LCAW2022: Japan’s ESG benchmarks are finally in the spotlight

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Celebrating London Climate Action Week, this article is part of IFA Magazine’s editorial campaign throughout the week, which aims to highlight key issues, news and viewpoints in the field of climate action.

Junichi Takayama, Director of Japanese Equity Investments at Nikko Asset Management

While in today’s world many companies display their ESG credentials as a badge, Japanese companies have long had an enduring mindset, though they rarely express it more broadly.

That’s because in Japan, a deep-rooted connection to the environment and society has always been common sense, not something that needed to be articulated.

Japan’s circular economy has deep roots

It is impossible to look at Japan today without remembering its history. Japan’s deep connection to the environment and society has been a feature for centuries, dating back to the Edo period from the 17th to the 19th century. During this period, while Japan’s economy was effectively closed to the rest of the world, its urban economy was fueled by respect for nature and a determination to maximize all available natural resources.

According to historian Tanaka Yuko: “Edo was a circular economy in which energy and resources were supplied domestically and all major vital resources – clothing, food and housing – were recycled and reused”

While the rest of the world is slowly adapting by introducing its versions of a sustainable circular economy, these instincts are already embedded in Japanese culture and are therefore being reintroduced at a faster rate of progress.

And yet, today, on many important ESG indicators, Japan lags behind its developed market peers, meaning there is still room for significant improvement. The active engagement of Japanese companies is therefore essential in order to 1) encourage them to better articulate positive ESG activities already underway, or 2) advance new ESG initiatives, thus unlocking more value. As the world’s third-largest economy, with an investment universe of 3,700 companies, there is clearly a lot of work to be done, but a meaningful commitment to ESG principles certainly has the potential to produce hugely positive results.

Capitalism and stakeholder engagement

Similarly, Japan has for centuries had a culture of stakeholder capitalism – putting people and planet first in economic and corporate policies – which has now been more firmly reinforced by government policies.

The establishment of the Stewardship Code, one of the main pillars of an economic recovery plan initiated by Prime Minister Shinzo Abe in 2014, marked a turning point in terms of changing the way institutional investors interact with companies in which they invest. is a “constructive engagement with beneficiary companies” that institutional investors are encouraged to undertake to foster sustainable growth.

Specifically, the Stewardship Code encourages engagement between institutional investors (such as asset managers) and beneficiary companies in the following ways:
• Owners of assets, such as pension funds, are encouraged to monitor whether the asset managers who invest on their behalf carry out stewardship activities in accordance with the policies of the asset owners, and the quality of the dialogue between the asset managers and beneficiary companies is a key valuation point.
• The code emphasizes constructive engagement between institutional investors and recipient companies to resolve governance issues that the latter may face.
• Institutional investors in charge of passive management are encouraged to take active responsibility for engagement and voting (on the principle that passive management gives institutional investors fewer options to sell the shares of beneficiary companies and that they are therefore able to promote longer-term capital growth.

How engagement leads to alpha

The engagement has gained traction through its positive impact on all parties involved: asset owners, institutional investors and beneficiary companies. Academic research shows that the engagement activity of large institutional investors targeting companies with potential areas of improvement, such as governance, poor return on assets (ROA) and excessive liquidity, has had a positive impact on target companies.

This resulted in a higher return on equity (ROE), more independent directors and a proportion of shares held by management. In Japan’s changing landscape, we believe engagement is an important source of differentiation. By identifying undervalued names that have the potential to increase their value due to ESG-related factors, engaging with those companies – on issues such as decarbonization, human capital management and improvement of their governance frameworks – will improve their fundamentals, increase their enterprise value and ultimately lead to higher returns.

More importantly, engaging with Japanese companies can offer another dimension, bringing hidden value to light. There are strong arguments to suggest that the ESG credentials of many Japanese companies go unnoticed globally, either because Japanese companies have reputational or legacy issues to overcome, or because companies neglect to push their case. ESG with as much force as they could.

Kawasaki Heavy Industries: Designing a Hydrogen Society

Kawasaki Heavy Industries (Kawasaki) has a worldwide reputation as a multinational industrial manufacturer of motorcycles, engines and heavy equipment. It does not have a reputation for being a clean energy provider. But after playing a role in helping Japan become an industrial powerhouse in the 20th century, Kawasaki Heavy is firmly aiming for the 21st century with a focus on hydrogen.

Hydrogen is expected to play a key role in plans for Japan to become carbon neutral by 2050 as Japan reduces its dependence on fossil fuels. Green hydrogen has been labeled “the ultimate clean energy” because it can be used like gasoline to power vehicles, but also to generate electricity. While hydrogen can be produced from fossil fuels, it can also be extracted from water through electrolysis, using electricity to break down H2O into hydrogen and oxygen, a technology we expect to accelerate in the years ahead. coming.

But since Japan does not have the necessary natural resources, nor the space to build large-scale solar farms for electrolysis, it will have to acquire hydrogen from Australia and the Middle East, which have abundant resources. resources, land and sunlight for solar agriculture. Getting hydrogen to Japan currently presents a significant technological challenge. It must be transformed from gas to liquid by cooling it to -253°C before it can be transported. At reduced volume, the efficiency of hydrogen storage, transportation and distribution increases dramatically.

From a value perspective, Kawasaki seems significantly undervalued. It already has several years of experience in the transport and storage of liquefied natural gas at temperatures of -162°C. Kawasaki already has the cutting-edge technologies needed to mass transport hydrogen that could transform Japan into a hydrogen-driven society. In April 2022, the Japanese Hydrogen Association HySTRA announced the completion of the world’s first maritime transport of liquefied hydrogen, including its loading and unloading, in Kobe, Japan.

Kawasaki is an example of a cutting-edge company judged on its legacy operations rather than its future possibilities. From an engagement perspective, it has not been able to fully articulate the scope of its clean energy ambitions to the wider investment community, or reposition itself away from its reputation as a ‘” heavy industry “. In recognition of this, Kawasaki has established a “Sustainability Promotion Department” which will seek to further explain its clean energy initiatives.

Summary

The growing importance of ESG and social responsibility is an opportunity to identify hidden value in companies that are prepared to tackle and solve social issues. Additionally, the transition to a decarbonized and more sustainable society creates growth opportunities for companies with environmentally friendly technologies, especially in clean energy solutions. However, while companies around the world are eager to demonstrate their ESG credentials, very few companies are able to make a meaningful difference in the future direction of the world.

While companies such as Kawasaki have the technology, know-how and determination to drive this change, the technologies themselves are either still intangible – and have yet to be represented in data – or still experimental and unrecognized as the main source of income for these companies. profits. It is therefore understandable that global investors, even those with an ESG perspective, still overlook these companies. But these hidden-value businesses, driven by a combination of innovative problem-solving principles and deep-rooted sustainability principles, deserve closer examination.

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