Feature 1: Is ESG investment going to end with a boom?How Far Will the ESG Investing Trend Catch On? - ESG for Small- and Mid-Cap Stocks -

Founder and CEO, Suscon Japan

Mikako Awano

Mikako Awano graduated from the Graduate School of Political Science of Waseda University (Major: International Political Science). In 1990, she joined the staff of WWF Japan, working in the WWF panda mark licensing business and corporate partnership planning activities. In July 2009, she was transferred to the Nature Conservation Division, where she was responsible for business and biodiversity issues and the United Nations Collaborative Programme on Reducing Emissions from Deforestation and Forest Degradation in Developing Countries (UN-REDD Programme).
In 2016, she resigned from the WWF and founded SusCon Japan, a non-profit general association. Ms. Awano is also involved in numerous information disclosure-related activities, including serving as a committee member for the “Handbook on Disclosure Items, etc. of Environmental Reports, Version 3” of the Ministry of the Environment.

Four years ago, the Ministry of the Environment launched the “Environmental Reporting Platform Development Pilot Project” (hereinafter, the “Reporting Platform Project”). The progression of this project marks the tremendous transformation experienced by ESG investing in Japan over the past four years. The author of this article has participated in all of the reporting sessions held by this project at the end of every fiscal year since the very first session. The growth in the size of this event has been truly remarkable. The first session held in 2014 had the feel of a casual gathering of around 140 insider participants. Two years later, when the author took the stage as a panelist, the venue was full to capacity with an audience of 300 people. Moreover, the reporting session held in March 2017 also proved immensely popular. In fact, the session reached its capacity limit of 500 people in just the first week after we started accepting applications to the event.
Despite this surging interest in ESG investing, companies often say that they receive no questions about ESG from investors, or that they are not interviewed about ESG individually in the first place. Is ESG investing relevant to only an extremely small handful of the largest companies?

No ESG Questions ≠ ESG Disclosure Is Unnecessary

The absence of questions focused on ESG is a universal theme in every country, regardless of the scale of business. In February 2017, London Stock Exchange Group issued ESG Reporting Guidance for companies, and held a commemorative panel discussion to mark its publication. Comments made at the event support the claim that investors seldom—if ever—ask questions about ESG. Shanks Group plc (currently Renewi plc), a waste management company that became the first private-sector issuer of green bonds for on the London exchange, clearly noted that it hardly ever receives questions about the company’s sustainability targets from fund managers. Even Unilever Group, which has a sterling reputation as a sustainability-driven company, responded with a wry smile, noting that it receives no questions about ESG in the U.S.

In response to these comments, the investors at the meeting stressed that by the time they attend discussions with companies, they have already closely examined non-financial information, and that ESG has already been factored into their assessments. It is understandable investors and companies may be unable to cover ESG topics within the short space of time available for these interviews. In other words, regardless of whether the interviews are undertaken or whether ESG-related questions are asked at the interviews, it is crucial for companies to have provided disclosure of non-financial information.

What merits caution here is that meaningful non-financial information for ESG investing does not constitute the “activity reports” that have so far been provided by companies in their CSR reports. Instead, companies must disclose information that ESG investors can use to make judgments about future risks and opportunities. However, even in the case of integrated reports, there is often very little disclosure of Environmental (E) and Social (S) information. Regrettably, we find that there are a considerable amount of reports that merely follow the formalities of an integrated report, without providing real substance. We find that even the companies participating in the abovementioned Reporting Platform Project submit many reports that contain only an explanation of current conditions and an activity report, and do not go into their future outlook and strategies. Even in the UK, where ESG investing originated, the enhancement of non-financial information is considered to be a top priority. With this in mind, the stock exchange took the lead in preparing reporting guidance.

Companies may believe that they are disclosing ESG information. However, it may be better to assume that if no ESG questions are received, then it is probably because companies have not provided investors with enough disclosure of information to allow them to ask meaningful questions.

The Strong Needs of Overseas Institutional Investors for ESG Disclosure

The need for the appropriate disclosure of information is a common theme regardless of the size of companies. However, companies that are not interviewed individually and do not have the opportunity to provide ESG information in person must improve their publicly disclosed information by making use of the aforementioned disclosure platform and various reporting guidelines. The reporting guidance issued by London Stock Exchange Group targets small and medium-sized enterprises as important readers, demonstrating a strong desire to promote disclosure in this sector.

However, for companies that are unable to assign dedicated personnel, are there really any advantages to taking the trouble to enhance ESG information? We must focus on who is seeking this information, or in other words, the principal agents of ESG investing. The Government Pension Investment Fund (GPIF), the leader behind the rise of ESG investing in Japan, has already introduced an ESG index. Overseas institutional investors play a sizable role in the market in terms of selecting stocks more actively and directly, including divestment. Therein lies the advantages of ESG disclosure.

Plainly speaking, overseas institutional investors are searching for ESG investments. Divestment from the coal industry and companies that do not support climate change initiatives has now reached US$5 trillion, led by pension funds in Northern Europe. These funds are reportedly being redirected to climate change-related fields, including renewable energy and energy conservation technologies. However, it is not necessarily the case that suitable investments have been found for the entire US$5 trillion. Considering that the funds were withdrawn because of environmental problems, suitable ESG investments must be found. However, because suitable ESG investments are difficult to find, there are some investment funds that are postponing divestment. Supply and demand are out of balance.

From the point of view investors searching for ESG investments, many Japanese small- and mid-cap stocks are likely to be seen as an unknown quantity. In 2015, the author surveyed the issuance status of CSR reports by just over 1,900 companies listed on the First Section of the Tokyo Stock Exchange. The survey found that only half of the 700 companies issuing CSR reports publish a CSR report in English. Even information vendors say that less than one-quarter of their client companies provide disclosure in English. In an environment where the importance of non-financial information has not taken hold, this state of affairs would obviously bar companies from even being considered as potential investment candidates.

Even so, interest among investors has been steadily increasing. FISCO has also received more and more requests for reports and individual interviews from overseas investors. In addition, Chief Investment Officer Hiromichi Mizuno of GPIF has been proactively speaking up overseas, and this has led to stronger interest in the Japanese market. Appropriate ESG information that serves as the basis for investment decisions is essentially data. There is no need for companies to prepare lengthy reports. It is fully possible for small- and mid-cap companies to disclose information that meets the needs of overseas investors. Companies need to seize this opportunity and not let it slip by.

The Supply Chain as an Investment Risk

Until now, I have discussed the possibilities of companies directly subject to ESG investing. However, we must not overlook the indirect impacts of ESG investing. In other words, we must consider the ESG priorities of suppliers.

The most prominent supplier priority in terms of ESG is the supply chain program launched by CDP in 2014. Under this program, CDP sends questionnaires to supplier companies on behalf of large companies. In 2016, the number of surveyed suppliers reached 8,200. Apple Inc. has set a target of achieving the use of 100% renewable energy in its supply chain. This underscores growing awareness of the fact that initiatives by suppliers are essential to mitigating the risk of climate change.

In addition, this year CDP also introduced a supply chain program focused on deforestation-related disclosure. Eight major global companies, including McDonald’s Corporation and L’Oréal S.A., requested surveys of their respective suppliers. But why deforestation? This theme is subject to the most criticism from environmental NGOs. For companies that are close to consumers, the impairment of brand image can have a direct bearing on their corporate value, making it all the more essential to respond or take preventive measures. Meanwhile, the true aim of NGOs is to change the behavior of upstream suppliers at the frontlines of social and environmental problems. Therefore, companies will not exempted from their responsibilities unless their measures have an impact on upstream suppliers, nor will their risk exposure decrease. The environmental problems faced by major companies in the downstream segment of the supply chain must be shared by all companies in the supply chain.

The risks that arise in the supply chain are similar, if not greater, in terms of social issues. Last year, Samsung Group and Panasonic Corporation were publicly criticized for the role of supplier factories in Malaysia that were involved in issues surrounding immigrant laborers from Nepal. This is one typical example of a social issue. The Modern Slavery Act that came into force in the U.K. two years ago targets companies with sales of 36 million pounds or more (approximately ¥5.2 billion). This is to force suppliers to recognize the problem and provide disclosure. It is no exaggeration to say that the Environmental (E) and Social (S) risks depend entirely on suppliers.

Non-manufacturing businesses cannot remain immune from these risks. In the UK, even market research firms have been requested by their customers to join Sedex, and have decided to set up CSR departments. There is a growing awareness among companies that are the direct targets of ESG investing that investors’ concerns cannot be dispelled unless the potential risks that lie hidden in the supply chain in every business sector are minimized and controlled.

Today, supply chains have become global, and every company is indirectly exposed to the scrutiny of ESG investing. The investor engagement experienced by client companies can no longer be dismissed as somebody else’s business.

ESG: All the More Important for Small- and Mid-Cap Stocks

When viewed as investment targets, small- and mid-cap stocks offer certain advantages in terms of supply chain risk. Although it will depend on the business sector, compared with the risks that exist in the complex and expansive global supply chains of large corporations, the problems faced by small- and mid-cap companies can be limited to specific issues. In addition, small- and mid-cap companies are hardly ever targeted directly by NGOs. Most NGOs have limited resources, so they target global corporations downstream where the NGOs are able to leverage their resources.

Small- and mid-cap companies can also expect to derive secondary benefits from building a strong reputation as ESG investments. Shanks Group plc, which I mentioned at the beginning of this article, identified the following three benefits of issuing green bonds:
(1) Increased opportunities to gain media exposure through heightened media attention;
(2) Instilled a positive corporate identity among employees;
(3) Improved the company’s recognition as a good employer and workplace.
Notably, items (1) and (3) above are benefits that would probably not be mentioned by large corporations.

The lack of a CSR Report is not a cause for concern. People often say that CSR reports should present information in a narrative, “story-telling” format. There are certainly some stakeholders, such as employees and local residents, with whom it is important to connect emotionally and win their hearts and minds. However, the world of ESG investing is all about data. Even social contribution activities must be undertaken to strategically reduce future business risks, in order to be meaningful to ESG investing. Conversely, if a company’s disclosure is limited to only social contribution activities, the company could receive a negative evaluation as being unable to even recognize risk.

There are also certain points to watch out for in providing disclosure of simple data. The first point is to ensure objectivity. As with financial information, investors require independent verification of non-financial information. Ensuring the reliability and comparability of data is just as important to ESG investing. In addition, we must remember that outside Japan, the general view is that human nature is fundamentally flawed, and investors have a low degree of trust in corporations. Therefore, a self-declaration regarding the authenticity of the data will not be sufficient.

The second point is the responsibility of management. Naturally, stakeholders will view a company with concern if management does not understand the meaning of the company’s financial statements. The same can be said of ESG information. One component of ESG risk is whether or not management is able to discuss why ESG data is material to their company.

Even as I write this article, the world is moving rapidly, with developments including the announcement of a climate plan by the French government and a plan to develop an analysis tool for disclosure of climate change information by major banks in Europe and North America. Companies that move forward to address the new challenge of ESG investing should be able to survive through this tumultuous business environment. Now is not the time to search for excuses to ignore this urgent priority.