What China’s Sustainable Development Ambition Means for Private Capital

The Chinese Communist Party’s fifth plenum showed sustainability will be at the heart of its economic development policies, but becoming a world leader on this front will require closer coordination between private and public capital

China’s declared interest in improving the quality rather than quantity of its economic growth, and fighting climate change as it does so, presents a unique secular growth opportunity for private capital. Coming out of the depths of the pandemic-induced crisis last year, China set an economic growth rate target above 6% for 2021. Opening this year’s National People’s Congress in March, Premier Li Keqiang announced the target would enable the country to “devote full energy to promoting reform, innovation, and high-quality development.” Market observers may peg the figure as “modest” or a “low bar” for the world’s second-largest economy, especially considering the blistering 8.4% real GDP growth forecast published by the IMF. 

That said, the political rhetoric highlights China’s continuing fundamental policy shift from growth at all costs, toward cultivating “high-quality” growth for future generations. What could this mean for private capital keen to tap into the future of sustainable development in the country?

A Tipping Point toward Sustainability
To answer this question, it is important to zero in on what a multi-faceted concept like “high-quality growth” means to the Chinese Communist Party (CCP). A widely publicized tipping point for policy transition came in 2014 during Premier Li Keqiang’s landmark speech where he criticized China’s “inefficient and blind development” and called upon the country’s citizens to declare war on rising pollution levels. Economic reform has since become a top priority for the country’s leadership, setting their sights on trail-blazing sustainable development efforts over the subsequent six years. 

Climate change has been high on the agenda ever since. At the 19th National Party Congress in 2017, the government stressed the need for the country to “take a driving seat” as “torchbearer” in the international cooperation to fight against climate change. As part of this, the CCP began to implement targeted plans to cultivate a comprehensive green finance initiative in line with suggested guidelines put forth by People’s Bank of China (PBoC) and six other government agencies a year earlier to fuel the sustainable transition. The PBoC defines “green finance” as financial services provided for economic activities that are supportive of environmental improvement, climate change mitigation, and more efficient resource utilization.

Sowing the Seeds of Private Capital in the Green Transition
To say the role of capital in China’s greener future is important would be an understatement. Around the time of the 19th Party Congress, BNP Paribas estimated that it would take around $247-468bn of annual investment from 2014 to 2020 to shift China’s economy toward the government’s sustainable vision of the future, with the vast majority (90%) likely to come from the private sector. The PBoC, on the other hand, pegged the figure needed for a green transition at a staggering RMB 2-4tn ($310-620bn) per year.

By some measures, the establishment of the green financial system in China has worked beautifully. Without a doubt, the “green bond” market has boomed to reach $165bn as of November 2020, up from less than $1bn at the end of 2014. Impressively, more than 80% of the existing green bonds were issued in the onshore market and, when looking at both onshore and offshore issuances together in 2019, they accounted for one-fifth of all new global green bond deals. There have been some growing pains – for example around the standardization of issuances and restrictions on the proper use of green bond proceeds, which allowed capital labeled as “green financing” to find its way into questionably green projects like “clean coal” – but things are improving quickly. In June 2020, the PBoC outlined the eligible use of capital proceeds for green bonds, setting the stage for more targeted capital flows into sustainability-oriented projects. While this is great news for financing a greener future for China, the country’s ambitions are only growing, and current capital flows will have a hard time keeping up. 

It is clear from China’s fifth plenary session of the 19th Communist Party Central Committee that the pandemic is accelerating many of the government’s original sustainable development plans. The plenum set the foundation for the country’s highly anticipated 14th Five-Year Plan (2021-2025) and strategic longer-term policy objectives. Committee members showed a renewed focus on domestic demand growth, import substitution, and technological self-sufficiency, which was largely expected by many market-watchers in light of ongoing US-China trade tensions. 

The plenum also expressed the need for faster progress toward a green economy and increased focus on climate change by 2035. It set higher standards for pollution, environmental protection, and improving the share of energy generation from non-fossil-fuel sources per unit of GDP. All factors that will require significant technological innovation, upgrading of existing infrastructure, and new models of doing business for the years to come. Surely, a very attractive proposition for patient capital providers.

However, few things captured global climate change headlines last year more than President Xi Jinping’s surprise announcement at a UN General Assembly in September 2020. Xi pledged that China would step up its efforts to reach peak carbon dioxide emissions by 2030 and achieve complete carbon neutrality before 2060 – a massive undertaking for a developing country responsible for around 30% of global emissions.

In line with these lofty new plans, China’s green financial system looks like it will face significant improvements in the short term. Central bank governor Yi Gang announced in April 2021 that the central bank will be encouraging all domestic financial institutions to transition toward green finance as early as possible to help the country reach its carbon neutrality goals. It will also unveil new tools to boost financing for carbon emission cuts. Most significantly, the governor mentioned that China was in the process of drafting new green financing standards this year to make it easier for foreign investors to enter the green finance market. This will be a boon to international capital flows in the coming years.

Investors have a significant opportunity to help China realize its goals. Reaching net zero before 2060 puts China on a growing roster of countries formalizing zero-carbon agendas, including the likes of Japan, South Korea, and members of the EU. However, given the country’s economic scale and stage of development, a lot of work needs to be done. This is opening a once-in-a-lifetime secular growth opportunity in support of decarbonization across renewable energy, electric automobiles, and energy storage – not to mention a whole myriad of emerging cleantech and business services supporting the coming transition. According to Goldman Sachs, cleantech infrastructure investment to get China to its 2060 target alone could require as much as $16tn, and add an additional 40 million net new jobs to the economy.

Global Investors Step up to Fill Capital Void
Asset managers and investors of all sizes have noticed the dire need for significant capital to satisfy the expanding sustainable development goals in China. In public markets, capital flows into environmental, social, and governance (ESG)-themed exchange-traded funds (ETFs) in China increased by 464% between 2018 and 2019, reaching a record $20.5bn in 2019, according to a study by China-based insurance company Ping An. Bloomberg Intelligence estimates that China is set to post the fastest growth in Asia for ESG investments, after the country witnessed an 18-fold increase in ETF flows in the past two years. China is expected to drive much of the interest in ESG-related ETF flows for the entire Asia region this year, and will contribute to a 20% growth in assets.

There is similar ballooning interest in ESG on the private capital front. The number of private capital fund manager signatories to the UN PRI in Greater China has increased steadily every year (Fig. 1). In 2020, the figure reached a record high of 52 fund managers – up from 44 in 2019, according to Preqin Pro. This is partly driven by institutional investors increasingly looking to Asia for diversification and return-enhancing investment opportunities for their portfolios, who are at the same time growing more interested in ESG.

Our Preqin Investor Outlook: Alternative Assets H1 2021 report found that over three-quarters (79%) of global investors surveyed in November 2020 said that demand for ESG had increased either modestly or significantly in the prior 12 months (Fig. 2). In addition, when asked why managers were establishing a policy, 78% said it was in response to their demands and 67% said it was to meet best practices in the industry. As for emerging markets presenting the best opportunities, China ranked the highest across five out of six primary alternative asset classes covered by Preqin.

Private Equity & Venture Capital: Leading the Green Pursuit
Private equity & venture capital (PEVC) has quickly emerged as one of the largest and most prominent alternative asset classes in China. So it should come as no surprise that PEVC is well positioned to help fuel the country’s green economic transition. As of September 2020, Greater China-based PEVC industry AUM stood at a record $1.01tn – registering a more than 20% increase from just December 2019, and a 4.5x increase in five years (Fig. 3). What’s more, fund managers are currently sitting on around $233bn in dry powder ready to be put to work across the country’s emerging investment opportunities.

As the Chinese Government’s ambitions have expanded, investment in sustainable companies in China has become more prominent. This has held true even through the uncertain climate brought on by the pandemic. Greater China-based venture capital and private equity-backed buyout deals in the sustainability technology/green energy sector both secured a record amount of aggregate deal value in 2020. VC deals saw a significant spike, climbing to $10bn last year – up more than 75% on the $5.7bn transacted in 2019, even though only 70 deals reached completion (Fig. 4). 

On the buyout front, PE fund managers have seen a steady rise in investment flows since 2018, reaching an all-time high last year, with four completed transactions worth a combined value of $3.2bn (Fig. 5). Both charts highlight that PEVC fund manager interest in the sector rose in the past few years – right around the time China’s policy stance became explicitly greener and more proactively supportive. 

It is important to note two points when comparing deal numbers for PE and VC in Figs. 4 and 5. First, the developing nature of China’s economy and the maturing nature of its PEVC industry mean that late-stage buyout activity is still emerging. Second, China has seen a boom in investment activity across the digital economy in recent years, and sustainability technology is a new industry favoring earlier-stage investments. As things progress, we expect fund managers to become increasingly active across the sustainable technology and green energy sectors, allowing for more dynamic investment activity across various stages of the investment lifecycle. 

While prospects are good for the PEVC industry in China, much more needs to be done to make a dent in this $16tn green transformation. Thus far, surging AUM figures and record deal activity in sustainable pursuits barely moves the needle in terms of China’s overall capital needs. To accelerate progress and make good on the country’s 2060 net-zero pledge, deeper coordination between public and private capital markets will be required. Plus, the government will need to ensure fiscal spending is highly targeted and quickly deployed to reach its lofty sustainability goals.

In short, there is no lack of domestic financing demand going forward. China is at the start of a journey that will rewrite its entire economic development model from the ground up, all while finding a balance between the consumption needs of current and future generations. There will likely be setbacks and policy pivots along the way as China’s leadership recalibrates and optimizes its efforts; fund managers will have to settle in for the long haul to reap the rewards.

Practical Challenges Remain in the Face of Opportunity
There is significant opportunity for private capital to fuel China’s expanding sustainable development plans, but practical challenges remain. Adoption of standardized ESG data and indicators to facilitate capital flows is hard enough at the global level. This is doubly difficult when one tries to adapt these factors to China’s local context, given its unique policy and business environment. Also, ESG reporting and disclosure requirements are still a relatively new concept even in public equity markets and are not yet mandatory in China. This means that the general acceptability and proficiency of ESG concepts across the entire capital market is likely still at an early stage. However, this looks to be changing quickly in favor of supporting ESG adoption.

As of mid-2020, 1,021 Chinese A-share companies – those listed in RMB on the Shenzhen and Shanghai exchanges – had published annual ESG reports, up from only 371 companies in 2009. These firms make up around 27% of all A-share companies and a whopping 86% of CSI300 A-share companies (a group of the 300 largest, most liquid A-share stocks), highlighting significant ESG adoption among the most influential listed companies in China. This is measurable progress and establishes a solid foundation for further ESG uptake among businesses, as well as expanding general awareness of these issues across the domestic financial services industry.

The future is bright for ESG in China. If this trend of adoption persists among high-profile companies, there is a good chance best practices will spill over into the rest of the public equity market, and eventually enhance efforts in the private deal-making domain. Companies and fund managers will likely become familiar with and buy into ESG data collection, reporting, and dissemination. 

Reaching this point will mean more investment opportunities across the entire investment lifecycle in China’s sustainability sector, from early green technology innovators to more established renewable energy providers. It could also create competitive advantage over more traditional peers. Those domestic and international fund managers that possess specialized expertise in helping companies navigate sustainable transformation projects, or those that can effectively leverage ESG data in due diligence processes, could carve out a unique place in the market. 

We remain optimistic about China’s economic transition toward sustainable development, and the growing role of private markets in this endeavor. To accelerate this evolution, and achieve the country’s aspiration of leading the world through the Fourth Industrial Revolution, pushing through supportive policies that prioritize ESG transparency will be key.