Two factors hampering green stock indices in China

Green stocks are a key part of the green finance sector in China, as recent government documents have made clear. China’s green lending and green bond markets have made great progress, and are now the largest and second largest in the world, respectively. Green stocks, meanwhile, are just off the starting blocks.

Green lending and green bonds both focus on whether a particular project is or isn’t green, whereas green stocks consider the longer-term environmental performance of companies. Investors in green stocks often rely on green indices to guide them where to invest. Such indices track multiple stocks at the same time based on certain conditions.

Currently, there are two types of green stock index in China, namely theme indices and strategy indices. 

Theme indices are simpler, selecting firms by “green themes”, such as new energy and waste treatment. Money from an investor in a theme index will then be split equally between each company in that index.

Strategy indices are more flexible. When selecting firms, they apply some “green standards” – the percentage of income a company earns from green operations and the type of green business the firm is involved in – then weight investment amounts in accordance with companies’ environmental and financial performance. 

The two methodologies involve selection – to decide whether or not a company should be included on the index – and weighting – to decide the size of the investment to be made.

Two factors determine whether an index attracts investment. One, are the selection and weighting processes “green” enough. Two, does the market have enough data available to ensure the index can be relied upon? A look at China’s existing green indices shows that both the methodologies and the underlying data are inadequate to attract and direct investment appropriately. This is hampering green stocks and indices getting off the ground.

How can green indices be ‘green’?

When a company meets selection criteria it can be included in a particular index and so receive investment. Accurate selection criteria will ensure that only companies that are overwhelmingly green, or are demonstrably investing in becoming so, are included, and that the index is therefore green.

Publicly available documents on methodologies show that when selecting firms, many of China’s green-themed indices refer to the National Development and Reform Commission’s Green Industry Guidance Catalogue, or related sectoral lists of green industries and business areas. That approach decides if companies are green or not depending on their area of business, but does not look closely at their actual environmental performance. In other words, if the company’s area of business is included on a “green” list and its financial performance meets the requirements of the index, it may be included despite potentially causing environmental harms in its operations or supply chain. This failure to consider actual performance may benefit “greenwashing” companies.

Compared with theme indices, strategy indices take a more flexible and nuanced approach to selection and weighting, applying detailed environmental standards rather than just looking at a firm’s area of business. This means a more comprehensive assessment of a firm, for example by looking at carbon intensity and environmental risk management. It can also use that assessment when deciding on weightings, so firms with better results get more investment.

However, this flexibility has not been demonstrated in China. Why not? We found most strategy indices stick to a single benchmark. Some require only that firms earn a certain amount of their income from environmental protection business, for example, while having no requirements in other key areas, such as carbon emissions, environmental goals and low-carbon transition plans. That means investors remain unable to understand how their portfolio contributes to protecting the environment. This is particularly an issue now China’s targets for peak carbon (before 2030) and carbon neutrality (before 2060) are in place, as indices are no longer simply intended to help green industries grow. They also need to steer capital towards carbon-intensive sectors to help them transition. That requires more detailed and comprehensive selection and weighting processes. The existing green indices will not substantially help China meet its carbon targets.

It is worth looking at the detailed environmental requirements that leading international financial institutions use when producing their indices. MSCI’s Climate Paris Aligned Indices Methodology has a range of requirements on companies’ transition risks, physical risks, transition opportunities, and diversification objectives under a 1.5C climate scenario. These are reflected in 19 selection criteria on Scope 1, 2 and 3 emissions (namely direct emissions, emissions from energy purchase, and indirect emissions in the value chain); reductions in intensity of greenhouse gas emissions; green revenue; uncovered risks under a 1.5C target; and quantified climate targets. Those criteria reflect a company’s current performance and also future intentions. That helps investors find 1.5C scenario-aligned companies to invest in and manage the climate performance of their portfolio.

Green is not enough

Investors have different goals for different investments, depending on their overall strategy. Some of those goals may be more general and aimed at achieving various aspects of sustainable development. Some may be targeted at specific parts of the sustainable development agenda: carbon neutrality, reducing pollution, protecting biodiversity or promoting social inclusion. Green indices have goals in a specific area.

To avoid losses, investors in green stocks don’t just look at how a sustainability index is constructed. They also need to consider other factors which might affect a firm’s financial performance. How can they be sure that a firm won’t suffer after being found to have been causing water pollution, breaching labour laws, or employing corrupt executives? Green indices need other criteria to avoid other sustainability risks and prevent the main green goals being missed, and to ensure basic social standards are met.

The most common approach for China’s sustainability indices is to have a threshold for entry based on an environmental, social and governance (ESG) rating, allowing for a preliminary filtering which excludes those with low scores or only admits those with high scores. Environmental criteria or themes are then used to further narrow the field. But the ESG standards applied aren’t the index’s core goals – they are additional basic requirements, intended to make sure core goals are met. The use of ESG ratings from external bodies to filter potential investments reduces sustainability risks within the portfolio. The problem is, different providers of ESG ratings use different methodologies and therefore scores and rankings for a single firm can differ, affecting the chance of inclusion in an index.

To increase the comparability of sustainability indices, some systems for evaluating environmental performance are including more authoritative frameworks in their methodologies as a precondition. Some practices newly adopted overseas may be worth looking at. Cicero Shades of Green, a corporate green performance assessment body, requires companies meet the requirements of the EU taxonomy for sustainable activities, for example. That means that it is not enough for firms to show that their activities make a contribution to a single EU climate target. They must show those activities are not having a negative impact on other climate goals. The company must also meet Article 18 of the EU Taxonomy Regulation on minimum safeguards, ensuring its activities align with a number of authoritative documents, including the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

This brings in non-environmental sustainability standards and increases comparability across different methodologies, meaning the outcomes of the selection process are easier for investors to use.

Corporate environmental disclosures are key

If green indices are to support green finance, apart from scientific methodologies for producing them, it is also vital to have reliable data in the market on which those indices can base their decisions. It’s widely agreed that the most reliable data is that published by the companies themselves and then certified by a qualified third party. When the market cannot provide that data, indices can look to their second-best option: modelling environmental performance based on other data made public by the firm. The more detailed the published data, the more accurately that modelling process and the final selection outcomes will reflect actual performance.

Syntao Green Finance has recently looked at information disclosures on China’s A-share markets in 2021, in order to understand what data is being made public. Its study found that only 26% of the 4,138 firms covered published ESG reports, with a notable lack of quantitative data that could be used in analysis. Of the 800 companies in the China Securities Index 800, less than 200 disclose greenhouse gas emission data, while next to none publish quantified climate goals. That means investors can’t make predictions for future performance and cannot hold useful dialogues with the firm.

So, currently, disclosures by companies with A-share listings aren’t providing the data needed to build sustainability indices and give ratings. That means index and rating products will be unable to improve and investors will be unable to identify listed companies to invest in. Work is therefore needed to improve the disclosure of sustainability and environmental information, and in so doing boost market transparency.