CFA Institute extends its appreciation to Chan Fook Leong, CFA, for authoring this post.

State-owned enterprises (SOEs) have been criticized for poor governance and questionable efficiency. But in a recent paper titled “Leviathan Inc. and Corporate Environmental Engagement,” Pedro Matos, from the University of Virginia Darden School of Business, Po-Hsuan Hsu from the University of Hong Kong, and Hao Liang from Singapore Management University share the results of an international study they conducted on the impact of state ownership on a firm’s engagement in environmental, social, and governance (ESG) issues.

Matos presented the findings at a seminar held 6 June 2017 at HKU SPACE in Hong Kong. The video and presentation of the event are available online (login required).

Tax as the Standard Policy Solution to Combat Air Pollution

Pick up any college economics textbook, flip to the chapter on market failures, and look under policy solution. Invariably, you will find tax as one of the solutions.

Standard economic theory dictates that the free market is prone to market failures, such as air pollution. When it comes to Adam Smith’s model of the free market, firms have one sole objective — to maximize profits. Firms will pull scarce resources to produce goods. They will pay for rent, wages, and raw materials as they are needed to produce finished goods. If they do not pay wages, no one will turn up at the assembly line. Nonpayment for raw materials also means production will not start. But there are additional costs (known as externalities in economics) to society in producing finished goods, such as damage to the environment in the form of air pollution.

Will firms pay for this damage to the environment? Based on the assumption of firms maximizing profits, the answer is no. This then results in a suboptimal outcome to society — for example, people have to wear masks outdoors in a few Asian cities. Hence, governments need to step in to rectify the situation by imposing a tax to ensure firms take into account the damage to the environment. When this happens, production is reduced, pollution levels fall, and welfare is maximized.

SOEs as an Alternative to Taxing Firms

SOEs are companies in which the state is a significant shareholder. In emerging markets, such as China, Brazil, and India, SOEs account for a significant share of gross domestic production. In China, SOEs represent 65% of market capitalization on the stock exchange. In many revenue ranking exercises, SOEs pepper the global top 30 list; Petrobas in Brazil, Industrial and Commercial Bank of China, and Gazprom in Russia are a few examples. These are huge companies forming “Leviathan Inc,” as the Economist has labeled them.

When SOEs take into account the cost of environmental damage in production, the end effect is similar to that of a tax on pollution. Dr Matos said, “the alternative way [of combating environmental costs] is the one we are examining here… [and] is by the government conducting business itself (SOEs).” Emerging countries may have to depend on SOEs to mitigate environmental externalities if there are inadequate institutions in a country or incentives for the private sector to do so.

SOEs Leading the Way in Environmental Engagement in Asia

The green tech race is a race to move transit to clean technology, reduce fossil fuel emissions, and limit climate change. China is at the forefront of investing resources into green technology (the United States is number two) and increasingly issuing green bonds to finance them. And SOEs in China are tasked to pursue public interest with regard to environmental engagement.

But in the developed world, the private sector is in the driver’s seat when it comes to the green tech race. Such firms as Tesla have invested billions in electric cars, lithium-ion batteries, and solar panels. One of the contributing reasons for the private sector leading environmental engagement in the developed world is because there are significantly fewer SOEs in developed countries. Many developed countries pursued privatization of national firms many years ago, under leaders like the late British Prime Minister Margaret Thatcher, who was a firm believer of the free market. She saw privatization as fundamental to improving the efficiency of the British economy.

Positive Correlation between SOEs and Environmental Scores

Matos, Hsu, and Liang looked at data collected by Thomson Reuters ASSET4 ESG database for firms in 45 countries during 2004–2014. The trio found that SOEs score highly on environmental performance. Matos explained, “The environmental pillar measures a company’s impact on living and non-living natural systems, including the air, land, and water as well as complete ecosystems. It reflects how well a company uses best management practices to avoid environmental risks and capitalize on environmental opportunities in order to generate long-term shareholder value.”

Labeled the ENVSCORE, it is made up of three data points: (1) emission reduction (ENER), (2) product innovation (ENPI), and (3) resource reduction (ENRR).

The team of researchers found the environmental engagement stronger for the following firms:

• Those with direct domestic state ownership rather than firms with sovereign wealth fund ownership, possibly because of the state “requiring” management to solve urgent air pollution issues that are choking residents in cities where the SOEs operate. The same is not required for SOEs operating in a foreign country, although sovereign wealth funds may be more focused on financial returns and hence do not impose the requirement of preserving the environment.
• Those from emerging economies, such as countries in the Asia Pacific.
• Those from countries that lack energy resources.
• Those from countries that are in conflict with neighboring countries

The study also found that higher environmental engagement does not destroy shareholder value.

SOEs Social and Governance Integration

The team of researchers also used Thomson Reuters ASSET4 ESG database to look at social engagement (SOCSCORE) and governance (GOVSCORE) issues. The dependent variable GOVSCORE for SOEs was not significant, which is in line with the perception of most investors that SOEs do not score highly in corporate governance.

But the dependent variable SOCSCORE was significant for SOEs, implying they were relatively more engaged in the social aspect. This finding is indeed a plus for employment quality, health and safety, training and development, diversity, human rights, and community and product responsibility, which does not always rank highly in Asia-Pacific countries.

Matos concluded, “SOEs have a bad [reputation], particularly in the Western perspective; this is one aspect [SOEs looking after the environment] that partially offsets it… so the policy implication here is that…there is some leading role for SOEs.… There seems to be some evidence in our study that suggests that they are better in resolving this bad or negative consequences of business, which might be pollution, or which might be climate change, etcetera.”

The modern Asia-Pacific SOEs have emerged to be more effective than their private counterparts in dealing with market failures, especially in the case of environment externalities, and without necessarily sacrificing shareholder returns. Who, indeed, would have thought of that.

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