Authors: ESG Research Center
ESG indicator system
ESG indicators measure the impact of corporate operations and investment activities on environmental, social, and governance dimensions. Establishing a systematic ESG indicator system is necessary to assess the value of the investment. While the international ESG index systems listed above have proven influential globally, they all face challenges in adapting to the Chinese market. Due to a lack of understanding of Chinese specific conditions, international ESG indicator systems do not adequately measure the ESG performance of the Chinese enterprises.
International ESG indicator systems
Several influential ESG information disclosure standards and evaluation systems have been established internationally, including MSCI, Thomson Reuters, FTSE, and Dow Jones. Below is the comparison between different ESG indicator systems applied internationally. The general framework of the indicator system is consistent globally and bases on the three core factors of environment, society, and governance. Most of the secondary indicators adopt common international standards, while there are usually differences between third-level indicators.
International ESG Rating Systems are not adequate for China
While the international ESG index systems listed above have proven influential globally, they all face challenges in adapting to the Chinese market. This article analyzes the reasons behind the failures of the international ESG index systems in China from four aspects.
1. International indicators are not differentiated
International indicators usually apply the same indicator system for all companies in the world. They do not fully consider regional differences and specific national conditions. ESG development in China has its characteristics, but international indicators generally do not adjust to them. Because Chinese companies have many unique characteristics, many indicators are not relevant for Chinese companies and cannot effectively capture their ESG performance.
For example, the MSCI ESG indicator system has only two sets of indicator logic, one for mature markets and one for emerging markets. Since there are no specific localization indicators for China, the standard indicator system for emerging markets is applied to Chinese enterprises.
2. International ESG indicators don’t fully reflect ESG performance of Chinese companies
The international indicator systems follows global capital market principles and standards when comparing Chinese companies in the global context and is more suitable for assessing the ESG performance of listed companies in Europe and the United States. It might lead to the underestimation of the ESG performance of Chinese companies
3. International indicators lack depth and do not capture all Chinese ESG data.
Data acquisition is one of the critical steps in ESG assessment. However, international index companies have difficulties in obtaining ESG data from Chinese companies. The language barrier makes obtaining Chinese information more complicated than elsewhere.
4. Different ESG requirements lead to different ESG evaluation criteria.
International standards and principles commonly used by international institutions are widely applied on a voluntary basis. In China, ESG development is primarily led by the government. This also means that the social dimension of ESG in China is different from that in Europe or America and ESG evaluation standards used in China should reflect this.
Main features of the ESG Indicator System Created by IIGF
In 2017, based on research on green evaluation systems, the International Institute of Green Finance (IIGF) at Central University of Finance and Economics independently developed a localized ESG indicator system for Chinese companies. The system comprehensively reflects the ESG performance of Chinese companies with qualitative and quantitative indicators measuring the environment, social responsibility, corporate governance, negative behavior, and risks.
Different industries have their specific industry characteristics and business models; therefore, the focus for ESG in different industries is also different. IIGF referred to the Guidelines for the Industry Classification of Listed Companies issued by the China Securities Regulatory Commission (CSRC) and assigned all listed companies to one of the three categories: manufacturing, services, or financial sectors. Under the three primary sectors, the manufacturing industry was sub-divided into 16 secondary sectors, the service industry into 12 secondary sectors, and the financial industry into capital market services, money, and financial services, and insurance.
For ESG scores in each sector, typical and key indicators were set according to industry characteristics. Finally, each industry was assigned three first-level indicators, 25 second-level indicators, and more than 200 third-level indicators. To emphasize the quantitative measurement of negative ESG risks, IIGF’s ESG Indicator System also captures negative behaviors and risks and deducts points accordingly. The IIGF ESG indicator system includes environmental penalties, debts, defaults, disputes, breach of contract, safety, quality, and regulatory violations of a given company.
In addition to qualitative indicators the environmental (E) dimension also includes quantitative indicators capturing environmental risk, green income, and quantitative environmental data to comprehensively measure the environmental performance of the listed company across the whole production cycle. The qualitative indicators of the social (S) dimension include charity and poverty alleviation indicators, with consideration of communities, employees, consumers, and suppliers. In contrast, quantitative indicators focus on assessing the social risk and social responsibility of a company. The governance (G) dimension includes qualitative indicators such as organizational structure, investor relations, information transparency, technological innovation, risk management, and quantitative indicators such as corporate governance risk and quantitative governance data. In the light of serious problems in earnings management of listed companies in recent years, the research team also used the Modified Jones Model in academic research to estimate earnings quality indicators and incorporate them into the evaluation of corporate governance. In addition, the negative behavior and risk dimension mainly account for the environmental risks, credit risks, labor risks, product risks, and non-compliance risks of listed companies.
Comparison of ESG Indicator Systems at Home and Abroad
While international ESG indicators are qualitative indicators, IIGF has added quantitative indicators suitable for domestic conditions, emphasizing the importance of quantitative indicators for the environment (E). At the same time, in the evaluation of qualitative indicators, IIGF also adopted a score of 0 points and 1 point to minimize the error caused by analysts’ subjective judgment. Below we outlined main differences in each of the ESG indicators.
Environmental indicators
IIGF localization indicators also differ from international indicators in the definition of “green revenue.” For example, the FTSE Green Revenue Index includes oil in calculating “green revenue,” which does match with China’s policy or market realities. The definition of green revenue adopted by IIGF was based on green industry regulations specified in the Green Industry Guidance Catalogue (2019 Edition) promulgated by the National Development and Reform Commission (NDRC), which evaluates whether business activities of a company bring environmental benefits. Income deriving from the relevant business is measured to calculate the corresponding proportion of green income out of operating income.
Social indicators
International indicators are often inconsistent with the development priorities of Chinese enterprises. China’s key national policies, such as “targeted poverty alleviation,” are significant aspects of China’s development of social responsibility. Many Chinese companies, especially state-owned enterprises, actively participate in poverty alleviation efforts, conducting various relevant activities to contribute to the sustainable development of society. Therefore, such poverty alleviation activities must be reflected in ESG indicators. IIGF created qualitative and quantitative social indicators tailored for China, such as charity, poverty alleviation, and disaster relief. In contrast, the international universal ESG indicators do not highlight the particular social responsibility characteristics of Chinese companies. For example, Chinese enterprises emphasize social security and labor welfare, while international social responsibility indicator systems tend to attach more importance to human rights indicators. At the same time, differences in legal standards also cause companies to behave differently. For example, international labor law is quite different from China’s labor law, meaning that many related indicators are not suitable for Chinese companies. IIGF referenced many policy documents and regulations to reflect those differences in IIGF ESG Indicator System appropriately.
Governance indicators
International indicators fail to account for the characteristics of China’s unique state-owned enterprises (SOEs). International indicators tailored for regular profit-maximizing companies are often ill-suited for SOEs, failing to adequately evaluate high-performing SOEs. Technological innovation is a key development strategy for Chinese enterprises. In 2019, the NDRC Department of Science and Technology issued guiding opinions on building a market-oriented green technology innovation system. IIGF incorporated indicators such as scientific and technological innovation in its governance indicators to measure the R&D performance of Chinese companies.
Suggestions for the Future Development of China’s ESG Indicator System:
1. Establish unified standard for localized ESG information disclosure
As ESG development in China relies heavily on government guidance, relevant regulatory authorities should introduce localized ESG information disclosure standards as soon as possible and gradually shift to mandatory ESG information disclosure. Additionally, it is necessary to establish related laws and regulations to enforce compliance and improve the ESG information disclosure environment through a sound regulatory mechanism. It will provide better support for ESG development in China. Establishing unified ESG information disclosure standards will also offer an essential reference for ESG assessment, further supporting the establishment of a localized ESG indicator system.
2. Improve market awareness regarding ESG
At present, the Chinese market underemphasizes the benefits of ESG reporting, and the concept is still in its infancy. Improving this understanding is vital for the development of ESG assessment in China. One aspect of this is enhancing the willingness of enterprises to disclose ESG data. At present, the ESG data disclosure happens on a voluntary basis in China. Therefore it is necessary to help enterprises realize the benefits of ESG data disclosure and encourage them to issue independent social responsibility reports. At the same time, it is crucial to guide more financial institutions to invest in ESG. At present, financial institutions have the ability to identify general risks, but their capacity to identify environmental and social risks is relatively weak. Therefore, it is necessary to strengthen institutional investors’ awareness of ESG risks and improve ESG investment capability through organizational training.
3. Encourage third parties to establish ESG databases
International experience shows that robust ESG indicator systems strongly rely on database support. More comprehensive data improves the accuracy and objectivity of ESG assessment. Therefore, it is necessary to establish a comprehensive database to support China’s ESG indicator system development. At the same time, third parties should be encouraged to participate in ESG database building. IIGF has taken initial steps in this regard. Its ESG database covers 1,303 listed companies, 486 unlisted bonds, and ESG data of 1,789 companies. In addition, the database includes all ESG data of companies on the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong stock connect, as well as the 142 companies reported on China’s Science, Technology, and Innovation board. In the future, the IIGF will further expand the ESG database to include more listed companies and bond entities. By 2019, it is expected that ESG ratings will be complete for 2,279 bond entities, including 737 listed entities.
As of April 2021,IIGF ESG database covers 4459 listed companies (15131 company/year), more than 3000 unlisted bonds (5208 company/year), and ESG data of nearly 8000 companies (20000+ company/year). For instance, full A-share ESG data 2018 to 2020, the Environment part of CSI 300 Index main companies in almost 9 years, and the ESG related data of CSI 800 index objectives in 5 years. Additionally, all ESG data of companies included in Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong stock connect has been recorded as well, along with those of the 142 declaration main bodies in Chinese Sci-Tech innovation board. Meanwhile, the IIGF ESG database involves the ESG rating of 4730 bond entities (12047 company/year), including 1634 listed entities (6839 company/year) and 3096 non-listed entities (5208 company/year).
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