Feature 1: Is ESG investment going to end with a boom?Meaningful ESG Information is Found in Effective Medium- to Long-Term Strategies

BlackRock Japan Co., Ltd.
Investment Stewardship Department, Investments Group

Right: Akitsugu Era /  Left: Satoshi Ogoshi

Interview & text by FISCO FINANCIAL REVIEW, Photograph by D.Araki

BlackRock, Inc. is one of the world’s largest asset management firms. As of March 31, 2017, BlackRock had more than ¥600 trillion of assets under management, a level surpassing the GDP of Japan. BlackRock Japan Co., Ltd. holds over ¥20 trillion of assets in Japanese equities alone, thereby exerting considerable influence over the Japanese economy. FISCO FINANCIAL REVIEW asked two members of the Investment Stewardship Department of the Investments Group of BlackRock Japan to share their perspectives on the Japanese equities market and their insights into ESG (Environmental, Social and Governance) information.

BlackRock’s Expectations for Japanese Companies

In early March 2017, BlackRock made headlines when Chairman and CEO Larry Fink sent a letter to around 400 leading Japanese companies. In the letter, BlackRock stated that it is focused on whether management is actively investing in developing workers’ skills and helping to improve their living standards. BlackRock’s emphasis on the ESG activities of Japanese companies attracted significant public interest.

Era: Around one month has passed [as of this interview] since the letter was sent. It has generated a tremendous response. BlackRock sent the letter directly to the CEOs of each company. As a result, we have been given more opportunities than before to directly engage in dialogue with the CEOs themselves. The letter’s message itself applies universally to all companies. However, we have received a lot of inquiries regarding how to apply the message to the specific circumstances of individual companies. Going forward, we plan to communicate our views by engaging in a dialogue with each individual company.

This letter was the fifth communication of this kind, right?

Ogoshi: That’s right. In all the letters sent so far, we have consistently conveyed our expectations for companies to undertake management from a long-term perspective. As a long-term investor, we seek to support such an approach to management.

In this letter, BlackRock discusses the importance of ESG in terms of two themes. The first theme is that BlackRock is focusing on companies that actively invest in developing workers’ skills and helping to improve their living standards. The second theme is that ESG is essential to the sustainable growth of corporations. Global companies must be firmly rooted in the local communities of the markets they enter.

Era: Anxiety about the future is now spreading around the world. Based on its analysis, BlackRock believes that this anxiety may be linked to the major political events that materialized in 2016. When society becomes unstable, business also becomes unstable. By investing in developing workers’ skills and appropriately returning corporate profits to employees, we believe that companies can help stabilize society, thereby increasing the sustainability of business itself. This reasoning has led us to ask companies a very basic question: “Have you drawn up a long-term management strategy?”

Focusing on Companies’ “Broadly Defined Governance”

In September 2015, the Government Pension Investment Fund, Japan (GPIF), the world’s largest pension fund, became a signatory to the Principles for Responsible Investment (PRI), leading to surging interest in ESG investment in Japan. What do you make of the boom in ESG investment, particularly in the asset management industry?

Ogoshi: It is often noted that Japan’s corporate governance frameworks present several unique features in comparison to those of Europe and North America. Various positions can be taken on whether Japan’s corporate governance frameworks are good or bad in terms of shareholder value. The very least we can say for sure is that investors around the world often point out that Japanese companies have low profitability. We believe that Japan’s unique governance frameworks have come under focus as one reason for this low profitability, and investors are seeking an explanation.

What is the greatest difference between corporate governance in Japan and abroad?

Ogoshi: Overseas companies have many different governance frameworks. These differences encompass not just the governance systems, such as the Board of Directors, but also various underlying rationales and objectives for appointing board members. Some companies emphasize monitoring by outside directors, whereas other companies stress monitoring not only by outside officers, but also by Audit & Supervisory Board members and other internal bodies. I believe it is crucial to understand a company’s “broadly defined governance.” In our daily dialogue with companies, we not only discuss the companies’ “narrowly defined governance,” including issues related to the composition of the Board of Directors and remuneration of board members, but also seek information on priorities from a medium- to long-term management perspective, such as management and financial strategies, as well as human resources strategies and corporate culture. We seek this information to better understand companies’ “broadly defined governance.”

How are profitability and governance linked together?

Ogoshi: The key question is whether the views of shareholders who actually invest in a company are reflected in the company’s governance. Of course, the company’s “narrowly defined governance,” including the steps it is taking to enhance corporate governance, is also important. However, I believe that the reality is that this approach alone is often not enough to solve the profitability problem.

We confirm the business strategies and approaches taken by companies in the competitive environment, among other factors, and discuss these matters with companies at times. In the process, we evaluate the medium- to long-term strategies and the corporate value of those companies from an investor’s perspective. These activities are underpinned by our firm belief that it is engagement that will lead to better profitability and corporate value.

As an institutional investor, you must size up a company’s “broadly defined governance” not only by exercising your voting rights, but also by taking full advantage of opportunities for dialogue. For companies that have properly developed a growth strategy from a medium- to long-term perspective, the Environmental, Social and Governance information can be used to advantage based on that strategy.

Ogoshi: Evaluations of the individual components of ESG information, specifically, Environmental, Social and Governance information, will vary depending on the stakeholder. From the standpoint of shareholders like ourselves, the important thing is to find out how each component of ESG information will help to improve a company’s corporate value and shareholder value.

Does that mean that rather than merely check the individual components of ESG data, you are focusing on specific examples of activities that lie behind the data, or on how those activities help to generate corporate revenue and earnings? In other words, are you confirming the narratives or strategies of companies by engaging in a dialogue with them?

Ogoshi: Absolutely. We believe the corporate value creation process is born where Governance information is integrated with Environmental and Social information. However, we have the impression that a lot of Japanese companies are still exploring effective ways of conveying this information externally. For example, many Japanese companies discuss improvements in management strategy and governance separately. Rather than explain the individual components of ESG information as separate issues, we have high hopes that more and more Japanese companies will discuss ESG issues with reference to the narratives of their corporate and business strategies.

Investors Are Watching the Competitive Edge of Companies

For example, when carefully reading the information disclosed by companies, such as disclosures about their human resources initiatives, I believe there are two types of information: (1) information that would be identical from company to company even if the agent of action was switched from Company A to Company B; and (2) unique information that can only be disclosed by, let’s say, Company A. I believe that many companies treat ESG as a framework and plug information into the framework, explaining to investors how much they have accomplished by disclosing the extent of their activities on this basis. However, aren’t investors dissatisfied with those ways of disclosing information?

Era: Institutional investors are watching the competitive edge of companies. That is why they would compare Company A and Company B, and would investigate the rationale for judging Company A to be superior to Company B, or whether the companies can be expected to grow in the future. Institutional investors focus on information that helps them to arrive at these sorts of judgments. In the example you provided, where the information remains basically identical even when switching the agent of action from Company A to Company B, this type of information unfortunately does not provide us with any value. The reason is that unless we can compare Company A with Company B, we cannot measure the competitive edge of one company over the other.

Ogoshi: Although we would not reject the framework itself, we find it important to understand the key features of companies, or their unique aspects, from an ESG perspective. While some of the information plugged into the framework can be valuable, we hold the expectation that there is information and there are activities unique to a given company that cannot be simply plugged into the framework, probably in the “E” (Environmental) and “S” (Social) components of ESG as well. In particular, if a company could actively disclose more unquantifiable information—i.e., information about their activities, processes, strategies and the like—then this information would be very useful in helping us to understand the key features of that company.

Era: Around six years ago, we had the opportunity to directly meet and engage in dialogue with around 50 companies a year. Last year, that number increased to around 200 companies. This year, the number is on track to increase further to around 250 companies. The engagement agenda has also grown to encompass an extremely broad range of themes.

When conducting a session on strategy and the direction of management, you wouldn’t divide your questions about ESG into separate queries about the “E” or “S” components, right?

Era: That’s right. First, we would ask a company about its long-term strategy. In that context, we might confirm activities related to the “E” or “S” components or the related aspects. However, if we judge that these matters would not have a major impact on business, then we might not ask any particular questions about the components. Also, we put the strongest emphasis on the “G” component of the three ESG components. That’s because as long as a company has solid governance and management, we have an expectation that the company will also properly address the “E” and “S” components, as they are essential priorities for executing business strategies.

ESG Is Not a Magic Wand

In regard to the disclosure of ESG information, the companies that work to provide this disclosure based on the proper awareness have already been largely determined and are generally known. Currently, there is talk about how companies could increase their profitability if they work to disclose ESG information, or that every company should work to disclose this information. Even so, the reality is that there are a lot of companies currently unable to address the requirements of this disclosure. How do you see this problem?

Era: We believe that the disclosure of ESG information is closely tied to the size of a company and its growth stage. In addition, it is only natural for the specific content of ESG information to vary according to the industry sector and business conditions. We need to be cautious about expressing views on ESG activities, such as giving specific advice on what we think those activities should be like.
That said, generally speaking, ESG priorities are crucial to competition strategies, i.e., ensuring a company’s competitive edge. Accordingly, we believe that ESG priorities will only take on greater importance going forward.

Ogoshi: As a practical matter, I believe that almost every investor understands that it would be difficult for so-called middle-cap and small-cap companies to undertake the same ESG activities as those of companies with an extremely large market capitalization. Naturally, these investors would not seek the same level of disclosure from middle-cap and small-cap companies as they would from large companies. However, as I said earlier, investors will use the ESG information disclosed by companies to determine how ESG will contribute to growth strategies and how useful ESG will be in measuring a company’s competitive edge. Put differently, we don’t think that merely disclosing ESG information will lead to an increase in profitability.

ESG clearly isn’t a magic wand. Do you have the feeling the total number of Japanese companies that have compelling narratives behind their management strategies are increasing?

Ogoshi: Here too, we must adjust our perspective depending on the stage of the company. A strategy needed to increase market capitalization by a company in a growth stage cannot be regarded in the same light as the strategy of a company that is already in a mature stage.

With the strategy of a company in a mature stage, it is crucial for the company to provide investors with information on management plans spanning three to five years, and on how those plans are being discussed in the Board of Directors. On the other hand, let’s use companies in a growth stage that have just publicly listed their shares as an example. For these companies, change may not necessarily be a crucial factor. Rather than changing a strategy that has already been determined, there may be cases where steady and efficient execution of the existing strategy may contribute the most to increasing corporate value. In these cases, companies may believe that investors may not fully understand the narrative behind their management strategies, including ESG, as it becomes difficult for investors to identify changes in the company. However, in those cases, there is a lot that investors like us can confirm if companies convey the process of how they are executing their management strategies.

That said, we have the impression that we have had an increasing number of opportunities in the past two or three years to meet with and hold discussions with companies that are properly disclosing their management strategies to investors as a compelling narrative.

We have seen a particular increase in opportunities for us to confirm the basis for making decisions when there is a change in strategy. It is very important for companies and investors to exchange thoughts and ideas with one another through engagement. ESG information is being recognized as an important conduit for engagement, and we certainly see this as a highly positive trend.