How Private Equity Can Stay Ahead of ESG Demands in Mainland China and Hong Kong

The global environmental, social and corporate governance (ESG) landscape is constantly evolving. Compared to developed Western countries that have more than 80 percent of global ESG market share, Asian investors are catching up and increasingly looking to adopt and apply ESG factors in their investment.

We recently spoke with Rong Yu (pictured below), senior ESG business development manager at S&P Global Sustainable1, to learn more about the current ESG market landscape and trends in mainland China and Hong Kong.

SS&C Intralinks: Can you tell us about yourself and your background in ESG?

Rong Yu: S&P Global is a leader in ESG analytics and solutions. On Earth Day 2021, we launched S&P Global Sustainable1, a single source of essential sustainable intelligence from S&P Global. Sustainable1 brings together S&P Global's full breadth and depth of resources and full product suite of benchmarking, analytics, evaluations and indices that provide customers with a 360-degree view to help meet their unique sustainability needs.

My current role within the company is to lead ESG business development in the greater China region, including Hong Kong and Taiwan. Prior to joining S&P Global, I worked in sustainability and climate change consulting for more than ten years across the U.S., U.K., Europe and Asia, including at a strategy consulting firm and international organizations like the United Nations. I worked with investors and companies to consult on industry trends, assess their ESG performance and advise on the integration of tools that help manage ESG exposures and opportunities.

Can you speak about the latest ESG trends in mainland China and Hong Kong?

As you may be aware, China has pledged to curb carbon emissions before 2030 and achieve carbon neutrality before 2060. Carbon neutrality has become a hot topic in China. Corporates and financial institutions are all actioning on it. Many are starting to develop their own low-carbon strategy and vision for a low-carbon transition. Investors including private equity (PE) funds are looking for opportunities in this area. More ESG and climate-related financial products are being developed.

The Chinese government has set steps to achieve a low-carbon economy, one of which is launching the national carbon emission trading system. That’s a big step forward from the subnational piloting schemes in seven provinces and cities including Beijing, Shanghai and Shenzhen in 2011. As a result, many companies will have to purchase their emission permit if their emissions exceed the quota they are assigned. The anticipation of an increasing carbon price will subsequently boost investment in clean-energy technology and other higher carbon-efficient industries.

The other trend happening is regulators are requiring corporate ESG disclosures, especially environmental disclosures. Currently, there are no mandatory ESG disclosures in mainland China. Therefore, less than 30 percent of all listed A-share companies have published their corporate sustainability report (CSR). However, Chinese regulators had set a goal for mandatory disclosures for listed companies by 2021. Hong Kong also increased the pace of ESG requirements by tightening a series of rules. For instance, Hong Kong Exchanges and Clearing Limited (HKEX) has announced that all IPO applicants are required to put in place additional disclosures of corporate governance and ESG information upon listing. Regulators are also exploring mandating Task Force on Climate-Related Disclosures (TCFD)-aligned disclosures by financial institutions and listed companies by 2025.

With the shifting global and local conditions and markets, private equity firms are recognizing the value that strong ESG management brings to their portfolio companies, including improving accountability to stakeholders, reducing systemic risks and uncovering opportunities. We have seen more and more China-based PE firms adopting the United Nations-supported Principles for Responsible Investment (PRI) and considering environmental, social and governance factors at all stages of investment and value creation processes.

What are the key market gaps and pain points?

Challenges remain at two levels: fund-level ESG management and portfolio-company-level ESG performance reporting. As I mentioned before even listed companies are at an early stage of managing ESG performance and reporting externally. When talking about private companies, only a small portion have started incorporating ESG into their enterprise management. There are many opportunities for general partners (GPs) to drive momentum among their invested companies and cascade the importance of ESG management. Companies can start small, for example, focusing on understanding and quantifying their operational carbon emissions (scope 1 and 2), and then gradually build internal capacity and move to cover more ESG metrics and targets such as supply chain carbon emissions (scope 3).

For private equity firms, integrating sustainability at the firm and portfolio-company level usually starts with a set of policy and pre-acquisition procedures. But how to monitor and measure ESG progress and performance improvement during hold period is the most critical part in creating stronger and more valuable companies. As material ESG factors vary across industries, for example, a restaurant chain vs. a power generation company may have very different ESG metrics and targets, PEs should guide their portfolio companies to understand ESG materiality and develop appropriate ESG metrics that can inform company strategy and operations to enable stronger and more sustainable long-term growth.

How can GPs incorporate ESG into their investment strategy?

To achieve a successful integration of ESG, general partners (GPs) need to have an internal collaboration of investment process and portfolio management as well as awareness across the whole organization on how the firm’s responsible investment policy will affect daily operations. That includes ESG management across the deal lifecycle.

Many GPs have started incorporating ESG elements into their due-diligence checklists, such as setting up a negative screening system that includes elements and restrictions that prevent GP from investing in certain industries or geographies. The next stage would be developing ESG assessment tools that identify companies’ ESG risk factors pre and during hold periods.

For GPs who are in the process of adopting responsible investment philosophies, they should collaborate with external ESG experts to develop a credible ESG evaluation framework. One of the most recognized ESG scoring methodologies is S&P Global’s Corporate Sustainability Assessment (CSA). Regarded as one of the most advanced ESG evaluation frameworks it draws upon over 20 years of experience analyzing the impact of sustainability practices on a company’s long-term value creation.

Participating in the CSA will provide PE firms and companies access to critical ESG metrics that allow benchmarking against their industry peers and understanding the roadmap to operational excellence in ESG. The CSA can be used as part of the PE fund’s approach to determine the maturity of its portfolio companies’ ESG programs and set a baseline against which progress can be measured.

Overall, ESG is more than checklists in certain deal stages. ESG frameworks should be integrated into the entire investment process and become an essential set of metrics for annual management reporting.