How to Build Sustainability into Your China Allocation

Allocating to China is a thorny issue for many asset owners. Investors are increasingly concerned with the level of sustainability in their holdings, just as the world’s largest emitter of carbon emissions is becoming a more important allocation in Western portfolios.

But China can still fit into a sustainability framework, according to Willis Towers Watson. Environmental, social, and governance (ESG)-minded investors who are deliberating how to invest in the country’s assets should consider a total portfolio approach, instead of a strategic asset allocation, the consulting firm argued.

“While adding Chinese assets incurs a penalty if looked through the sustainability lens in isolation, at the aggregate level, there is a substantial positive contribution to portfolio quality, mainly driven by increased diversity and higher expected return,” read a report the firm released Tuesday. (Willis’ report, called “China Through a Sustainable Investment Lens,” is a two-part series.)

The approach helps institutional investors consider how they can spend their “sustainability budget,” the consultants said. A ding in environmental performance from carbon-intensive assets in China could be offset by reducing exposure to carbon-intensive assets elsewhere in the fund. Oil and gas companies are a couple examples.

Or, investors could improve their portfolios by investing in climate technology solutions that are gaining momentum in China. These opportunities run the gamut of growing investments in this sector, including solar, wind, storage, and smart grid energy solutions; buildings made from renewable materials and outfitted with energy systems; and autonomous and electric vehicles.

There are other examples: improved products designed for reuse; plant-based foods that are rising in popularity; smart infrastructure in cities; and even carbon calculators for people who want to keep track of their carbon footprints.

But Willis warned against investing in China without skilled active management. Allocators should seek investment managers who have integrated sustainability into their investment practices. Among the other resources that partners should have in Beijing? Artificial intelligence (AI) and machine-learning capabilities to better collect ESG data.

“Asset owners do not necessarily have to have a presence in China or internal staff who can speak Chinese, but they do need to have well-resourced, on-the-ground partners on whom they can lean when making allocation decisions and selecting managers,” the report said.

Why a Standalone China Allocation Still Makes Sense

For many US investors, China comes with a grocery list of environmental and regulatory issues. It is still dependent on coal energy, after all.

By the measure of FTSE Russell, Chinese businesses scored lowest for corporate social responsibility among larger markets, the Willis report said. It received 1.5 out of 5, when the average emerging market nation scored 2.1 in the FTSE4Good rating.

Regardless, Willis’ consultants argued that the growing momentum in ESG investing in China suggests there will be greater sustainable returns over time, particularly as more foreign investors access its markets.

“They have built up strong positive momentum and we’re expecting that positive momentum to continue over the coming years and decades,” said Liang Yin, director of private equity research and project lead on China at Willis Towers Watson.

At the moment, investors in the US have a relatively miniscule allocation to Beijing. Despite holding the world’s second-largest equity and bond markets—with a $12 trillion market value—the country accounts for about 5% of the MSCI All Country World Index (ACWI). Experts say that is not an even distribution given China’s growing share of the world’s capital markets.

“That’s just not a very resilient portfolio going forward, in particular, into an emerging world order,” Yin said. “Of course, no one knows what the new world order will look like, but I think investors should prepare for all possibilities.”

Last year, Willis told global investors they should be making a standalone allocation to China, investing up to one-fifth, or 20%, of their return-seeking portfolios to the country by 2030.

The Chinese government is also working to bring sustainability mainstream. Last year, at the United Nations General Assembly, Chinese President Xi Jinping pledged that his country would reach carbon neutral by 2060.

With the backing of the Beijing government, ESG disclosure practice in China is already stronger than it is in the US, according to ESG data from Bloomberg. More than one-quarter of A-share companies issued ESG information in 2019.

Willis also reported that local asset managers are under pressure to develop ESG disclosures to attract international investors.