Contributed

Feature 1: Is ESG investment going to end with a boom?The Essence of ESG Investing and Prospects for the Future

Managing Director, Head of ESG Research Center
QUICK Corp.

Etsuya Hirose

Profile
Mr. Hirose joined QUICK Corp. in 1984. He worked in business planning and marketing of services for European asset managers and pension funds in Zurich and London. After his return to Japan, he focused on business planning and development of services for asset management operations. He was appointed as Director of QUICK Corp. in 2013. In 2014, he established the ESG Research Center and was appointed as its Head (current position). That year, Mr. Hirose served as the head supervisor of survey and research operations entrusted by GPIF. In 2016, Mr. Hirose was appointed as Managing Director of QUICK Corp. He has delivered a number of lectures on ESG at seminars for institutional investors and companies at PRI, RI Asia, CDP and other forums.

Introduction

In the past year, the phrase “ESG investing” has been appearing in the news media and other sources much more frequently than before. Feature articles on ESG have been carried not only by trade journals and business dailies, but also by ordinary newspapers. The prevalence of this phrase alone suggests that ESG investing is steadily catching on among the public. Just three years ago, many people were puzzled by unfamiliar phrases such as “Stewardship Code” and “Comply or Explain” and by how they work. Today, these concepts have become well established. On May 29, 2017, the Financial Services Agency of Japan finalized and published an amended version of the Stewardship Code, three years after it was first issued.

During this time, ESG investment in Japan has even started to attract interest from abroad as a result of the tremendous efforts of various stakeholders and other related parties. This development is to be welcomed wholeheartedly, but one concern does come to mind. Will this rapidly accelerating trend come to an end as a popular fad, as has often been the case with so many trends ending in failure in the past? Even with the immense potential of ESG investing, the buzz words alone can take on a life of their own and mislead people, or ESG investing could be presented as an inward-looking framework, when it should always be considered from a global perspective. It is also possible to lose sight of the essence of ESG investing as short-term profits and complacency take precedence over real substance. With expectations running so high, the fallout from such setbacks have stood out in the past, and people have been disappointed by the gap between their expectations and the reality.

Japan is currently at a crucial juncture for ESG investing to truly succeed. In order to ensure that it does not end up as a mere passing fad, we must carefully consider the importance of targeting the sound growth and penetration of ESG investing. In this article, we will seek to impart an understanding of the essential meaning of ESG investing and responsible investment and to discuss its prospects for the future.

GPIF Becomes a Signatory to PRI

Ten years have passed since the launch in 2006 of the Principles for Responsible Investment (PRI), which embraces ESG as one of its principles. In the global asset management sector, the balance of assets held by signatories and their institutional investors has steadily continued to increase (Chart 1).

(Chart 1) Trend in the Number of PRI Signatories and Assets Under Management
graph

Source: PRI Annual Report 2016

In Japan, where the number of signatories had previously been relatively low compared with the size of assets, the heightened presence of PRI in the country was undoubtedly triggered by the signing of the PRI by the Government Pension Investment Fund (GPIF) in 2015. In the year before that, GPIF had announced its acceptance of Japan’s Stewardship Code, which shares the same basic concepts as PRI, and had been promoting activities in line with the Stewardship Code. GPIF has swiftly and proactively implemented and pushed ahead with these activities, including setting up the “Business and Asset Owners’ Forum” and the “Global Asset Owners’ Forum” and establishing the “Stewardship & ESG Division.” The signing of the PRI was an integral part of these efforts. At the PRI annual conference in September 2016, which was held one year after the signing, GPIF Executive Managing Director and CIO Hiromichi Mizuno ran for office in the PRI Board Election from the asset owner category, and was elected and appointed as a board member of the PRI Association. I personally attended the speech given by Mr. Mizuno when he announced his candidacy at a venue in Singapore. The content of the speech was indeed appropriate to a board that serves as a global leader of responsible investing. GPIF has also been devoting energy to strengthening collaboration with stakeholder bodies and institutions worldwide. Since signing the PRI, GPIF has been stepping up activities to drive ESG as one of the world’s largest asset owners. These type of actions by the GPIF have been serving as a driving force in Japan, paving the way for the widespread familiarity with ESG investing and responsible investment found in Japan today.

GPIF Stewardship Activities

What kind of an impact and results are being sought from ESG investing by GPIF and other institutional investors around the world, particularly asset owners? In “Fiduciary Duty in the 21st Century,” a report compiled by PRI and others, the following view was published: “Failure to consider all long-term investment value drivers, including ESG issues, in investment practice, is a failure of fiduciary duty.” Understanding the true meaning of this statement will help to clarify the core significance of ESG investing. As one way of gaining insight into this subject, I’d like to take a look at GPIF’s stewardship activities (Chart 2).

((Chart 2) GPIF’s Stewardship Activities
May 2014 Announced the acceptance of Japan’s Stewardship Code and published the “Policy for Fulfilling Stewardship Responsibilities”
October 2014 Entrusted three companies with “Research on Stewardship Responsibilities and ESG Investments at Government Pension Investment Fund”
March 2015 Announced its “Investment Principles”
September 2015 Signed “United Nations Principles for Responsible Investment (PRI)”
January 2016 Published “Summary Report of GPIF’s Stewardship Status in 2015”
April 2016 Published “Summary Report of Listed Companies’ Survey about Institutional Investors’ Stewardship Activities”
July 2016 Started call for applications for ESG indices for Japanese equities
July 2016 Announced the establishment of “Business and Asset Owners’ Forum” and “Global Asset Owners’ Forum”
September 2016 Convened the first meeting of Business and Asset Owners’ Forum
October 2016 Established “Stewardship & ESG Division” (comprising seven members including two full-time staff members)
November 2016 Joined the 30% Club in the U.K. and the Thirty Percent Coalition in the U.S.
November 2016 Convened the first meeting of Global Asset Owners’ Forum
November 2016 PRI elected Mr. Hiromichi Mizuno, GPIF’s Executive Managing Director and CIO, as a board member (term of office: from January 2017 to December 2019)

Source: Prepared by QUICK ESG Research Center based on the “Report of Stewardship Activities in 2016” published by GPIF (January 2017)

GPIF has issued a call for applications for ESG indices for Japanese equities, convened the Global Asset Owners’ Forum and the Business and Asset Owners’ Forum, and joined the 30% Club in the U.K. and the Thirty Percent Coalition in the U.S. to gather information on measures to promote diversity outside Japan. Furthermore, GPIF has expanded ESG investing to other asset classes such as bonds. GPIF expects these activities to produce benefits such as mitigating medium- to long-term investment risk and generating excess investment returns. Notably, from the perspective of a universal owner that holds most of the stocks on the market, GPIF is seeking to boost the entire Japanese equities market and to increase corporate value by facilitating the effective functioning of the investment chain—the flow of investment funds from beneficiaries to investee companies (Chart 3).

(Chart 3) Investment Chain
Investment Chain

Source: QUICK ESG Research Center

Global ESG Issues and Universal Ownership

Last year, GPIF presented several ESG issues as “examples of possible ESG factors to consider in developing ESG indices.” Looking at some of these issues, GPIF lists several global stakeholder issues, such as factors contributing to international cooperation for the purpose of building a sustainable society, such as the Sustainable Development Goals (SDGs), ‘E’ factors: climate change, water resources, biological diversity, ‘S’ factors: gender diversity, employee health” and ‘G’ factors: board composition, fair competition, corruption. If some of the companies held were to neglect these issues, the risks could cause universal owners such as GPIF to internalize the negative externalities of corporate activities. We can infer that the asset owners are investing in ESG indices and promoting engagement in order to encourage all companies to address the abovementioned ESG issues, thereby maximizing the benefits of this endeavor. Accordingly, asset owners are requesting ESG investment as mandates issued to investment management companies. As a result of these investment instructions, asset owners such as pension funds, which are stable, long-term shareholders, are accounting for an increasingly higher ownership ratio of companies with high ESG evaluations.

Going forward, even in Japan, asset owners will be required to act as responsible investors in the investment chain, in order to contribute positively to the interests of beneficiaries including pension beneficiaries. To do so, the asset owners themselves must understand global ESG issues, share a common understanding with asset managers and investee companies, and engage in a constructive dialogue to increase corporate value. Meanwhile, companies for which these types of asset owners become shareholders must understand the vision sought by investors. It will be crucial for these companies to ask what will be required to strengthen their CSR and IR activities as part of their ESG strategies and to properly position these priorities within management.

Core Significance and Issues of ESG Investing

In this manner, unlike the existing practice of Socially Responsible Investment (SRI), which evaluates the social contribution of companies, ESG investing and responsible investment put a clear focus on fiduciary responsibility, which seeks to generate returns as a result of long-term growth in corporate business performance. In order to generate those profits, companies must first have a structure in place to respond to issues requested by society and to mitigate risks in their business through those responses, and must be able to envision a long-term scenario for realizing the creation of value in their core businesses. These sorts of factors will be the benchmarks for evaluating companies. The important thing for companies is to understand what kinds of surveys, research, and discussions investors have undertaken to arrive at their conclusions about global issues. Understanding the background and the underlying principles in this process will serve as the foundation of due diligence toward the issues faced by one’s own company.

Many companies also believe that the most important concepts for understanding the essence of ESG investing are themes such as the material issues and risks in a company’s business, the differences between domestic and global issues, the scope of responsibility in the supply chain, the importance of processes and mechanisms, not only the degree of achievement, and the existence of many different stakeholders. Requests for disclosure of this information have certainly become stronger than ever. However, companies must not adopt the preparation of reports as their final goal. Nor should companies consider inclusion in an index or obtaining a high rating to be their final goals. By strengthening their core long-term strength as enterprises, companies should see their goal as being to obtain an outstanding scenario analysis from investors. Although branding strategies and pure social contributions will be crucial in a different sense, companies must recognize the difference between these factors and ESG priorities, which will lead to the creation of sustained corporate value. They should see ESG investing as a prime opportunity to reassess their fundamental competitive advantages and weaknesses and to win over shareholders who have a shared understanding of those elements and are willing to support companies on this basis.

Meanwhile, I’d like to highlight one example of a problem that asset owners and asset managers could get caught up in, i.e., a current issue that they should be focusing on. It is the problem of ESG investing becoming an empty formalism. Asset owners and asset managers could sign or accept the Stewardship Code, the PRI and so on, but end up not taking any action in practice. Under PRI, signatories are obligated to report on their activities. To address the empty formalism problem, PRI has decided to revise the reporting framework and to start scoring and ranking the content of reports. After three years of revising the reporting framework and starting rankings, PRI has laid out plans for enhancing effectiveness, including requiring itemized disclosure of the exercise of voting rights and the effective use of collaborative engagement. One priority that will require further improvement in the future is monitoring of counterparties based on the proper methodologies by stakeholders both in the upstream and downstream parts of the investment chain. This monitoring will ensure the effective operation of specific functions in the investment chain and help to deliver the maximum benefits across the entire chain.

In Closing

The essence of ESG investing is to invest in the future to build a sustainable society and world for the years to come. To do so, we must tackle a number of challenges from a long-term point of view. As an example of one of these challenges, I’d like to highlight the need to convey the strength of Japanese companies globally. In terms of sustainability, there are many Japanese companies that have been in business for more than a century and are still active at the forefront of their respective fields today. While it is important to incorporate a global perspective, it is also crucial to consider what has driven the sustainable development of these companies to this day. I suspect that these companies have strengths that they themselves may not be aware of. In order for companies to find investors who will become good partners, it is necessary for companies and investors to increase their mutual understanding through disclosure and dialogue. I believe that these activities are also meaningful in terms of helping to make the Japan Revitalization Strategy more effective.

In addition, when we expand our horizons from Japan to Asia as a whole, we may be able to identify new roles for Japan to fulfill. In Asia, there are regions that are considered to be highly risky in terms of various ESG factors. If Japan assumes a leadership role in the region and is able to support the stable growth of the Asian market as a whole, this may have a positive impact on the global economy as well.

Turning to the current state of the world, we find that various problems have become apparent. Under the Paris Agreement, the international community agreed to a goal for mitigating climate change, but there are high hurdles that must be overcome to achieve the 2°C target. Moreover, we have seen unstable political trends such as nationalism and populism come to the fore, with events including the Trump administration’s announcement to withdraw the U.S. from the Paris Agreement. The background to this political environment involves issues such as economic disequilibrium and the growing severity of poverty. If these underlying issues continue to be neglected, not only will capitalism be unable to achieve the prosperous society it has aimed for, but the sustainability of that prosperity may also be put at risk. In response to these mounting issues, companies and the shareholders and financial markets that support their business activities must consider what kinds of actions must be taken.

Through ESG investing and responsible investment, companies and shareholders will strive for one goal. The dialogue needed to make this happen is now getting started in Japan.