The Tokyo Foundation for Policy Research


The Tokyo Foundation for Policy Research

The Evolution of ESG Investing: From Ethical Concern to Corporate Value

June 6, 2017

Why are the socially responsible policies once viewed as additional cost factors now being treated as indicators of corporate value? The basic reason , notes Mariko Kawaguchi, is a change in the social and institutional environment in which companies operate .

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© Ivary/Getty Images
© Ivary/Getty Images

Around the beginning of 2016, the acronym ESG began turning up with increasing frequency in the Japanese media. ESG stands for environment, society, and governance, the three broad areas of corporate social responsibility encompassing such issues as environmental protection, gender diversity, and labor rights. ESG investing is an approach to investment decisions that factors in businesses’ policies and performance relative to such issues. By the end of 2014, the global ESG investment market had grown to $21.3 trillion (about ¥2,560 trillion at then-prevailing exchange rates), accounting for 30% of all professionally managed assets.

Evolution of ESG Investing

Not long ago, investment geared to social and environmental concerns was widely referred to as “socially responsible investment,” or SRI. The phenomenon of responsible investing first emerged in the United States back in the 1920s, when churches with assets to invest began applying faith-based criteria to exclude certain investments from their portfolios—businesses in the alcohol or tobacco industry, for example. In the post—World War II era, amid the rise of the civil rights and antiwar movements, activists turned to shareholder advocacy, a major form of SRI, to influence corporate behavior in a manner consistent with their environmental and social goals. Whether faith-based or linked to a social movement, such “responsible investment” was regarded as a niche investment category by mainstream investors, unique in that it placed ethical or moral considerations over financial returns.

The tide began to turn in the 1990s, as ESG-related issues began attracting more and more attention. In the area of the environment, the 1990s witnessed such milestones as the Rio Earth Summit of 1992, the release of international standards for environmental management (ISO 14001) in 1996, and the adoption of the Kyoto Protocol in 1997. It was a time of growing environmental awareness worldwide, accompanied by the adoption of rules and regulations addressing a wide range of emerging environmental concerns, from toxic chemicals and recycling to climate change.

In Europe, inclusion was emerging as a key social issue as the region moved toward full integration. Social cohesion became a central social issue, and respect for human rights emerged as a priority theme in CSR. The period beginning in the mid-1990s was also when the apparel industry came under scrutiny for child labor and other human-rights abuses in its international supply chain, leading to boycotts of Gap Inc. and other companies. In the early years of the new millennium, business ethics and compliance issues were much in the news. In Japan, the food industry was hit by a series of safety and mislabeling scandals implicating such major companies as Snow Brand and Nippon Ham, while in the United States, the Enron scandal was cited as one of the biggest audit failures in the country’s history.

Amid these changes in the social climate, corporate managers began to embrace environmental management, equal opportunity, work-life balance, supply-chain labor rights, and other socially responsible policies as integral to the management of business risks and opportunities—rather than as cost-incurring “contributions to society.” At the same time, a growing number of institutional investors began eyeing environmental and social performance as indicators of long-term corporate value. The realization also spread that governance and transparency problems—an unhealthy corporate culture at the root of the abovementioned scandals, opaque decision making, excessive executive salaries, and so forth—should be perceived as risk factors.

In short, some business managers in Europe and North America began to move away from the idea of social contributions as an additional business cost and toward the concept of ESG policies as integral to the management of business risk and opportunity. Western investors, meanwhile, began to recognize the importance of ESG criteria in investment decisions predicated on the assessment of business risks and opportunities, as opposed to value judgments grounded in religious or social movements. At the same time, ESG investment promised to exert a positive impact on industry and society as a whole by giving businesses additional incentive for pursuing robust ESG policies. Major Western public pension funds in particular, with their long-term investment orientation and public missions, eyed the potential of ESG investment to boost performance and bring about positive social change. With the establishment of the Principles for Responsible Investment in 2006, these ideas began to spread rapidly among institutional investors, particularly in Europe.

Japan’s Stunted SRI Market

The dawn of socially responsible investing in Japan can be traced to 1999, a time of rapidly growing public awareness of global environmental and social issues. The next few years saw the proliferation of “eco-funds” and “SRI funds,” investment trusts targeted to individual investors with an especially keen interest in environmental or social causes. However, the notion of ESG criteria as valid indicators of corporate value, now widely embraced in the West, made little headway among Japanese institutional investors, and SRI remained largely the preserve of niche funds targeted to those individual investors who placed environmental and social concerns over financial returns. Public pension funds, which have been the biggest major driver of ESG investment in the West, largely ignored these criteria. As a result, Japan was largely isolated from global trends; as of the end of 2014, its ESG investment market was valued at under ¥1 trillion, less than 0.5% of the global total.

But the “black ships” have arrived to challenge this national isolation. The adoption of Japan’s Stewardship Code in 2014 and the Corporate Governance Code in 2015 have changed the ground rules for investment. In addition, in September 2015, Japan’s Government Pension Investment Fund, the world’s largest public pension fund, signed onto the Principles for Responsible Investment. As a result, the PRI’s signatories now comprise more than half of the world’s top 20 pension funds and account for more than 70% of the top 20’s assets.

Purpose of ESG Investing

The term ESG investing can be traced to the Principles for Responsible Investment, a set of global guidelines drawn up under UN leadership and adopted in 2006. As of June 6, 2016, the PRI boasted 1,531 institutional signatories, including 310 pension funds and other asset owners, 1,011 investment managers, and 210 service providers. All signatories pledge to “incorporate EGS factors,” along with financial data, when making investment decisions and are required to provide detailed public information faithfully representing their approach to responsible investment.

But what exactly does it mean to “incorporate ESG factors”? Basically, it means to include among one’s investment criteria the ESG policies of potential investees and, where appropriate, to engage them to adopt stronger ESG policies. These encompass initiatives relating to the environment (such as carbon emissions, energy efficiency, resource efficiency, recycling, water resources, renewable energy, control of chemical substances, preservation of forests and marine resources, and manufacture and sales of environmentally friendly products), social issues (including workplace diversity, working conditions across the supply chain, child and forced labor, and modern slavery), and corporate governance.

But why are the same policies that were once viewed as additional cost factors now being treated as indicators of corporate value? The basic reason is a change in the social and institutional environment in which companies operate. Mounting threats to human society from such global problems as climate change, wealth gaps, the refugee crisis, and terrorism have spurred changes in attitudes among consumers, workers, and other stakeholders and led to regulatory and other systemic reforms. Within this new context, the realization is spreading that, in the twenty-first century, the neglect of ESG issues in business strategy and operations constitutes a major risk.

Paralleling these developments are changes in the interpretation of fiduciary duty—the legal responsibility of pension fund trustees, investment advisors, and asset managers to act in the best interest of those whose assets they manage. Until fairly recently, there was a widespread assumption among such professionals that the application of ESG criteria to investment decisions out of ethical concerns was a violation of fiduciary duty. However, in 2005, a research report compiled by the international law firm Freshfields Bruckhaus Deringer reached a different conclusion. After analyzing the legal situation in nine major industrial countries, it concluded that there were many situations in which “the decision-maker would be entitled to [choose] on the basis of . . . non-value-related ESG characteristics, without thereby being in breach of his or her fiduciary duties or civil law obligations.” More recently, the 2015 asset owner survey conducted by Responsible Investor concluded that appropriate application of ESG criteria is essential to the fulfillment of fiduciary responsibility.

Also in 2015, the adoption of two important global frameworks, discussed below, accelerated this shift in thinking among institutional investors and helped usher in a new era of ESG investing in Japan.

The Paris Agreement

In November—December 2015, the parties to the United Nations Framework Convention on Climate Change met in Paris for the twenty-first Conference of the Parties (COP 21) to establish a new framework for greenhouse gas reductions to succeed the Kyoto Protocol. The result was the Paris Agreement, which acknowledges the need for a response to the urgent threat of climate change and commits the parties to measures to address that threat. The agreement sets the goal of zero net greenhouse gas emissions from human activity by the second half of the century in order to hold the increase in the global average temperature to well below 2°C (and preferably below 1.5°C) above pre-industrial levels and binds all the parties to “undertake and communicate ambitious efforts” toward that goal. More specifically, it obligates each party to set targets for emissions reduction or limitation, implement domestic measures to achieve those targets, and submit data on its progress for international review and evaluation. New targets are to be set every five years in accordance with global conditions and outcomes.

The ripple effect of this agreement can already be seen in action by industry, local government, and the investment community. A major example in the private sector is RE100, a “collaborative global initiative of influential businesses committed to 100% renewable energy.” Such global corporations as IKEA, Nestl—, Swiss Re, Philips, Microsoft, Goldman Sachs, Tata Motors, and Google have signed onto the initiative. Subnational governments have committed themselves to fight climate change at the local level under the Paris City Hall Declaration. In the asset management community, there is growing interest in investing in renewable energy and energy-efficient technology and divesting from fossil fuels. Some have even warned that fossil fuel reserves could become “stranded assets.” The argument here is that most of the known fossil fuel reserves of energy and mining companies is unusable, since the total stock represents 2,795 gigatons of carbon dioxide emissions, whereas only 565 Gt can be emitted between now and 2050 if the global temperature increase is to be kept below below 2°C. (However, these “stranded assets” have yet to show up in financial reports or valuations.)

In addition, in December 2015 the Financial Stability Board launched an industry-led Task Force on Climate-Related Financial Disclosures. The task force was scheduled to publish a set of preliminary recommendations for public comment by the end of 2016. As these examples testify, a commitment to slashing carbon emissions is fast becoming a prerequisite for running a major global business.

The Sustainable Development Goals

The second milestone of 2015 was the adoption of the Sustainable Development Goals by the 194 countries of the UN General Assembly in September that year. Formally titled Transforming Our World: The 2030 Agenda for Sustainable Development , the document is an ambitious action plan for addressing global social issues (from terrorism to poverty) and environmental challenges (from climate change to biodiversity) that threaten the sustainability of human society. It consists of 169 targets for the achievement of 17 aspirational global goals, including poverty eradication, good health and well-being, quality education, clean energy, sustainable cities, responsible consumption and production, and action on climate change.

Countries around the world are already drawing up and implementing policy measures aligned with the SDGs. For example, the British Parliament passed the Modern Slavery Act 2015, which requires all businesses with turnover above a certain threshold to submit a transparency statement regarding the labor situation in their supply chains. In the same year, France passed legislation on “energy transition for green growth,” which calls on financial services to disclose the carbon footprint of their products. In May 2016, the Japanese government established the SDG Promotion Headquarters, headed by the prime minister. With all cabinet ministers participating directly, the headquarters aims to integrate the SDGs into government policies dealing with commerce and industry as well as health, labor, and welfare. In the private sector, some forward-looking Japanese companies are already moving to align their CSR strategies to the SDGs.

Japan’s Coming ESG Investment Boom

These new global frameworks, combined with the impact of Japan’s Stewardship Code, have energized Japan’s lagging ESG investment sector. Valued at less than ¥1 trillion at the end of 2014, the market seems to be making up for lost time. Japan’s more progressive institutional investors have already begun modifying their behavior in response to the adoption of Japan’s Stewardship Code. In a survey conducted by the Japan Sustainable Investment Forum in October—November 2015, the 24 institutional investors responding reported a total of ¥26.7 trillion in ESG investments, 11.5% of all assets under their management. And the responsible investment trend has accelerated further since GPIF became a signatory to the Principles of Responsible Investment in September 2015. Between September 2015 and June 2016, the number of Japanese signatories to the PRI rose from 36 to 45, and the number of Japanese institutional investors employing ESG specialists has soared.

Both Japan’s Stewardship Code and the Corporate Governance Code call for constructive dialogue between investors and businesses with a view to enhancing long-term corporate value. This is another opportunity to highlight ESG considerations, since human resources and environmental policy are issues that investors are likely to raise in the context of long-term business strategy. That said, ESG covers a great deal of ground, and there is still no consensus on the precise ESG factors to be integrated into assessments of corporate value or on the methods to be applied in such assessments. A growing number of Japanese corporations are already experimenting with ways of integrating the SDGs and the commitments of the Paris Agreement into their own long-term business strategies. Japan is entering an exciting new phase in which businesses and investors search for answers together through the ongoing exchange of data and analyses.

Over the years I have encountered corporate representatives and institutional investors who believed that SRI would never take hold in Japan. But the institutional investors in the aforementioned JSIF survey reported an average of more than ¥1 trillion in ESG assets under their management. The day when Japan’s ESG investment market tops ¥100 trillion cannot be far off.

    • Managing Director and Senior Analyst, ESG Research Department, Daiwa Institute of Research
    • Mariko Kawaguchi
    • Mariko Kawaguchi

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