Big steps for ESG in Japan, but long road ahead

Despite significant progress on corporate governance, the challenges for Japanese companies remain enormous.

The Japanese Stewardship Code and Corporate Governance Code for investors are the most important corporate governance reforms introduced under “Abenomics” to boost business competitiveness and facilitate engagement activities. These reforms have been supported by key players such as the Bank of Japan (BoJ) and the Government Pension Investment Fund (GPIF), providing momentum and contributing to their validation.
Among the changes introduced by these reforms in Japan, the most prominent is the requirement for the appointment of at least two external outside directors in to the boards of most companies included in the TOPIX Index*. The role of the “Sodanyaku” – retired senior executive managers who still hold influence with existing management – has also been under the spotlight, with shareholders voting against company proposals for appointment of these senior advisers in some cases.
What is more, investors have increasingly been looking at the creation of corporate foundations financed by company equities, following concerns that the intensions of these foundations are not in the best interest of shareholders. Perhaps one of the most significant change has been that investors have pledged to engage with management by signing up to the Stewardship Code, keeping management informed of any shareholder concerns. Both the Stewardship Code and the Corporate Governance Code have therefore been playing an important role, shaping the direction of corporate strategies and Environmental, Social, Governance (ESG) approach of many Japanese companies
The pace of change over the last few years when it comes to ESG is seen as a tectonic shift, even from a domestic perspective, where many have experienced various false dawns. Indeed, in the domestic market, transparency has also improved. Following the introduction of corporate governance structure reforms, larger domestic investment managers have started to disclose proxy voting results after AGMs, making decisions on the selection of board members known to the public, based on their proxy voting polices. This has encouraged Japanese companies to move towards globally recognised standards.
Despite significant progress on corporate governance, the challenges for Japanese companies remain enormous.Memorable failures and incidents from companies which used to be leading players in Japan further prove this point. Among these are Toshiba and KOBELCO who this year became typical examples of where the gap between corporate governance reforms and realities remain large. Both these cases taught investors that traditional ways of management thinking fall far short of expectations. Although the level of disclosures on ESG by Japanese companies has generally improved, the standard ESG metrics in areas such as human capital are still not widely disclosed. Of course, the future success of companies is not guaranteed by disclosing such information, and there are companies who perform well without having to be transparent. However, many issues can be hidden behind old corporate structures and change beyond management is required to break the mould.
In order to cope with opportunities and challenges at home and abroad and continue to flourish and improve their returns, Japanese companies need to seize these reforms and mobilise their capital and resources. Domestically, despite Japan having a shrinking and aging population, dramatic changes in immigration policies to support growth are unlikely due to current political sentiment. Moreover, given the country’s geographic location, Japanese companies find themselves in the best spot to access the Asian market relatively easily. To some extent, we have already seen how this works in practice, with companies such as Japanese cosmetics leader Pola Orbis expanding its franchise by focusing on local tastes and preferences in countries like Thailand and Indonesia, taking advantage of local demand.
It is a well-known fact that Japanese companies have accumulated cash, at the expense of employee wages and benefits, at the same time lowering returns to investors who are frustrated by the lack of meaningful initiatives and are taking advantage of relatively flexible balance sheets.
Investing in human capital is the next step that Japanese companies need to implement to improve their competitiveness. This can be achieved by finding talent regionally as well as globally and throughout an organisation.
It is no secret that Japan suffers from an older population which is increasingly retiring from their jobs,
and shortages of a younger workforce. This has been chipping away at the traditional corporate system which has been the foundation of many Japanese firms. In order for Japanese companies to be successful in light of recent corporate governance reforms, they need to make generational shifts to reflect the current working environment. One way to do this is by improving diversity at the senior management and workforce level. Indeed, recent corporate scandals and failures can be traced to the inability to find the skills and talents in a changing environment.In these cases, investors should play their part and oust incompetent management teams who are unable to make decisions that are critical to increase long term returns.
The next chapter of reforms to revive Japan Inc should be focused on human capital and financial capital changes. Although significant steps have been made to improve ESG in Japan, there is still more ground to be covered before it reaches its final destination.

Seiji Kawazoe is an ESG specialist at SuMi TRUST