By Helena Fung, head of sustainable investment, APAC
The appetite among domestic investors in Japan for ESG (environmental, social and governance) instruments has undoubtedly been gaining momentum.
The Japan Sustainable Investment Forum (JSIF) reports that total sustainable investment AUM rose to JPY336.4 trillion (USD3.1 trillion) in the 2019 fiscal period, marking a 45% jump from the previous year. These assets, according to the Global Sustainable Investment Alliance (GSIA), represent 55.9% of the total professionally managed money in Japan, up from just 3% in 2016.
The GSIA credits progressive moves made by large institutional players, notably the country’s USD 1.5 trillion Government Pension Investment Fund (GPIF), along with the overhaul of the Japanese Stewardship Code, for encouraging asset managers to further integrate ESG principles into their portfolios and promote stronger governance standards across the board.
Additionally, there is evidence to prove that aligning investments with morals and values can be just as profitable. Research conducted by the IMF shows that funds with a ‘sustainable mandate’ have returns similar to those of conventional equity funds. Of course, those figures exclude the long-term benefits to the planet and communities accruing from measures such as reducing the carbon footprint, eliminating child labour or stamping out corruption.
Dissecting the reality
Do these trends prove that Japanese investors have fully integrated ESG measures into the investment process? A detailed look at the issue shows there is considerable room for improvement.
Bond investments, estimated at JPY 146 trillion (USD 1.35 trillion), represent the largest sustainable AUM by asset class, according to JSIF. This is largely due to the GPIF’s enhanced commitment to ESG integration across all asset classes, which includes a large allocation to Japanese government bonds. As commitments turn into further action, how sovereign bond investments are integrated with environmental and social concerns will be an interesting trend to monitor.
The second largest AUM tranche is that of domestic equity investments. One of the first steps of sustainable investment implementation for this asset class is thought to be engagement, which is the most common method of sustainable investment implementation in Japan representing an estimated AUM of JPY 218.6 trillion (USD 2.03 trillion)
In a market originally hesitant toward engagement activities, the increase in engagement efforts including participation in global initiatives such as Climate Action 100+ and keen alignment to the TCFD framework is encouraging. However, the relatively poor overall ESG performance of Japanese companies compared to key developed market peers shows that there is still room for such engagement efforts to result in market-wide higher levels of disclosure and action by the investee companies.
Building a post-coronavirus market
Given the heft of Japan’s blue chip majors, there is a natural inclination to focus mainly on these firms and their ESG strategies. However, this can both mask risks in the wider market, as well as do a disservice to smaller companies who are taking proactive steps to enhance their visibility in this space.
Admittedly, many small-cap companies face challenges in committing the same breadth of resources as their larger counterparts, whether that is systematically collating and disclosing the relevant data, or having the firepower to sustain ESG-appropriate performance. This could be a contributor to the clear overall underperformance by the smaller companies that are now covered by FTSE Russell’s ESG research for the first time (See Chart 2).
These underperformance trends by smaller companies are even more prominent when looking at how well they are managing their supply chain risks, such as monitoring, training, and managing the labor rights of their suppliers (See Chart 3). If nothing else, the recent outbreak of COVID-19 has heightened our attention to the importance of understanding the risks and opportunities inherent in global supply chains.
However, it may be too simplistic to look at the smaller companies in isolation. While listed in their own rights, mid and small market cap companies are often subsidiaries or part of the global value chain of larger listed Japanese conglomerates. By understanding the ESG performance status of smaller Japanese companies, investors may fine-tune their engagement efforts with the larger companies to create a trickle down risk management effect.
Surveys of listed Japanese companies have shown that smaller companies that were not part of any assessment universe for ESG indexes did not have the necessary information or incentives necessary to drive action. On the other hand, including small caps in reputable ESG research coverage allows them to benchmark their position on a myriad of themes against their global peers.
Such metrics can guide executives on the changes that need to be made, and their extent, in order to plug gaps and boost their ESG credentials. FTSE Russell’s recent expansion to cover all small cap Japanese companies under the Global Equity Index Series, which almost doubles the research universe to approximately 1,300 securities, should provide helpful insights into the wider market.
Such enhanced research and analysis—which is based on the same ESG rating methodology that forms the backbone to FTSE Blossom Japan, the flagship domestic ESG index—can facilitate advances in both recognition and demand from domestic investors on ESG issues; whether they choose to prioritize ESG principles in their overall decision-making, or pick specific themes to build portfolios around.
Overall, as regulators and authorities endeavor to create universal definitions and standards to realize the full potential of impact investing, the current uptrend in ESG-related financing is going to diversify and deepen, not only in Japan but around the world.
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FTSE ESG Ratings: https://www.ftserussell.com/data/sustainability-and-esg-data/esg-ratings 
FTSE Blossom Japan Case Study: https://www.ftserussell.com/index/spotlight/ftse-blossom-japan-index
 Data from 30.12.2019. Average ESG Rating score of large and mid cap constituents in markets with more than 50 constituents within the FTSE Developed Index universe.
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