Among the 3,600 companies listed on the First Section of the Tokyo Stock Exchange, there are said to be around 660 to 700 companies that prepared annual reports in FY2016 (the year ended March 2017). With the growing emphasis on the disclosure of ESG information in recent years, I believe that an increasing number of companies have been switching from annual reports to integrated reports, or publishing integrated reports for the first time. Do you think these trends will continue into the future?
If I were asked whether disclosure of ESG information has reached a peak, I’d say that disclosure has not progressed that far yet. That said, I’m concerned that developments indicative of a “bubble in ESG” could unfold going forward.
Do you really think such a “bubble” could happen?
Yes. My concern is that the disclosure of ESG and non-financial information may undergo a boom in popularity, and may not fulfill its original purpose of ensuring a “proper assessment of corporate value.” This is because everyone has been rushing to adopt this new perspective, just as they had previously rushed to adopt new perspectives during the “IT Bubble” in the past. Some of the reasons for this are that ESG disclosure is a global movement not just confined to Japan, and it has the backing of the Government of Japan*1. In any case, the market has become overcrowded with new entrants. There are said to be around 100 ratings agencies specializing in ESG. Each agency has diligently created their own proprietary ESG indicators and they are assigning ESG ratings to companies as they see fit.
In that case, the evaluation of a company would change depending on which indicator and rating was adopted as a standard. Wouldn’t that cause problems?
Absolutely. If a wide cross-section of the general public were to start investing in companies based on unverified evaluation standards or managing assets in line with indexes developed with some particular agenda or purpose in mind, stock prices could increase in a way that diverges from any improvement in their corporate value in the traditional sense. This would indeed create a bubble.
In this environment, the Ministry of Economy, Trade and Industry (METI) launched the Study Group on Long-term Investment (Investment evaluating ESG Factors and Intangible Assets) toward Sustainable Growth*1 in August 2016. You have also been participating in the Study Group as a member. Why do you think the Government of Japan is backing ESG investment?
I believe the global financial crisis, of which the most prominent symbol was the Lehman Brothers bankruptcy in 2008, has been a major factor behind this support. The government learned important lessons from the fact the capital markets had neglected to properly allocate capital at the time and that the only decision-making standard for capital allocations had been investment returns. Of course, investment returns are important, but an overemphasis on returns alone has perpetuated various social issues without helping to solve them at all. That is why the government is signaling that the capital markets as a whole need to revise their capital allocation policies and try to allocate capital so as to solve social problems more effectively. I believe that the government’s underlying aim is to develop guidelines to achieve this goal.
In May 2017, the Study Group compiled guidelines titled “Guidance for Integrated Corporate Disclosure and Company-Investor Dialogues for Collaborative Value Creation: ESG Integration, Non-financial Information Disclosure and Intangible Assets into Investment” (Guidance for Collaborative Value Creation). Could you please discuss the differences between the evaluation standards that could lead to an ESG investment bubble, as you mentioned earlier, and the guidelines published by the Study Group?
Overview of the Guidance
For example, with one standard, criteria related to environmental regulations and human rights have been drawn up, and companies that breach several of these criteria will be put on an exclusion (disqualified) list and removed from investment. Asset owners in the public sector are particularly sensitive to problems that could ripple out to social responsibility issues. Therefore, they have a strong tendency to emphasize these sorts of standards. With passive investments, stock prices can be moved simply by triggering the inflow and outflow of funds through the designation of investment targets as “disqualified” or “index company” based on decision-making standards that emphasize ESG evaluation. In the case of passive investors, this could happen, for example, when the formation of an ESG index triggers investment by a passive fund. Meanwhile, active investors, even those who stress ESG, tend to monitor ESG in connection with businesses. They may ask questions such as “Is my understanding of your current business model correct?” or “Is this your most important resource, or driver, of your business model?” They may then follow-up with questions like “I think this type of obstacle may hinder your plans. What kinds of measures would you take in response?” An “integration-oriented” investor who sees ESG as integrated into a company’s business may dig even deeper and try to ascertain whether a company is able to convert these kinds of risks into opportunities. The latter investor monitors corporate value, not the stock price. The main difference between the former investor (passive investor) is that the active investor’s core focus is always the business model.
So the underlying principle is that the source of competitiveness of companies will be measured by how thoroughly companies are prepared to convert ESG factors into opportunities. Is that right?
That’s correct. We are concerned about the notion of a simple checklist of evaluation standards becoming the norm. Companies will assign priority to ESG factors differently depending on their circumstances, and communication between investors and companies will be crucial to gauging opportunities. To make this happen, we believe that a “shared language” is needed to facilitate and deepen dialogue between companies and investors.
The “Overview of the Guidance” chart does not list the ESG factors separately.
We believe that it is important to incorporate ESG evaluations into the overall picture of a business, rather than treating these evaluations separately as something special. Let me share an incident that actually happened in the course of dialogue with a company. Being very diligent, this company tried to individually disclose all of its activities related to each of the 17 SDGs. In the process, the company started to lose track of the connections between each activity. Ultimately, they consulted us by asking “How far should we pursue this approach?” We told them that there was actually no need for this kind of approach. We conveyed to the company that we expect them to select 5 or 6 activities important to the company, assign a priority to each activity, and pursue those activities, and that we would evaluate their performance on this basis. That said, investors themselves need to adopt a clear approach to their ESG evaluations in order to articulate such a clear-cut process.
It’s important for companies to determine the materiality of their activities, right?
The materiality must also address the sustainability of a company’s competitive advantages. This is something I’d like to make absolutely clear. Although ESG and CSR have some aspects that overlap, there are a lot more aspects that do not overlap at all. In regard to CSR reports, every company writes a lot about their social contribution activities. For example, a company may say that they are working to protect forests because they have used lots of paper to prepare their reports, and that they are planting trees. However, this is CSR, not ESG. As an investor, I wouldn’t take these aspects into consideration in evaluating a company’s ESG performance. This doesn’t mean that I reject CSR as a vain effort. In fact, I applaud companies that devote their efforts to social contribution activities. That is all fine and good, but it isn’t a factor that would cause their business to grind to a halt if it were missing. That is how the evaluation would be made from an investor’s perspective.
On the other hand, are there cases where companies hesitate to provide negative information?
I think you are alluding to negative information such as legal disputes in emerging countries. I have learned that companies are extremely sensitive to these concerns — it explains why they are associated with the term “negative information.” Even if companies do not disclose such information, most investors who gather information from around the world have a generally good grasp of these matters. Therefore, I would like to see companies disclose this information immediately. The reason for providing this disclosure is that unless these matters are clearly explained to investors, they cannot determine how serious the situation actually is. This is true even if they are already vaguely aware of the situation. As a result, investors will allow for the situation to deteriorate further, so the stock price will only get pushed down further. Conversely, if the matter is disclosed properly, investors will realize that “Oh! That’s all that has happened.” and the evaluation of the company will be made at that time. That is why I strongly believe that companies should proactively get their message out, thereby promoting their transparency and integrity.
Are these points that you have discussed unique to Japanese companies?
That might be the case. Looking closely at the evaluations of Sustainalytics, an independent ESG research and ratings agency, I believe that Japanese companies tend to receive lower evaluations than warranted by actual conditions. I found three key reasons for this, “Companies have ESG activity policies in place, but do not provide disclosure on the content of their activities,” “Companies are undertaking ESG-focused activities, but there is no evidence of setting goals, introducing incentives or tracking the degree of accomplishment,” and “Companies have presented evidence of ESG activities, but there is no independent verification by third-party agencies.” In essence, the problems lie in how the information is disclosed, not the activities themselves. The recently announced guidance has been prepared to set a course for enhancing the quality of dialogue between companies and investors, not to provide a methodology for disclosure by simply telling companies to “take these steps and you’ll be fine.” Since the materiality of issues will vary across different companies, I encourage companies to identify this materiality in the course of engaging in dialogue with investors and to provide disclosure of information that conveys this materiality clearly.