The Chinese market is full of compelling investment opportunities, but for investors focused on sustainability, finding reliable environmental, social and governance (ESG) data on Chinese companies has often proven difficult.
But things are changing. Recent regulatory changes now require certain listed and private companies to make additional disclosures, specifically on carbon emissions. The rules marked an important step on the country’s path to 2030, the year by which the Chinese government aims to peak carbon emissions. Although disclosure rates have risen in the past two years, data challenges persist and Chinese companies lag their global peers for ESG disclosures.
With the right capabilities, it is possible to bridge some of these gaps. At J.P. Morgan Asset Management, we have explored how to enrich our insights with regard to financially material ESG factors, and how to plug some of the gaps related to ESG information, by developing our machine learning capabilities in two ways. The first tool approximates for financially material metrics not included in company ESG disclosures, such as certain emissions data, by scanning information from other available data sources, including social media. The second tool parses relevant information and assesses corporate controversies that are not normally considered in third party ESG scorecards but which may affect risk-adjusted investment returns.
Tool 1: Filling gaps in ESG disclosure
ESG disclosures provided by companies are among the main sources of information that we use to judge a company’s ESG credentials. Our first proprietary ‘gap-filling’ tool helps us overcome the fragmented landscape of corporate ESG disclosures in China. The tool incorporates a diverse collection of metrics reported by companies, including revenue breakdown. It then uses a machine learning model to identify features that can be used to estimate missing company data points. These features are used to produce baseline estimates for J.P. Morgan Asset Management Quantitative ESG Score1 that is further refined through the expertise of J.P. Morgan Asset Management’s sustainable investing team.
Our approach to generating estimates of ESG metrics for Chinese companies
Source: J.P. Morgan Asset Management; information as of November, 2022.
Tool 2: Uncovering ESG controversies
Our second machine learning tool is focused around identifying and analysing ESG controversies – events in which poor ESG risk management could have a significant negative effect on a business’ financial performance. Companies are often reluctant to report potential controversies proactively or after one emerges to share information about it in a timely manner. The ability to unearth controversies early is extremely valuable. And, it requires not just the information itself but also some understanding of the local language and market.
How the ESG controversy signal works
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Source: J.P. Morgan Asset Management; information as of November, 2022.
We find this approach to controversies to be a powerful tool when assessing financially material ESG risks at Chinese firms, yet there are two caveats. First, controversies datasets by themselves do not provide a holistic view of a company’s ESG risks and opportunities. Such datasets should also be considered in the context of the effectiveness of a company’s ESG policies and programmes.
Second, controversy datasets have a notable market cap bias. Smaller firms and their controversies may draw less media attention and focus, but this does not necessarily mean that they are managing financially material ESG risks more competently than larger companies.
Engaging with companies to enrich our understanding and research
While these tools help us fill in some of the missing information, machine learning techniques cannot fully substitute for actual company disclosures. To encourage companies to collect and disclose financially material ESG information themselves, data analytics needs to work in conjunction with active stewardship.
We believe it is in a company’s best interests to report on financially material ESG topics, including greenhouse gas emissions and human rights risks in their supply chains. Through active engagement, we may highlight good ESG reporting practices and encourage companies to fill any gaps as soon as possible. As investors, we are interested in both standardised ESG disclosures and company-specific information, including controversies and global norms breaches that may not be voluntarily reported.
Case study A
Company A, an appliance manufacturer with worldwide sales and distribution, produced corporate social responsibility reports for 2019 and 2020. As the name suggests, this report focused on the social-related data and initiatives. We had an ESG-specific engagement with Company A in 2021 to share our thoughts and explained that the absence of environmental and governance topics was a major challenge in assessing the company’s sustainability risks and opportunities.
Company A’s May 2022 report was revamped in format and content. Notably, it was renamed as an ESG report and included far broader coverage including:
- Greater transparency on the company’s policies, internal governance and supply-chain management practices
- One-year targets for emission reduction, water consumption and other environmental issues
- One to three-year targets for other sustainability topics such as completing the internal due diligence for all suppliers having conflict minerals, increasing the social responsibility audit for 90% of suppliers and having zero service delay and zero complaint from customers.
Case study B
Company B is a large-scale China-based mining company with mineral resources and logistic assets around the world. We reached out to the company to find out more about an allegation that it was sourcing conflict minerals. Company B acknowledged the problem and explained that it was an isolated incident. The company operation in Brazil occasionally purchases phosphate ores from a supplier, the vendor, which operates phosphate mines in Morocco and also has a mine in occupied Western Sahara. Company B had used a third-party system to review its suppliers’ compliance about conflict mineral sourcing which failed to detect this issue.
The company has stopped sourcing Western Sahara ores and asked its vendor to provide certification of origin for its ores. It reiterated its commitment to supply chain management and said it will strengthen due diligence on high-risk suppliers in the future.
Looking forward
As new regulations take effect, corporations will need to comply by producing more in-depth ESG reports that cover additional ESG metrics. This will generate more ESG data, which will give investors a more comprehensive understanding of Chinese companies’ practices and processes from a sustainability perspective.
1 JPMAM’s assessment of companies using machine learning and analysis and its estimates and conclusions may not be effective in identifying risks and opportunities of companies. While the JPMAM looks to a variety of data inputs, JPMAM cannot guarantee the accuracy of its process or the reliability of data including information self-reported by companies.
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