Japanese CSR in the Age of Responsible Global Investing
Recent years have witnessed important milestones in the global trend toward sustainable investment. In May 2013 the Global Reporting Initiative released the G4 Sustainability Reporting Guidelines at the Global Conference on Sustainability and Transparency in Amsterdam. And in December that year, following a period of public comment, the International Integrated Reporting Council published the final draft of its International IR Framework. In the following, I would like to discuss the challenges facing Japanese companies amid these developments, as seen from the perspective of the foreign institutional investors with whom I have worked for more than a decade. Note that the opinions expressed here are my own and do not reflect those of any organization or institution.
Institutional Investors and CSR Reporting
Institutional investors consist broadly of two types: asset owners, such as pension funds and foundations, which provide the funds to be invested; and asset managers, to whom the asset owners delegate the management of their funds.
Of the foreign institutional investors who invest in Japanese equities, only a very small portion actually read the individual corporate social responsibility reports published by Japanese corporations. One reason for this is limited resources. Investment firms with global portfolios hold shares in a huge number of companies: between 1,000 and 2,000 in the case of midsized asset managers, and 5,000 or more in the case of the big management firms. These days most of the larger asset management firms have departments dedicated to ESG (environmental, social, and governance) risk assessment, but even so, reviewing the CSR report of each and every listed company is physically impossible.
Who, then, is reading them? The most important readers of CSR reports are ESG rating agencies. These are organizations that analyze and rate the ESG performance of stock-issuing companies on behalf of institutional investors, mostly on the basis of data from the companies’ environmental, social, and governance information in CSR reports, along with answers to questionnaires and, occasionally, interviews and observation. These agencies may bring their own special research methods to bear, and virtually all global investors depend on them for ESG information.
In these ratings, Japanese companies as a whole fall somewhere between the middle and bottom of the global rankings, and there has been no appreciable change in this position over the years. In the environmental component, Japanese corporations rank near the top. However, in the social component they rank in the middle or lower, and when it comes to corporate governance, they are near the bottom. These results are consistently seen among all the reports compiled by these agencies.
New Trends in Institutional Investing
Such is the situation today. How has CSR as an investment criterion evolved over the past decade? Until about five years ago, no foreign institutional investor hardly made any mention of CSR to me. To some degree this reflects my personal concerns, which until then were focused squarely on corporate governance. A more fundamental reason, though, is that until fairly recently, investors—even those involved in medium- and long-term asset management—were preoccupied with short-term returns. The only exceptions were a few specialized SRI (socially responsible investment) funds. But all this began to change after the 2007–2008 global financial crisis.
Investors, particularly asset owners, were among those hardest hit by the crisis. In its aftermath, there was much soul searching regarding the obsession with short-term gains, particularly on the part of pension funds charged with managing assets over a period of decades. The result was a new consensus that investment management should entail not only the pursuit of high returns—a basic premise of institutional investing—but also medium- to long-term investments guided by lasting corporate value so as to minimize the risk of investment losses. From this consensus arose the concept of ESG.
How, then, does ESG differ from CSR? I have explained the difference as follows. “CSR encompasses the basic corporate activities and policies that help ensure a business’s medium- and long-term survival by considering the welfare of all stakeholders, while ESG refers to activities and policies oriented to institutional investors who are seeking steady and reliable growth in corporate value.” In other words, ESG is not something distinct from CSR. Rather, ESG ratings and reports highlight the so-called “material issues” of CSR—aspects of CSR that are especially meaningful in terms of disclosure to institutional investors and extended two-way communication because they are relevant to corporate value. ESG in no way diminishes the importance of CSR in corporate management. What it does is to meet institutional investors’ need for concrete data on factors pertaining to long-term corporate value that are not adequately covered by the typical CSR report.
New Challenges for Japanese Corporations
In this context, what are the major challenges facing Japanese stock-issuing corporations today with respect to institutional investors?
SHIFT TO INTEGRATED REPORTING The reporting trends embodied in the G4 Sustainable Reporting Guidelines and the International IR Framework emerged in response to the new emphasis on longer-term value among institutional investors. While retaining the original structure of the GRI’s sustainability reporting framework, with its focus on multiple stakeholders, the G4 Guidelines introduce the element of corporate value into the equation via the concept of “materiality.”
Integrated reporting likewise attempts to address the demand by institutional investors for information needed to assess long-term corporate value—information effectively conveyed by neither the traditional annual report, the typical CSR report, nor the two combined.
From the standpoint of institutional investors (and rating services), the annual report and the CSR report will retain their utility as information sources to be included in the database. But integrated reporting is something new, drawing on both financial and nonfinancial information to succinctly communicate “the full range of factors that materially affect the ability of an organization to create value over time.” The challenge in adopting integrated reporting is to avoid the temptation simply to combine the annual report and the CSR report into one massive publication, increasing the quantity of information yet communicating less of material relevance .
PROBLEMS WITH CURRENT CSR REPORTING As I have noted, Japan’s overall ESG ratings, based primarily on individual companies’ CSR reports, are consistently at or below average for advanced industrial countries. In fact, Japan is in danger of being overtaken by emerging economies like Brazil and South Africa. The Japanese CSR officers and others who have spent hours preparing voluminous CSR reports for their companies may well wonder why their efforts are not rewarded by better ratings. Most of the rating agencies use Japanese researchers to compile and analyze data on Japanese companies, but my discussions with these experts reveal the following problems.
First, from the standpoint of foreign institutional investors, Japanese equities are usually part of a global or Asian portfolio and have been for some time. This means that they are evaluated by global standards, with no allowances for circumstances that are special to Japan. Moreover, the basis for comparison is not other Japanese corporations but all corporations in the global portfolio.
Second, when rating stocks by global standards, the corporation is never given the benefit of the doubt. If a CSR policy or initiative is not spelled out in the report, then the raters assume that the company is not doing it.
Third, many research and rating agencies send companies follow-up questionnaires to verify items not specified in the CSR report. In the case of Japanese companies, researchers find that the same items must be verified year after year, and the responses they receive are often inadequate.
Fourth, when it comes to corporate governance systems, Japanese companies almost invariably lag behind their Western counterparts in such social responsibility measures as supply chain management, human rights, labor practices, and diversity.
As for the public-relations effectiveness of Japanese CSR reports, the comments I have heard highlight the same basic issues uncovered by the Tokyo Foundation’s CSR Survey. The very act of publishing a report appears to have become an end in itself, with the result that the content varies minimally from year to year. One senses little attention to such essentials of purpose-driven marketing as who will be reading the reports and what the readers are looking for, and which companies in what countries provide the basis for comparison and what sorts of reports they have published. There are too few specifics pertaining to the identification and resolution of problems and shortcomings.
These are generalizations, of course, and exceptions to the rule do exist. A few Japanese companies earn high overall ESG ratings. Unfortunately, when the country as a whole ranks low in the ratings, there is little motivation for investors to seek out those exceptions.
Learning from Institutional Investors
Japanese corporations, for their part, often find it hard to believe that ESG considerations figure prominently into the decisions of fund managers and analysts. This is understandable. The main thing asset managers look at when they make an investment decision is the stock’s target price, and this is based on an analysis of the financial data. To the best of my knowledge, this basic practice has not changed even after the financial crisis. This may explain why the CSR departments of Japanese corporations remain segregated from the investor relations and general affairs departments, and why ESG is rarely a topic at IR meetings. Judging from my recent discussions with corporate officers overseas, this is true to some extent at American and European companies as well. Enterprises that have recognized the importance of ESG—including those in Japan—meanwhile, also understand the need for good communication among company divisions.
It must also be stressed that foreign institutional investors are diverse in their orientation. They include long-term investors as well as hedge-fund managers and high-frequency traders oriented to short-term profits. In Japan there is an underlying assumption that long-term investment is good and short-term investment is bad. But there is nothing inherently good or bad about market transactions. Every institutional investor represents a certain range of clients who provide the assets to be invested, and it is this range that creates market depth and determines share prices.
That said, it is undeniable that the new focus on integrated reporting and ESG is being driven by investors and asset owners—the latter in particular—with a medium- to long-term investment time frame. The asset owners who were burned so badly by the Lehman meltdown want to know how well a stock will hold up over the long run.
This means that when it comes to two-way communication regarding ESG issues, companies need to place top priority on the opinions of asset owners. Within the asset management sector, they should be dialoguing with ESG officers who analyze risk using nonfinancial data and exercise voting rights, not the portfolio managers, who use financial data to monitor the performance of stocks that have already been purchased. Through such ESG-oriented dialogue, Japanese companies can play a more active role in cultivating the kind of medium- and long-term institutional investors best suited to their business.
Integrated Reporting and Japanese Business
Finally, I would like to comment on the significance of ESG and integrated reporting for Japanese companies. Ten years ago, my own interests were more narrowly focused on corporate governance. What caused me to broaden that focus to CSR and ESG was the shifting approach of foreign institutional investors in the wake of the financial crisis. As I contemplated the role and significance of nonfinancial investment criteria for Japanese businesses, I realized that the basic principles of CSR coincide substantially with the founding philosophies and corporate codes of most major Japanese corporations.
The similarity testifies to the long-term thinking of the business leaders who built modern Japanese industry. Virtually every entrepreneur back then wanted to build a business capable of making money while contributing to society over the long run—a business that rewarded long-term investors and proved its enduring worth to all stakeholders. Unfortunately, many Japanese business leaders began to lose sight of the big picture after the collapse of the 1980s asset bubble. As they struggled to cope with intensifying global competition, domestic deflation and its attendant price wars, the high value of the yen, and the demographic crisis, not to mention various natural disasters, many became too preoccupied with day-to-day survival to think about the next 5, 10, or 20 years. Japanese companies themselves fell into the trap of short-term thinking.
Now Japanese industry is regaining its confidence as earnings and stock prices respond to the economic policies of Prime Minister Shinzo Abe. I believe it is time for each management team to recommit to the principles on which the company was founded and enter into serious discussions on ways to enhance long-term corporate value and ensure the health of the business for generations to come.
Integrated reporting is merely a framework for such discussion. The material issues to be reported are decided by each corporation. At this point, institutional investors have no rigid ideas about what an integrated report should look like. The content of any given integrated report will depend on the company’s definition of value, its business strategy, and its ongoing dialogue with institutional investors.