The Network for Sustainable Financial Markets is pleased to announce that SFM’s response was acknowledged by Japan’s Ministry of Economy, Trade and Industry (METI) and integrated into its overall recommended directions in the ITO Review of Competitiveness and Incentive for Sustainable Growth released at the end of last April. The over 100-page Review is the interim report on the call for evidence and information about improving relationships between companies and investors last October.
The recommended directions (see this overview of the interim report, p16-21) consist of six issues:
- Companies and shareholders cooperative value creation as the foundation of sustainable growth
- Corporate value management based on capital efficiency and not on short-termism
- Capital market reform to transform under-used financial assets into national wealth
- Promoting true dialogue between companies and investors through cooperation and tension
- Reviewing corporate disclosures to promote sustainable corporate value
- Capital efficiency and corporative value creation as key to building and maintaining national wealth
1. Companies and shareholders cooperative value creation as the foundation of sustainable growth
The SFM response recommended integrated thinking on both financial and sustainability factors as useful for long-term growth of both companies and investor value. Companies should prioritise the integration of ESG factors into corporate competitiveness planning over the long term. The ITO Review suggests investors change their skewed view that their interests are subordinated to those of companies’ clients, employees, business partners such as Keiretsu companies and counterparties of cross-shareholding, and assess corporate value creation in the broader context of stakeholders’ value, which should lead to long-term increase in shareholder value.
2. Corporate value management based on capital efficiency and not on short-termism
The SFM response stated that management disclosures on their consideration of ESG factors are useful to long-term investors. This should help to ensure steady access to financing and lower the cost of capital. It also outlined three factors of good management disclosures: 1) board effectiveness and practices; 2) analysis of the relationship between long-term financial performance and ESG factors; and 3) executive incentive pay packages linked to measures of growth in economic profit. The ITO Review focuses on capital efficiency of overall business activities, rather than of variable executive incentive pay packages.
3. Capital market reform to transform under-used financial assets into national wealth
The SFM response identified serious agency problems within the investment value chain, for example, other stakeholders within the investment value chain have different time horizons, behavioural biases and incentives than investment beneficiaries. SFM also suggested potential regulatory approaches to solve the problem. The ITO Review emphasises significance of the misalignment of interests and promotes education of both individuals as beneficiaries and institutional investors. The Review also anticipates that the huge amount of household assets available for investment will become a source of financing for corporate sustainable growth. It focuses on using practical tools, such as the NISA (Nippon Individual Savings Account) and CSA (Commission Sharing Agreement) to unlock this potential.
4. Promoting true dialogue between companies and investors through cooperation and tension
The SFM response detailed why and how the stakeholders within the investment value chain act for their own interests. Asset owners prioritise the interests of parent organisations, lack necessary human and professional skills, and preferred short-term returns during the “lost quarter century” (no longer “lost decade”). This has resulted in asset managers’ short-termism being incentivised by their remuneration schemes and sell-side analysts’ prioritisation of daily communication with asset managers, at the expense of long-term business analyses. The ITO Review accepts these concerns and recommends that asset owners and managers spend more time and energy on engagement with companies and proxy voting. This is expected to improve their long-term returns with reference to Japan’s Stewardship Code and involvement in the establishment of Japan’s corporate governance code. Furthermore, the Review suggests sell-side analysts provide in-depth analyses from a long-term perspective. It strongly supports active investment based on sell-side analyses, rather than the currently prevailing passive investment.
5. Reviewing corporate disclosures to promote sustainable corporate value
The SFM guiding principles we cited emphasise that companies need to identify and value both hidden opportunities and risks. Companies should refer to Michael Porter’s Shared Value model and the Value Driver Model. The ITO Review accepts usefulness of the models by identifying four factors associated with competitive companies as 1) ability to provide value to customers, 2) business portfolio optimization; 3) continuous innovation, and 4) ability to respond to changes and risks. It also requires companies to use integrated reporting and avoid over-emphasis of short-term performance by promoting assessment of long-term value creation drivers, including ESG factors.
6. Capital efficiency and corporative value creation is key to building and maintaining national wealth
The SFM response stated that the integrated reporting model is fully consistent with beneficial components of the traditional Keiretsu relationship, since the model uses the following capitals as sources of corporate long-term value creation and inputs to corporate business models: financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital, and natural capital. The SFM also assumed that Japanese companies understand the inter-dependencies of these capitals and could adopt this integrated thinking and reporting approach. The ITO Review concludes that Japan has achieved a sustainable economy, but its growth rate has been low or negative. Therefore it identifies the capitals as important to move the economy to sustainable growth and stresses the significance of strengthening consideration of these capitals in Japan’s context of dramatic aging and declining population.
However, the ITO Review does not adopt all of SFM’s recommendations, including integration of preventable surprises analysis into corporate risk management, introduction of a FTT (Financial Transaction Tax) and amendment of accounting standards to reflect externalities. To create a more sustainable economy, we could learn from practices in different countries. Various systems have their pros and cons.
SFM participants will continue engaging with the METI to submit further comments in response to its public consultation call. The METI calls for further information and evidence related to the Review to be submitted by 20 May 2014 and plans to publish a final report in the early summer of 2014.