude to data privacy. China’s ability to deal with COVID-19 was largely due to the information authorities had on the whereabouts and status of citizens. The same abundant data means China is ahead in artificial intelligence. For example, facial recognition technology is used to curb jaywalking in major cities by automatically identifying and publicly shaming the jaywalkers.

Engagement is better than exclusion

Fund managers who actively engage with companies to improve ESG make a bigger difference to the world than those who avoid “poor ESG” companies. However, if a company is involved in a problematic industry (like creating facial recognition software to identify ethnic minorities), exclusion may be the only option. More often though, a better result can be achieved through engaging and advocating for better working conditions or safer products, which eventually leads to better corporate performance as less ethical competitors are shunned by consumers.