Localize Your ESG: How to Avoid Regulatory Black Swans in China

RESEARCH NOTE

ESG investing is one of the most important trends in global asset management. At its core, ESG investing seeks to do well by doing good. While some ESG proponents are content to assume that good karma will lead to good returns, most ESG champions argue that ESG related alpha opportunity arises from avoiding regulatory risk and benefiting from policy tailwinds. In this article, I explore this link between ESG alpha and government policy.

An important economics finding is that an unregulated free market can often encourage activities that produce negative externalities. Regulating the profit-maximization behaviour of firms is critical for reducing these negative social impacts, thus ensuring Adam Smith’s conjecture that personal greed leads to social optimum continues to largely hold.

In other words, appropriate regulation is necessary to save capitalism from capitalists. Industries which promote gambling, tobacco, liquor, recreational drugs, firearms, and sex — or those firms that pollute heavily, target minors, or wield monopolistic power — these firms are regulated because the invisible hand doesn’t quite move us toward a socially acceptable outcome.

To address these challenges, the visible hand of the regulator must work alongside the invisible hand of the free market. The visible hand often holds a heavy hammer: regulators in markets all over the world have busted up monopolies, reduced pollution, discouraged tobacco usage, protected minors from predatory businesses, or otherwise used their power to minimize or mitigate the negative externalities caused by a free market. Regulators are most likely to use their power against those industries and companies that generate the greatest negative externalities.

So, how does this relate to ESG investing? Whether you screen for ESG (Environment, Social, Governance), SRI (Socially Responsible Investing), or SDG (Sustainability, Diversity and Green), you are also reducing your portfolio’s exposure to regulatory risk. In other words, ESG investing helps investors avoid those companies that are most likely to be in the regulator’s crosshairs–essentially helping investors avoid policy black swans.

Many investors in Chinese companies learnt this lesson the hard way in recent months. Since early 2020, Chinese regulators have gone after payday loan sharks and lending platforms targeting teens. The Chinese government withdrew support for coal miners and traditional automakers and provided heavy incentives for EV makers and buyers. Beijing has forbidden Moutai drinking at government functions and discouraged managers from coercing subordinates to drink alcohol at corporate functions; the state media have begun to draw attention to China’s abnormally high incidence of liver cirrhosis and the relationship between liquor indulgence and cancer. Regulators have also gone after real estate developers who stockpiled cheap land, often obtained from the government through suspect means, only to restrict housing supply. This technique has generated stratospheric real estate prices; unaffordable home prices have consistently been the number 1 reason for adult unhappiness in China. The government gave a stern warning to 34 consumer tech giants and later fined Alibaba to the tune of 2.8B for anti-competitive business practices. More recently, Beijing gave an ultimatum to “for-profit” cram schools to change their business model in an effort to reduce the unhealthy and expensive test prep culture in China, which has contributed to the country’s high suicide rates and low birth rates. And just this past week, the state has begun warning consumers about the ill-effect of mobile games designed to create opium-like addiction in teens.

The savvy China ESG investors are already well-aware of the costs borne by average Chinese citizens and how these costs are unfairly imposed by the country’s profit-maximizing industries and businesses. They likely have limited their exposure to these types of businesses, thereby avoiding the plummeting value of these firms in the wake of regulatory action over the past 18 months. And as a result, they would have earned superior alpha.

But for western-centric ESG investors, getting ESG “right” in China often remains a mystery. The social problems that create pain for the Chinese people are often not the ones that Westerners care about. Insofar that Western-centric ESG seeks to improve outcomes that don’t line up with the pain points of the Chinese people, we are unlikely to observe improvements. This is because the visible hand of the regulator does not serve foreigners’ perception of what’s important. Instead, it serves the concerns of the local people.

This observation will be important to global ESG investors from both a risk/return perspective and a philosophical perspective. On the risk/return side, focusing on avoiding low ESG companies according to the local identification of ESG issues is significantly more likely to help investors avoid policy black swans as regulators deal with local social issues.

On the philosophical side, ESG investors have a more interesting question to ask themselves: Is ESG investing about divesting from companies that violate Western values, or is it about divesting from companies that cause the greatest harm to the local population and society? Investors may find these two are rarely the same.

This article was first published to LinkedIn:
https://www.linkedin.com/pulse/localize-your-esg-how-avoid-regulatory-black-swans-china-jason-hsu

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