ESG investment: A Japanese carrot and a stick
The UK’s Stewardship Code was hailed as ground-breaking when it was launched in 2010 with the aim of encouraging better relationships between asset managers and the companies in which they invest. It was praised by investment associations and cited as a worthy policy exercise by the European Commission. However, the Financial Reporting Council’s work for several years remained just that – worthy but not emulated by others.
This changed in April 2014 when Japan published a code for institutional investors. Upon his 2012 re-election, prime minister Shinzō Abe pledged to boost the Japanese economy with a mixture of unconventional monetary policy, activist fiscal policy and structural reform. The three-pronged policy of ‘Abeonomics’ also saw changes in the way institutions engage with listed companies, culminating in the Japanese Stewardship Code. This year also saw the publication of complementary governance guidelines. The new approach places an emphasis on more efficiently run companies overseen by directors that do not have a long-standing history with the firm. For Japan, this is a significant cultural sea change.
Another change in the way government tackles industry came when the Ministry of Economy, Trade and Industry, historically responsible for corporate governance, handed this oversight to the Financial Services Agency (FSA). Arguably, the step was needed to remove conflicts of interest in its mandate of ensuring healthy governance while promoting prosperous domestic industry.
Fiona Reynolds, managing director of the Principles for Responsible Investment (PRI), a United Nations-backed initiative to promote environmental, social and corporate governance good practice, points out that Japan has not traditionally been an activist market. It needed a different approach to deliver economic recovery on the back of a buoyant equity market supported by overseas investors. “This is why we’ve seen both the Stewardship Code and the Corporate Governance Code that have come into place in the last couple of years,” she says.
The Japanese code builds on the UK’s example and has attracted more than 180 institutional investors, including asset managers and banks as signatories. It has also been endorsed by Japan’s Government Pension Investment Fund (GIPF), the world’s largest pension fund with $1.2trn (€1.1trn) in assets at the end of 2014, according to Towers Watson. The number of signatories compares favourably with the UK, where 300 have shown their support in its five years of existence. The Japanese initiative was also boosted when GIPF announced it would only consider signatories of the code for mandates in its rebalancing of its portfolio, investing ¥8trn (€60bn) into the listed market.
The code represents a break from the prevailing culture in Japan, and the FSA describes its principles-based approach as atypical compared with other local regulations.
At a glance
• The Japanese Stewardship Code provides a publicly disclosed, clear policy on stewardship and managing conflicts of interest.
• It requires appropriate monitoring of investee companies.
• Constructive engagement with companies allows both sides to reach a common ground.
• Sustainable growth is more likely at companies where stewardship is not simply a compliance matter.
• Regular reporting on how stewardship duties are met is crucial.
• Investors must have in-depth knowledge and understanding of the companies they own.
‘The goal of the code is not to have all institutional investors meet minimum standards uniformly, but to have each investor continuously endeavour, in light of its specific conditions and situations, to be innovative and to differentiate itself so that activities of signatories overall will exceed the minimum standards,” the regulator said in September.
The approach is important because it encourages a behavioural change, according to Robert White, fund manager at Oldfield Partners. “Previously, governance was probably viewed as compliance.”
White says attitudes are gradually changing and companies more willing to listen. He believes there has been a difference over the last year in managements’ approach to shareholder returns and governance issues. As a result, a gulf is developing between companies. “There are those who really get it, and those who may take a little longer to get it – but I think we are moving in the right direction,” he says.
Companies that have more success, both in generating returns and adhering to the Stewardship Code, are likely to benefit from inclusion in the JPX-Nikkei 400 index, which was launched in 2014. It places a heavier emphasis on return on equity (ROE), with scoring based on a three-year average, and global corporate governance house ISS predicts the index will act as a “wake-up call to corporations to focus on capital efficiency”.
The index also looks at governance standards that are important to non-domestic investors, including issues such as the number of independent directors and the adoption of the International Financial Reporting Standards.
In addition to the focus on ROE, the ISS proxy voting guidelines, released earlier this year, have also been incorporated. One key feature of the guidelines is that institutional investors should not back the re-appointment of company directors where the ROE has fallen below 5% over the last five years, unless an improvement is already under way. Additionally, at least one “outsider” must sit on the board, either in the shape of an independent director, or a new appointee to the company.
“I hope that it does have a ripple effect across the Asia-Pacific, really, and that people start to see the benefit of it”
White says it has been recognised that a singular focus on ROE is not the best way to assess overall performance: “I think the important thing from the ISS’s point of view – and from the [Japanese] government’s and FSA’s point of view – is that companies are moving in the right direction to use their capital more efficiently.” He points to the ability to vote against directors as a crucial part of the institutional investor’s armoury.
White also says that the ROE argument has been harder to make following the demise of Lehman Brothers in 2008, because firms with substantial cash holdings and an unwillingness to pay out high dividends were better able to weather the financial crisis.
A year after implementation is too soon to measure the success of Japan’s Stewardship Code, but Reynolds at PRI believes its legacy could stretch further. “I hope that it does have a ripple effect across the Asia-Pacific, really, and that people start to see the benefit of it.”
The PRI does not have a strong regional presence outside of Japan, while the country itself is home to only five of nearly 300 asset owners globally to have signed its principles for responsible investment.
Reynolds points out that her organisation will pay attention to the region in the coming five years, and hopes to hold Japan up as an example. Reynolds is also positive about the prospects of her native Australia drafting its own Stewardship Code, potentially taking the place of the voluntary code currently being drafted by the Financial Services Council, an industry group.
For now, support for the Japanese code is likely to come from overseas asset owners that invest in Japanese equities. Only two of the 21 pension funds to have signed are from outside Japan but their ranks are bound to swell as the economic recovery takes hold.