CASE STUDY

Impact of Climate Risk Factors on China A-Shares Valuations

ABSTRACT

An increasing number of companies have embraced ESG, and an increasing number of investors have focused on the ESG impact behind their capital allocation decisions. To date, however, the prior academic literature has not distinguished the useful environmental indicators in China A-Shares market. We investigate the effect of environmental indicators on the valuation multiples. Using a normalized sample of 222 Chinese companies co-listed in China A-Shares and MSCI China Index, we find most of the environmental indicators are statistically significant. Total GHG CO2 Intensity per Sales and Percentage of water recycled have significance in determining P/B value. We also find that the higher the government involvement, the higher the energy inefficiency and the GHG CO2. These results speak to the significance of environmental factors in company valuation in China A-Share market, and also have implications for asset managers who have committed to the integration of environmental factors in their capital allocation decisions.

INTRODUCTION

Since the turn of the millennium, the world appears to have increased its commitment to sustainability and future growth. Closer to home, recognising the intensity and the severe consequences of climate risk the Chinese government has laid a very ambitious plan. China’s 13th Five-year plan targets a carbon intensity reduction of 18% and energy consumption cap of 5billions tons of coal equivalent for 2020. By 2030 they target to have 20% renewable energy and reduce the carbon intensity by 60%. These targets are critical given the role of China. According to BP Statistical Review of World Energy, in 2017, China is the most significant contributor to GHG global emissions holding 27% of the total, followed by USA and India with 15% and 7% respectively. Currently, in China, one of the most critical restricting factors on economic development falls into the scarcity of the natural resources resulted from resources imbalance and industrial pollution which alarmed the government and public. Take the water risk, in China alone, around 145 million people are at exposed to flooding risk due to sea-level rise. Even more acute is this issue in the Guangzhou area and surroundings due to the very high concentration of human and economic capital. The societal and economic implications are unmeasurable.

With the growth of the Chinese economy and opening-up procedure in the Chinese market, domestic and foreign investors could no longer ignore environmental risk. With the inclusion of Chinese A-share stocks into global equity benchmarks, asset owners must assess whether standard systematic approaches to mitigate risk and generate excess equity returns are equally valid in China. These environmental risks are underappreciated and have soon started to unfold. Significant spending on sustainable infrastructure and government incentives would be in need to meet emissions-reduction targets. These would present considerable investment risks and opportunities through tightening regulations, changing consumer preferences and disruptions caused by the advancement in technology.

Betting on better risk management and alpha generation, over the past decades, one of the most critical trends in portfolio management has been the incorporation of Environmental, Social, and Governance (ESG) data that integrate a measurement system to capture potential inequalities, social risk, and long-term performance. ESG is more than just an ethical way of investing. ESG can enhance the portfolio by substantially reducing volatility, increasing Sharpe ratios and limiting drawdowns and have some merit as standalone alpha sources according to Friede et al. (2015). Using a comprehensive meta-study, they conclude that in 90% of the cases there is a nonnegative correlation between ESG and company financial performance. As for individual studies just to mention a one or two, companies that perform high on environmental indicators, achieve a cost of equity (Goss 2011) and the cost of debt reduction Gupta (2017). Further, a 25% reductions on carbon emission per sales reduces the cost of equity, on average, by 0.4 basis points (Trinks et al., 2017). Oikonomou et al. (2012) find a negative (positive) relation between systematic risk and a measure of aggregate strengths (concerns) for S&P500 firms. They also find that community, employment, and environmental concerns are significantly and positively related to systematic risk. And the list continues.

While there is a growing body of evidence on risk/return impact of environmental factors, the results tend to be either weak or confusing. This is because too much focus is given to the model or robustness check, with little understanding of the indicators to be used, the data collected and the method to aggregate to date from the providers. The same type of indicator is very often measured in different ways, resulting in different meaning and conclusions (Gonenc et al. 2017). To avoid dubious results we employ widely used and quantifiable indicators, rather than ratings (such as ESG score) that often include activities that have no financially material implication on company level.

The primary objective of this study is to answer the following questions: What works and what does not when it comes to physical climate risk, closely related to environmental factors investing in China? Is there statistical importance of specific environmental indicators towards company financial performance in China A-Shares? Most of the indicators are industry-specific, hence what would happen if we normalize per sales and control for the industry as well?

We show that there is indeed a statistically significant relationship between physical climate risk capture by environmental score (E-score) and company financial valuations. Furthermore, the most striking result is that the most GHG polluting and most water-intensive companies are also the ones with the highest government ownership (%SOE). Last, we believe that most of these risks are currently not prices, giving rise to opportunities in certain sectors.

DATA AND SAMPLE DESCRIPTION

MSCI China A-Shares Index companies are all part of China A-Shares Market. As such they enjoy high market capitalization, and many other intangible elements such as the accessibility to foreign markets, and connections with the government among others.

The industry group is classified under the guidance of the Global Industry Classification Standard (GICS®). Our sample constitutes 221 Chinese companies co-listed in China A-Shares, and MSCI China Index deemed to be the most liquid among the China A-Shares. There are eleven industry sectors: (a) Communication (b) Consumer Discretionary (c) Consumer Staples (d) Energy (e) Financials (f) Health Care (g) Industrials (h) Materials (i) Real Estate (j) Technology (k) Utilities. Table 1 present the sectors and the number of companies in each sector. The largest concentration of companies is found in Financials and Industrials with 55 and 41 companies respectively. The lowest is in Communication with only 4 companies.

COMPANY VALUATIONS DATA DESCRIPTION AND ANALYSIS

The valuation multiples we choose are a price to earnings (P/E) and price to book P/B ratios. P/E ratio is an equity valuation multiple. It is calculated by dividing the market price per share by earnings per share (annually). It facilitates comparison between different companies within the same industry. Higher P/E ratio is often associated with growth stocks that are developing faster than average, which attracts investors. Lower P/E ratio often attracts the investors interested in investing in value stocks as low P/E ratio represents that the stock is available at a cheap cost. The other valuation multiple we use is the P/B ratio. The P/B multiple offers an insightful perspective on how the market evaluates a company's assets, comparing to its earnings. This makes it particularly useful for valuing firms with significant financial assets.

P/E and P/B ratios include information about other factors such as earnings turnarounds, growth prospects, and proportion of debt, management efficiency, and investor sentiments. We improve the measurement by normalizing the P/E and P/B ratio using the MSCI China Sector Average P/E (P/B) score based on MSCI Onshore China A Index as benchmarks.

We also collect and analyze the % Div. Yid per Industry (Average Dividend Payout Ratio of that industry) as a signal of investors’ preference on short-term cash inflow in the form of dividends or long-term stock price appreciation due to the growth funded by retained earnings. Anecdotal evidence indicates that the state companies in China are more inclined to operate in an environment with the absence of hard budget constraints and which is replete with moral hazard.

Last but not least, our analysis takes account of Average Ownership Ratio (Percentage of State-owned % SOE) as the Government Ownership Proportion in Terms of Equity in each company. Given the top-down ESG approach in China, we believe that that is an essential driver of environmental and social policies implemented on the company as well as on countrywide level. It is also a factor to be priced in company valuations given its importance in the decision-making process on the board level.

Table 1: Sectors and companies in each sector (There are 11 sectors and 222 companies overall). P/E and P/B ratios are normalized per each sector — data as of July 2018.

To illustrate valuation multiples across different sectors, we compare the normalized P/E ratios and P/B ratios. In particular, we see IT Sector owns the highest industry average P/E while Financials owns the lowest. In terms of P/B, Consumer Staples sections ranked as the top while Industrials is the lowest. 55 companies have been included under the Financials. On the contrary, only four companies have been listed under the Communication sectors. Among all the companies we’ve compared, Energy Sector owns the highest average ownership ratio which aligns with our expectation.

Figure 1: Cross-Industry Comparison, China A-Shares Market, LHS: P/E, Div Yid%; RHS: Average Ownership Ratio. In brackets is the number of companies per sector. Normalization as of July 2018.

For China A-Shares included in the MSCI index, the relation of the average ownership ratio is adverse to the company valuations captured by P/E ratio. Put it differently, the more independent the company, the higher the valuations. For example, Information Technology and Consumer staples with the lowest ownership ratio (10-20%) enjoy the highest P/E valuations (~30). The opposite is true for Energy, Communications and Industrials.

COMPANY ENVIRONMENTAL DATA DESCRIPTION AND ANALYSIS

This section aim at analyzing the potential relationship between the environmental factors and company valuation as well as the role/influence, if any, of the government ownership ratio.

Bloomberg has been adopted as the data provider for the environment indicators (E-scores). Based on BlackRock’s model and the emphasis outlined by the Chinese government’s Five-Year Plan, five indicators are chosen to quantify the environment risk (i): CO2 (Total GHG CO2 Emissions Intensity per Sales), Energy (Energy Intensity per Sales), Water (Water Intensity per Sales), Waste (Waste Generated per Sales), Recycled (Percentage of Water Recycled). The first four indicators are divided by total sales which stands for a good proxy for efficiency rather than the absolute level.

Table 2: Cross-Industry comparison of environmental indicators. CO2, energy, water and waste are reported as total number per sales. For example, CO2 is the total GHG emission divided by Sales. The recycled indicator is in percentage only.

Table 2 shows how these indicators behave across different sectors of MSCI China A-Shares companies. Sensitive industries perform a higher level of climate-related risk.

  1. None of the 4 companies in Communications sectors reports the key environmental indicators
  2. Consumer discretionary and Industrials pollute the most in terms of CO2 emissions. This result is consistent with the ones reported in Trinks et al., 2018. Working on a comprehensive sample of 1600 firms, from 43 countries with data of 2008-2016, they also found that the Industrials and Consumer goods sectors are the highest CO2 emitting industries.
  3. Utilities and real estate are the least efficient in terms of energy use while Materials and Utilities are the least efficient in water usage. This is important in light of hefty fines and stricter regulation in China due to high water scarcity and water pollution.
  4. Materials are also the sector with the highest waste per given sales.
  5. Overall, materials and utility sector have the highest environmental risk in China.

While some researchers argue that sensitive industries produce better ESG performance (Sanches, 2017), it may not be the case in China. Since the overall disclosure is scarce, there is little incentive for the companies in sensitive industries to disclose and improve their environmental performance in order to maintain or improve reputation. This simple analysis has important consequences: Investors looking to put money in these sectors, need to quantify, price and undertake stress scenarios and proper risk analysis to understand environmental risk in their portfolios better.

Getting more granular, within sectors, the company environmental performance, hence indicators (E-score) should be evaluated at a relative horizontal level, i.e. peer comparison. This is because the central added value of E within the ESG investing comes from how well the firms managed their industry-specific environmental risk while controlling for the differences of regulations, market landscape and operational risk level across industries. Consequently, based on the ESG data provided by Reuters, we normalize each environmental score.

Thus, environmental leaders and laggards in sectors could be identified. Except for % Recycled, the larger the level of the score, the higher the level of the environmental indicators used and therefore the higher the climate risk the company holds.

RESULTS AND INTERPRETATIONS

In an attempt to explain the statistical importance of the above environmental (E-score) indicators on P/E and P/B ratios of the firms listed in China A-Shares, we firstly ranked the stocks of the entities we’ve chosen in descending order according to a specific E-score. The lower the E-score, the better is the company managing its environmental risk and more specifically the physical part of climate risk. Two groups are established by taking out the first quartile (top 25% in the specific E-score) and the fourth quartile (last 25% in the specific E-score). We then calculate the mean and the standard deviation for each quartile. Finally, we make use of the difference in means methods to conclude whether there is a statistically significant difference between the two groups/quartiles.

TOTAL GHG CO2 EMISSIONS INTENSITY PER SALES

We analyse the Total GHG CO2 Emissions Intensity per Sales (CO2) versus the P/E and P/B ratios. Given that some companies do not report any data on this specific, our sample shrinks to 14 companies, 7 with high CO2 versus 7 companies with low CO2 emissions. Our first hypothesis is as follows:

Where n is equal to seven, in this case, the resulting t-statistics on , is 11.26 which is higher than 2.02 (for small sample size). Thus the null hypothesis can be rejected at a 90% significance level. It can be concluded that is statistically different among the top 25% quantile and the last 25% quantile.

Similarly, our second hypothesis test the significance of the mean difference of P/E and P/B ratios between top versus bottom companies. When comparing the companies ranked on the top 25% and the last 25% of the , the difference of mean t-statistic on P/E ratio and P/B ratio is -1.38 and -2.05 respectively. Hence at a 90% confidence interval, the only valuation captured via P/B is statistically different. From valuations perspective, it indicates that polluting companies have a lower price to book ratios.

Table 3: T-statistics and top/last quartile stocks in China A-Shares market ranked based on CO2 Intensity per Sales as our chosen environmental indicator

We analyzed 222 China A-Shares companies part of the MSCI EM Index. The data are as of July 2018. The P/E and P/B ratios are normalized per sector. Div. Yid. % is the sector average Dividend yield. Government Ownership is reported in the third column. We ranked the companies based on CO2 per given sales normalized per industry level as well (CO2 Industry Normalized). We then calculate the difference of means to find if there is a statistically significant difference between top versus bottom quartile companies in terms of the environmental indicator and financial variables presented in Table 3. We find that the difference of means is significant in terms of CO2 Industry Normalized usage, ownership ratio and firm performance P/B ratio. It is nonetheless not significant for the P/E ratio. The significance of the difference of means is measured via t-statistic T0 at a confidence interval of 99%, 95% and 90% and represented with (***), (**) or (*) respectively.

Furthermore, there is a statistically significant difference in the ownership ratio between top versus bottom, implying that the polluters tend to be mostly state-owned enterprises, operating in an environment that lack hard constraints. Thus, the message is clear, avoid companies with large government ownership as they tend to be the biggest polluters in GHG emissions and have a lower valuation in terms of P/B ratios.

We do similar analyses for other KPIs such as energy per sales, percentage of water recycled and waste management. Overall, CO2 pollution and energy efficiency, enjoy the most robust results. The least performing companies on energy and CO2 emission (top quartile), are also the ones characterized by high government ownership and from a low financial valuation.

We see no clear relationship between P/E ratios and Percentage Dividend Payout with any of the five E indicators we selected. Our interpretation is that, as an emerging economy, China share market shows anomalies. Strict constraints, common trading suspensions, and segmented share classes negatively impact pricing formation and market liquidity. Additionally, preferential differences of Chinese investors, valuation and investing process shape the unique Chinese market. The concerns on environmental issues and sustainable development are still at the very early stage comparing to the growth prospects. Furthermore, limited dissemination of companies’ information does not attract the attention of investors and financial analysts. Hence, the effect of environmental performance may have not substantially integrated into the firm value and unable to be reflected on certain valuation multiples.

IMPLICATIONS

With the development of ESG investing across the globe and the rising heated discussion on sustainable development led by the Chinese government, the environmental factors are closely watched both domestically and internationally. At the same time, the opening up of China A-Shares market has created a new dimension of complexity for those who seek to understand the behaviour of these factors in the Chinese market.

This paper analyzed 222 companies that are part of the MSCI China A-Shares Index. In the light of increased market awareness on climate risk, we studied the relationship between specific environmental factors and company valuations. For the environmental factors, we use the following indicators: CO2 (Total GHG CO2 Emissions Intensity per Sales), Energy (Energy Intensity per Sales), Water (Water Intensity per Sales), Waste (Waste Generated per Sales), Recycled (Percentage of Water Recycled). To avoid sector biases and the noise in the data, we normalize the score using the industry average. Similarly, we also normalize the two financial valuation ratios under consideration, P/E and P/B ratios.

The first level results show that certain sectors such as consumer discretionary and industrials are the most polluting in terms of CO2 emissions (utilities not reporting on this indicator), while real estate and utilities are the least efficient in energy usage. Utilities top the rank again along with materials in terms of as substantial water usage. The figures in waste and recycling are more difficult to compare due to a large number of companies not reporting on these indicators.

The second-level analysis ranked the companies on our four environmental indicators. The difference between top-quartile companies (the most air, water-polluting and energy inefficient) to the bottom quartile companies (less air, water-polluting and more energy efficient) is always statistically significant despite the narrow sample size of 222 companies. More importantly this difference it is not driven by market capitalization as one would expect and prove for ESG score in general, but a lot correlated with % government ownership in these companies.

We see a significant difference in the % government ownership and normalized financial valuation P/B ratio between high-quartile of CO2 and low-quartile of CO2. The same holds true for the Energy Intensity per Sales.

Intuitively, SOEs incline to operate in an environment in which there are no hard budget constraints. However, on the policy front, we expect environmental law reforms will set a price on pollution and CO2 emissions. It will introduce more costs for polluters, which is a particular concern for SOEs that historically shows 3 times higher average value of penalties, and 4% lower average net margins, than private-sector peers according to the MSCI 2015 report. Thus, energy efficiency can’t be ignored by SOEs anymore. Taken together with regulatory oversight over pollution across China at this time, these indicators represent a red flag. If the companies stay unchanged and operate with low efficiency, they are not likely to afford the increasing costs and would be most impacted by the environmental reforms, which should arouse investors’ attention.

Our third level analysis ranks companies according to environmental performance. It reveals significant differences between the top tier companies and bottom-tier companies. In particular, when controlling per Total GHG CO2 Intensity per Sales and Percentage Water Recycled, the difference in valuation as capture by P/B becomes significant. These results speak to the significance of environmental factors in company valuation in China A-Share market and have implications for asset managers who have committed to the integration of environmental factors in their investment decisions. The interpretation has been offered and focused on the current market landscape of China and the investors’ appetite.

On a final note, for China A-Shares market, the ESG and climate risk literature is scarce, and the knowledge between financial performance and ESG factors remains fragmented, on which further analysis could be conducted. Picking up on our analysis and upon the availability of more data, it would be interesting to find the impact of each of this indicators on the firm cost of equity, cost of debt, on risk and finally explain any related mispricing or just the lack of pricing.

Besides data, the role of environmental indicators on the company’s financials strongly relate to country effect and industry characteristics. While we try to control for the later one, by normalizing it, the country effect is relevant given significantly different regulatory and market environment. For example, we expect that high CO2 emitting and water-intensive companies in China should be associated with a higher cost of capital and lower valuations than otherwise. Firmly believing that as these risk factors are not priced in yet, from the asset manager and owners perspective there is ample room for market opportunities and portfolio enhancements. This aligns well and should be the base for a smarter and more efficient funding mechanism toward a low-carbon economy.

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