The escalating tariff war between the world’s two largest economies isn’t just hurting Chinese investment in the U.S. It may lead China to abandon its baby steps toward adopting ESG principles.

Chinese direct investment in the U.S. has plunged 90% — to $5 billion last year from a record $46 billion in 2016, according to the Rhodium Group. Silicon Valley startups looking for cash are feeling the pain.

Such direct effects are easily noticed. Harder to judge is the trade dispute’s collateral damage, especially when it comes to China embracing ESG. The country’s largest private firms and state-owned enterprises are only starting to integrate ESG principles into their operations, and some fear the movement will be blunted if tariffs lead China to abandon global best practices in a quest for self-sufficiency.

Drivers Beware

Several factors are driving the country’s progress on environmental policy. At the forefront is fear of a popular backlash and unrest after decades of appalling air pollution, scandals involving poisoned food products, toxic waterways, and other threats to quality of life. China also wants to reduce dependence on oil imported from the Middle East, which traverses shipping lanes that are vulnerable to disruption.

But growing importance to investors in the developed world of ESG metrics has raised the cost of portfolios shot through with high-carbon footprints, labor abuses and poor safety records.

“The trade war complicates this picture since it could encourage Chinese officials to double down on growth,” says Rachel Ziemba, CEO of Ziemba Insights and an adjunct fellow at the Center for a New American Security. She notes that investors act independently from governments in most cases, and that sovereign wealth funds in Europe and the Gulf also have leverage. “I don’t think this is the end of ESG-related matters.”

But the west’s leverage, never decisive in fast-growing China, is now divided. Rhodium’s report makes the same point. “Aggressive U.S. unilateralism and defensive policies towards China are polarizing other members of the Organisation for Economic Co-operation and Development (OECD),” the report says, with some wanting to coordinate with U.S. trade demands, and others pushing back just as aggressively – as France did in rejecting U.S. demands that allies steer clear of 5G networking equipment built by Huawei.

Make China Great Again

Even if the ESG movement falters within China, the country will still lead the world in some environmental areas. China is the world’s biggest producer of solar and wind power and related technologies. It has launched an electric-vehicle program that will easily make it the leading producer of low-emission vehicles by early in the next decade.

And the Trump administration’s abdication of global leadership on climate issues has given China a rare chance to play the geopolitical adult in the room, an opportunity Chinese leader Xi Jinping has played with particular relish in Europe and among his fellow BRICS (Brazil, Russia, India, China and South Africa).

ESG has only recently appeared on the radar of Chinese policymakers and business leaders. In 2017, the UN-funded Principles for Responsible Investment, a leading ESG watchdog, appointed its first chief China officer, Nan Luo.

Speaking to the South China Morning Post last year, Luo said Chinese leaders have taken note of the pressure ESG players like Western and Japanese pension funds and sovereign wealth funds can exert. But, she said, “they are concerned that including ESG factors into investment decisions may negatively affect returns and restrict their investments … many also do not feel comfortable disclosing information on their progress on this front.”  

As an illustration of how nascent ESG is in China, PRI has only 21 signatories from among the country’s tens of thousands of manufacturers and other corporations, according to PRI statistics. Notably absent is China’s huge SWF, China Investment Corporation (CIC).

One Belt, One Load of Carbon

It’s on CIC’s turf  – overseas – where China’s claim to climate leadership looks a lot like greenwashing. Ziemba, who advises firms on doing business in China, says “Chinese companies seem to be following western countries’ lead and exporting their emissions and heavy polluting industries and some of their weaker labor practices, especially in South East Asia and East African countries like Ethiopia.”

Across Asia and Africa, hundreds of new global coal mines and power plants are funded by Chinese state money.  “These coal plants being built externally don’t live up to the guidelines for domestic plants in China,” Ziemba says. “And obviously, it doesn’t live up to the green rhetoric we hear from Beijing, either.”

China’s “Belt and Road” strategic infrastructure initiative, which Chinese leader Xi loves to characterize as a macro EM anti-poverty program, is in some ways the antithesis of ESG. Mahathir Mohamad, the prime minister of Malaysia, has described BRI projects as a form of “new colonialism.” Corruption and the  possibility of a “debt trap” that leaves important infrastructure – like Sri Lankan naval bases – in Chinese hands is one well-publicized risk.

Less publicized is the risk of environmental devastation. The Environmental Energy and Study Institute concluded the initiative will produce “irreversible damage” to Earth’s environment as armies of excavating workers, usually exported from China, carve new railways, roads, tunnels, ports and pipelines across the map of Eurasia and beyond.

Xi and President Trump are set to meet at the end of June at the G-20 summit in Japan.

Regardless of whether a trade deal is reached, the incentives for China to encourage ESG compliance may have been severely damaged already and could disappear entirely.

The greatest danger here is that China could ultimately conclude that growth at all costs is the only policy that makes any sense. Given the enormous stakes involved, even if Trump wins his tactical trade battle, the world may certainly lose the larger war.