Does Japan’s ESG Trend Go Beyond the “G”?

ESG integration has been a key focus of our Japanese equity manager research over the past year.

JULIEN BARRAL - DIRECTOR, EQUITY RESEARCH

The headlines have certainly been powerful. Abenomics policies over the past four years have placed strong emphasis on corporate governance – an area where Japan had a distinctly poor reputation relative to other developed markets, despite the reforms from 2002 onwards. This has produced greater scrutiny of how companies operate, how boards reach decisions, how the management are compensated and so forth. In parallel, the country’s mammoth Government Pension Investment Fund has made high profile steps towards ESG integration.

Indeed, the GPIF CIO Hiro Mizuno has rapidly become one of the world’s most prominent and outspoken voices on sustainable investing issues, supporting research initiatives (including a World Bank partnership), conferences and associations dedicated to the subject. So far the GPIF has backed the launch of the Nikkei 400, which rewards the best-behaved companies from a corporate governance standpoint, and invested in three other Japanese indices: the FTSE Blossom Japan, the MSCI Japan ESG Select Leaders and the MSCI Empowering Women Index. In late 2017, Mizuno announced to a PRI conference that the fund would “integrate ESG in every single investment” they make.

Latest ESG findings

How well do the recent news stories and pronouncements reflect the changing ESG practices of Japan’s active equity managers? In researching Japanese active equity strategies over the past year, the integration of sustainable investing principles has been one of our highest priorities.

Such analysis has revealed a substantial minority of equity managers that offer (we believe) very credible ESG integration, particularly on the corporate governance side. There is also some compelling evidence of successful impact as a result of such engagement, although relationships between asset managers and management teams are distinctly different in this region and some of the traditional resistance to shareholder influence persists.

Despite these encouraging developments, it should be noted that a similarly sized minority exhibit minimal integration of ESG, while approximately half of the group offer some superficial consideration – such as becoming signatories to the Principles for Responsible Investment (PRI) or subscribing to some external ESG data – but little or no formal integration in the investment process.

BFINANCE ESG SCORES, JAPANESE EQUITY MANAGER ANALYSIS FOR A EUROPEAN INVESTOR, MARCH 2018

Note: bfinance’s ESG scores are always customised to clients – the above analysis is specific to the ESG priorities of the European investor in question. For more detail on how managers’ ESG practices are assessed, contact us.

Caution about ESG in Japanese equities is particularly well founded when it comes to the “E” and “S” dimensions. While there have been great strides in corporate governance, broader environmental and social themes have not received a similar degree of attention, with the possible exception of gender equality. Few active equity managers in Japan appear to be addressing wider sustainability concerns such as carbon emissions in a material way. That small minority essentially comprised the larger global asset managers with a more international clientele - the likes of Nomura and Nikko. We are not yet seeing significant evidence that domestic Japan-only specialists are addressing these broader subjects.

There are a number of potential interpretations for the governance flavour of Japan’s recent ESG trend. One is that investors are very alert to the reputed governance inefficiencies in this market. Another is that corporate governance changes may represent ‘low-hanging fruit’: companies can obtain some quick, inexpensive wins here in contrast to environmental impact, where changes may be more demanding and cost-intensive.

A third possible factor is the influence of the US on the Japanese market. In the US, corporate governance has been at the forefront of the ESG conversation, while environmental and social issues have taken significantly longer to reach the mainstream. Even today, North American ESG policies and strategies are distinctly more governance-heavy than their European counterparts. Local Japanese equity managers do feature a rather large community of US-educated or US-trained portfolio managers, who may naturally have imported a more North American perspective on responsible investing.

A third aspect is the data challenge. As of 2017, 38% of firms in the MSCI Japan index received an MSCI ESG rating of A or above. However, the coverage of MSCI and other ESG ratings providers such as Sustainalytics is strongly tilted towards large cap stocks in Japan, while active managers invest a significant proportion off-benchmark. In addition, managers may have greater opportunity to exert ‘impact’ lower down the cap scale, where they can take more significant stakes.

GREAT STRIDES

The increasing focus on ESG factors in Japan is immensely positive for investors. The changes are particularly significant when considering the historical context. Earlier attempts at improving corporate governance had not delivered the results desired by government policy-makers, in part due to the entrenched nature of Japanese institutions known as the “community firm” dynamic (Ingami & Whittaker, 2005) – a concept wherein companies are morally obligated to take care of their employees and management rather than their shareholders. Environmental policies in the country have also been a subject of much criticism. “There is something distinctive about the Japanese’s relationship to the natural world,” writes Michael Booth in The Meaning of Rice, referencing Alex Kerr’s Dogs and Demons. “Through worshipping nature and the seasons, the Japanese also do everything they can to control the natural world. … Sustainability is not a word you hear much in Japan.”

Today, international investors seeking Japanese equity exposure with a strong ESG dimension already have a credible group of managers to consider. Yet the trend is still in its early stages. As Japan’s investors, led by GPIF, place more emphasis on responsible investment principles, this impetus will continue to drive ESG-oriented practices among the region’s equity managers.