ESG focus ‘could be short-lived’ in Japan

Japanese investors’ growing focus on environmental, social and governance (ESG) factors could be short-lived if institutions don’t incentivise fund houses to focus on it, an AsianInvestor forum heard.

Asset managers are providing ESG services and solutions, but saying they have insufficient asset owners investing in this area, noted Kris Douma, director of investment practice and reporting for the UN’s Principles for Responsible Investment division (UNPRI), speaking at the fifth Japan Institutional Investment Forum last week.

“The driving force of this movement has to be the asset owners,” he said, suggesting the ESG debate had moved beyond a simple focus on whether good corporate social responsibility was beneficial to returns.

“The difficult question is: ‘Are investors able to capture that?’ That is more difficult because some of these issues are already priced in and some aren’t,” said Douma. “We know companies benefit from good social responsibility. But it is quite a difficult task to capture that as an investor. There is a lot to learn about that.”

Asked in a panel debate whether institutions in Japan were prepared to pay more for the deeper research required for ESG screening, former CFA chairman Charles Yang said the onus was on managers to exceed investors’ return expectations.

“If that can be done consistently over three to five years, my hope is asset owners will be prepared to share [fees] with the asset managers,” he said. “Without that financial incentive, I think this whole focus on ESG could be short-lived.”

Yang noted ESG research was time-intensive and analysts needed to be incentivised to focus on the long term, which would require a shift in mindset, given that Japan has operated in a quarterly earnings framework since 2008.

One challenge when it comes to convincing asset owners of the value of ESG screening is that evidence that it enhances returns or reduces risk is still largely anecdotal.

Douma highlighted how UK oil-and-gas company BP had seen its share price plunge 60% after its oil spill in the Gulf of Mexico in 2010. He argued that ESG screening would have picked up that the company had already suffered accidents that hurt its share price. “With the advantage of hindsight we could see that the signs were there,” he said.

He also noted that BP had policies on the environment and health & safety in place, but said the question was not whether policies were in place but how they were implemented. “Is it really something that has the attention of higher management?”

On the question of how to boost the average return on equity (ROE) of Japanese firms – which, at 7-10%, is well below the 21% in the US – Yang said it was still early days. But he has seen Japanese companies become increasingly explicit about ROE targets.

“Perhaps 8% [ROE] may not be too sexy compared with other companies around the world, but management being accountable for that ROE target in the next three to five years is a step in the right direction.”

Yang said he expected to see numerous studies over the next two years on what the right ROE target might be and what company management and engagement professionals could do to enhance the number.

Asked by a member of the audience to explain the extent to which ESG screening had penetrated the alternative investment universe, Douma said the practice was well established in the areas of infrastructure, real estate and private equity.

However, he recalled investing in a firm engaged in a mining project in Angola that partially listed several years later but subsequently saw its share price sink 30% after being dragged down by a corruption scandal in West Africa.

The company he worked for was doubly exposed; it owned some of the shares and was also a limited partner in the private equity firm.

“I was very angry with the GP [general partner] because he was supposed to be responsible for managing that company,” Douma recalled. “Secondly I do not want to find out about this through the media. I want to be informed by the GP.

“These are the kinds of issues that asset owners and limited partners are discussing with their GPs in the private equity sphere. PE has to do a better job at managing the issues and communicating with their limited partners.”

He said that while he had no such concerns for infrastructure and real estate, he worried about hedge funds. “That is the most difficult asset class to really get your hands on,” he stated.

“How do we integrate ESG into hedge fund investment? We have a lot of work to do on that one. That is the major challenge for the next two to three years.”