ESG Spotlight. Strengthening corporate governance in the Japanese market 24 April Key Insights. Corporate governance and economic growth

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1 Corporate governance adaptability score ESG Spotlight 24 April 217 Themes: Corporate governance and stewardship codes Sectors: Multiple Country: Japan Key Insights Recent macroeconomic trends in Japan illustrate how addressing corporate governance can help investors maintain an edge in global markets. We analyze a sample of 45 Japanese firms and find significant differentials in the corporate governance adaptability of Japanese industries and firms. Diversified Financials stands out as the industry best prepared to adapt to Japan s shifting corporate governance environment. Corporate governance and economic growth Recent macroeconomic trends and policy reforms in Japan underscore the importance of improving the corporate governance practices of Japanese companies. Prime Minster Shinzō Abe s third arrow of structural economic reforms has taken shape with several new policy measures, including the introduction of Japan s Stewardship Code and Japan s Corporate Governance Code. While Japan currently trails many global markets in corporate governance performance (see chart below), a closer look reveals substantial variation in governance practices both within and across Japanese industries. In this Spotlight report, we summarize Japan s corporate governance environment and deploy a composite metric to rank Japanese companies on their adaptability to strengthening corporate governance practices in Japan. For investors with exposure to Japanese equities, particularly those taking concentrated sector bets, this analysis can be used to inform sector weights or security selection processes. The findings can also help investors identify engagement targets. Corporate governance adaptability score across selected markets Authors Martin Vezér Associate Analyst, Thematic Research martin.vezer@sustainalytics.com Japan is working to improve its corporate governance profile, which currently trails global best practices. Martin Wennerström Associate Analyst, Corporate Governance martin.wennerstrom@sustainalytics.com 5 4 Doug Morrow Associate Director, Thematic Research doug.morrow@sustainalytics.com Source: Sustainalytics Corporate Governance Research 1

2 Investment as % of GDP Macroeconomic tensions in the Japanese market The Japanese market faces a downward trend in investment Source: Sustainalytics, IMF The Japanese economy has faced challenging macroeconomic conditions, including stagnating growth and the risk of a deflationary spiral, for the better part of the last two decades. Japan s nominal gross domestic product (GDP) in 215, at USD 4.4tn, was roughly the same as it was in As one comparison, US GDP was up over 13% during the same time period. 3 The causes of Japan s recent macroeconomic difficulties are interrelated and include the bursting of the country s asset price bubble in 1989, relatively high public debt as a percentage of GDP, low interest rates and declining investment. As shown in the chart to the left, investment as a percentage of GDP declined from 28% in 1995 to 22% in An additional factor is demographics Japan has the world s longest life expectancy, and people over the age of 65 make up a quarter of Japan s population. 5 Taking aim with Abenomics The three arrows of Abenomics Against this complex and challenging backdrop, Prime Minister Abe launched a series of stimulus reforms, colloquially known as Abenomics, in late 212. The policies seek to reinvigorate growth and promote spending and investment across the Japanese economy. The programme consists of three arrows: 1) fiscal stimulus, 2) monetary easing and 3) structural reforms. 6 While opinions vary about the extent to which these arrows have hit their targets, important lessons can be drawn from Japan s experience. Of particular interest for investors with an environmental, social and government (ESG) component to their investment or engagement strategies is the focus on improving corporate governance practices within the third arrow of structural reforms. Abe s third arrow Improving corporate governance can help boost investment Abenomics structural reforms include cutting corporate taxes, boosting agricultural productivity and liberalizing the energy sector. Alongside these policies is the ambition to improve the corporate governance practices of Japanese firms, which is a critical component in attracting foreign capital and boosting investment. Foreign investors have identified the lack of clarity and accountability in Japan s corporate governance and regulatory frameworks as one of the key factors inhibiting increased foreign direct investment in Japan. 7 Corporate governance Two strategic angles for taking aim at corporate governance reform Two key aspects of Japan s corporate governance initiative are Japan s Stewardship Code (JSC) and Japan s Corporate Governance Code (JCGC). While JCGC focuses on Japanese firms directly, JSC does so indirectly by encouraging investors to pressure companies to improve their governance practices. Like their counterparts in other countries, both JCGC and JSC are tailored to local conditions. While critics note that the efficacy of JSC and JCGC could be blunted by a lack of buy-in from the market, 8 these codes may spearhead a more concerted shift towards responsible investing in certain markets across the Asia Pacific region. 9 JSC has the backing of the Japanese Government Pension Investment Fund, which is the world s largest pension fund with an equivalent of USD 1.3tn in assets under management. 1 2 P a g e

3 Japan Stewardship Code Signatories Japan s Stewardship Code (JSC) Growth in JSC signatories Source: Sustainalytics, FSA In the hope of addressing a lack of shareholder activism in Japan, on 26 February 214, Japan s Financial Services Agency (FSA) published JSC. 11 Investors who sign JSC pledge to uphold seven principles for promoting sustainable growth, ranging from a commitment to 1) disclose publicly a clear stewardship policy, 2) address questions about potential conflicts of interest, 3) monitor investee firms and 4) engage with them on sustainable growth issues, 5) participate in voting, 6) report on stewardship responsibilities, and 7) remain well informed about investee companies. 12 Following the UK Stewardship Code, JSC is voluntary and provides signatories with the option to comply with the principles or explain deviations. 13 As shown in the chart to the left, JSC has attracted 214 signatories, 99 of which are domestic entities. 14 Taking aim at corporate managers A composite metric of four corporate governance indicators Japan s Corporate Governance Code (JCGC) With its sights set directly on corporate managers, JCGC entered into force on 1 June 215, covering all firms listed on the Tokyo Stock Exchange. JCGC defines five fundamental principles for effective corporate governance that focus on 1) securing the rights and equal treatment of shareholders, 2) appropriate cooperation with stakeholders other than shareholders, 3) ensuring the appropriate information disclosure and transparency, 4) responsibilities of the board and 5) dialogue with shareholders. Like JSC, JCGC operates within a comply-or-explain framework. Sharpening investment strategies: indicator analysis To help investors assess the adaptability of Japanese firms in relation to the principles of JCGC and JSC, we assessed 45 Japanese companies in our coverage universe on a composite metric that looks at four corporate governance practices referenced in JCGC. The underlying indicators, which are defined in the table below, are tailored to the Japanese market. 15 For instance, the board gender diversity indicator, which rewards companies that have at least one woman on the board, fleshes out leading practices among Japanese firms but represents a low threshold compared to global norms. Overall, the corporate governance adaptability metric provides a way for investors to identify companies and industries that are generally well-positioned to respond to a strengthening of JCGC-relevant practices. Corporate governance adaptability indicators Sustainalytics indicator Is there at least one non-executive director who displays CG 1.1 relevant industry experience as an executive or nonexecutive director at an outside company? Relevant aspects of JCGC principles The board should be well balanced in knowledge, experience and skills in order to fulfill its roles and responsibilities. CG 2.3 Is the board majority independent? Companies should appoint at least two independent directors. CG CG 4.6 Is there at least one woman on the board? Is a long-term incentive (LTI) plan disclosed? Companies should promote diversity of personnel, including the active participation of women. A proportion of management remuneration linked to mid- to long-term results and the balance of cash and stock should be set appropriately. Source: Sustainalytics Corporate Governance Research, JCGC 3 P a g e

4 Corporate governance adaptability score Comparing Japanese industries Performance gaps across industries Our analysis reveals significant (although far from dramatic) differentials in the corporate governance adaptability of Japanese industries. 16 With a score of 37, Diversified Financials stands out as the industry best prepared to adapt to Japan s tightening corporate governance environment. Banks narrowly trail with a score of 35. The Auto Components industry, which lags with a score of 21, may struggle to adapt to shifting governance norms. For investors taking concentrated sector bets within Japanese equities, this information can help inform target sector weights. Corporate governance adaptability score of selected Japanese industries Source: Sustainalytics Corporate Governance Research Four companies received a perfect score on our corporate governance adaptability metric Corporate governance leaders in Japan While Japanese companies, as a whole, trail global best practices in corporate governance, the corporate governance adaptability metric identifies important differences among Japanese firms. For instance, only four companies from our sample of 45 Japanese firms earned a perfect score on this metric (these firms are profiled in the table below). At the other end of the spectrum, 132 companies received a score of. These companies may be poorly positioned to adapt to tightening corporate governance standards in Japan and may represent timely engagement targets. Japanese companies with top corporate governance adaptability scores Company Industry Market cap (USD bn)* 1 year return Shiseido Co. Ltd. Household Products % 71.2 Hitachi Ltd. Technology Hardware % 66.1 Overall Corporate governance highlights ESG Score Shiseido is well-positioned in terms of board independence, with 57% of its directors being nominally independent. Moreover, the company provides fairly extensive disclosure of its long-term incentive plan. Hitachi s 13-member board includes two women. Several directors have relevant executive and/or nonexecutive experience from outside companies. Bridgestone Corp. Auto Components % 66.1 Bridgestone s board is over 5% independent and includes two women. Hoya Corp. Technology Hardware % 48.4 Hoya s board is over two thirds independent, with five out of six directors being external. * As of April 17, 217 Source: Sustainalytics Corporate Governance Research, Bloomberg 4 P a g e

5 Proportion of Japanese firms Corporate governance strengths in Japan Japanese firms perform relatively well on board experience Japanese firms struggle with board independence Board experience is a relative strength for Japanese firms. As shown in the chart below, 43% of Japanese companies have a board that includes at least one non-executive director who displays relevant industry experience as an executive or non-executive director at an outside company. While Japanese firms have a long way to go to fulfill the JCGC princple of maintaining a well-balanced board, they are well-positioned on this measure compared to other indicators in our composite metric. Board gender diversity is also noteworthy: one third of Japanese companies in our sample have at least one woman on their board. While this proportion is lower than that of most other developed markets, it reflects more diversity than some investors might assume for Japanese firms. An ongoing struggle is board independence: only 23 companies from our sample of 45 (5%) have a board that is majority indepdendent. While Japanese boards have become much more independent in recent years a 215 study from the Tokyo Stock Exchange (TSE) found that 87% of TSE-listed firms have at least one independent director, up from 32% in most Japanese boards are a long way from majority independence. Performance of Japanese companies on underlying corporate governance indicators 5% 45% 4% 35% 3% 25% 2% 15% 1% 5% % Board experience Board gender diversity LTI performance metrics Board independence Source: Sustainalytics Corporate Governance Research Informing investment and engagement decision-making Conclusion growing focus on corporate governance While the overall efficacy of Abenomics is an open question, investors expectations regarding the corporate governance performance of Japanese firms are rising. The JSC has gained slow but steady momentum, and improved governance is an important part of Japan s broader stance on structural reform. The corporate governance adaptability metric provides a way to differentiate Japanese industries and firms on certain JCGCrelevant practices. Investors with exposure to Japanese equities, particularly those taking concentrated sector bets, can use this metric to inform sector weights, security selection processes or engagement activities. 5 P a g e

6 Endnotes 1 The corporate governance adaptability score consists of four equally weighted indicators: CG 1.1, Board Experience, CG 2.3, Board Independence, CG Board Gender Diversity and CG 4.6 Long-Term Incentive (LTI) Performance Metrics. Country scores represent the average corporate adaptability score of companies within our corporate governance research universe that are domiciled in that country. 2 World Bank national accounts data, and OECD National Accounts data files, last accessed online ( ) at: 3 The Economist ( ), Abenomics Overhyped, underappreciated, last accessed online ( ) at: 4 Japan Investment (% of GDP) Statistics, Economy Watch, ( ), last accessed online ( ) at: 5 Marlow, Iain ( ), Japan s bold steps, The Globe and Mail, last accessed online ( ) at: 6 Financial Times, Definition of Abenomics, last accessed online ( ) at: 7 OECD, (215), Economic Surveys: Japan, last accessed online ( ) at: 8 Lewis, Leo ( ), Companies fail to buy into Japan s stewardship code, Financial Times, last accessed online ( ) at: 9 Lewis, Leo ( ), Code gives Abe a rare reason to be cheerful, Financial Times, last accessed online ( ) at: 1 Japan Government Pension Investment Fund (216), Investment results for the third quarter of fiscal year 216, last accessed online ( ) at: 11 Japan s Stewardship Code: Principles for Responsible Institutional Investors to promote sustainable growth of companies through investment and dialogue ( ), last accessed online ( ) at: 12 Recent revisions to the JSC are currently up for public comment until 8 May 217. last accessed online ( ) at: 13 Brooksbank, Daniel ( ), Asset owners should use stewardship for beneficiaries new Japan code draft Council of Experts consults on revision to three-year-old Stewardship Code, last accessed online ( ) at: 14 Japan Financial Services Agency ( ), Status of the Stewardship Code and Opinion Statement of the Follow-up Council, Material 3, last accessed online ( ) at: 15 For simplicity, the four indicators are equally weighted: a company receives 25 points for each yes it receives to the questions in the table on p. 3, and points for each no. This approach yields potential scores of, 25, 5, 75 and Industry scores represent the average corporate adaptability score of Japanese companies within our corporate governance research universe aggregated by industry. Selected industries have 17 or more company representatives. 17 Japan Exchange Group (215), Ratio of 1 st section companies with outside directors, JPX, last accessed online ( ) at: 6 P a g e

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