Celebrating London Climate Action Week, this article features as part of IFA Magazine’s editorial campaign throughout this week, which aims to highlight key issues, news and views in the field of climate action.
Junichi Takayama, Japan Equity Investment Director at Nikko Asset Management
While in today’s world many companies display their ESG credentials like a badge, Japanese companies have long held a sustainable mentality, even though they seldom articulate this more widely.
That’s because in Japan, a deeply ingrained 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’s impossible to look at the Japan of 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 19th century. During this period, when Japan’s economy was effectively closed off from the rest of the world, its urban economy was nurtured with a respect for nature and determination to maximise 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 life resources – clothing, food, and housing – were recycled and reused”
As the rest of the world slowly adapts by introducing their versions of a sustainable circular economy, these instincts are already ingrained in Japanese culture and are therefore being reintroduced at a faster rate of progress.
And yet today, across many important ESG metrics, Japan lags its developed market peers, meaning there is still the opportunity for significant improvement. Active engagement of Japanese companies is therefore essential in order to 1) encourage them to better articulate positive ESG activities already underway, or 2) drive new ESG initiatives forward, thereby unlocking further 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 meaningful engagement on ESG principles certainly has the potential to deliver extremely positive results.
Stakeholder capitalism and engagement
Similarly, Japan has had a culture of stakeholder capitalism – putting people and the planet first in corporate and economic policies – for centuries, which has now been more firmly reinforced through government policies.
The establishment of the Stewardship Code, one of the key pillars of an economic revival plan initiated by then prime minister Shinzo Abe in 2014, was a watershed in terms of changing how institutional investors interact with the corporations they invest in. One of the Code’s key elements is “constructive engagement with investee companies” that institutional investors are asked to undertake to foster sustainable growth.
More specifically, the Stewardship Code encourages engagement between institutional investors (such as asset managers) and investee companies in the following ways:
• Asset owners, such as pension funds, are asked to monitor whether the asset managers investing on their behalf carry out stewardship activities that are in line with the asset owners’ policies, and the quality of dialogue between asset managers and investee companies is a key evaluation point.
• The code emphasises constructive engagement between institutional investors and investee companies to solve governance issues the latter may be facing.
• Institutional investors tasked with passive management are encouraged to actively take charge of engagement and voting (based on the premise that passive management offers institutional investors fewer options to sell investee companies’ shares and therefore they are able to promote longer term capital growth.
How engagement leads to alpha
Engagement has come into focus thanks to its positive impact on all parties involved: asset owners, institutional investors and investee companies. Academic research shows engagement activity by large institutional investors aimed at companies with potential areas of improvement, such as governance, low return on assets (ROA) and excessive cash holdings, has had a positive impact on target companies.
This has resulted in higher return on equity (ROE), more independent directors and proportion of shares owned by management. Within Japan’s changing landscape, we believe that engagement is a significant source of differentiation. In identifying undervalued names which have the potential to enhance their value due to ESG-related factors engagement with these firms – on issues such as decarbonization, managing human capital, and enhancing their governance frameworks – will improve their fundamentals, enhance their corporate value and ultimately lead to higher returns.
More importantly though, engagement with Japanese companies can offer another dimension, by shining a spotlight on hidden value. There is a strong case to suggest that the ESG credentials of many Japanese companies are going unnoticed at the global level, either because Japanese companies have reputational or legacy issues to overcome, or that companies neglect to make their ESG case as forcefully as they could.
Kawasaki Heavy Industries: engineering a hydrogen-based society
Kawasaki Heavy Industries (Kawasaki) has a worldwide reputation as a multinational industrial manufacturer of motorcycles, engines and heavy equipment. It doesn’t have a reputation as being a provider of clean energy. But after playing a role in helping Japan become an industrial powerhouse in the 20th century, Kawasaki Heavy has its sights set firmly on the 21st century with its emphasis on hydrogen.
Hydrogen is expected to play a key role in plans for Japan to become carbon neutral by 2050, as Japan reduces its reliance on fossil fuels. Green hydrogen has been labelled ‘the ultimate clean energy’, because it can be used like petrol to power vehicles, but also to generate electricity. Whilst hydrogen can be produced from fossil fuels, it can also be extracted from water through electrolysis, using electricity to split H2 O into hydrogen and oxygen, which is a technology we expect to accelerate in the coming years.
But since Japan does not possess the required natural resources, nor have the space to build largescale solar farms for electrolysis, it will have to acquire hydrogen from Australia and the Middle East, which have abundant natural resources, land and sunlight for solar farming. Shipping hydrogen to Japan currently presents a big technological challenge. It must be turned from gas into liquid by cooling it to -253°C before it can be transported. At a reduced volume, hydrogen storage, transportation and distribution efficiency increases dramatically.
From a value perspective, Kawasaki appears significantly undervalued. It already has several years’ experience of transporting and storing liquefied natural gas at temperatures of -162°C. Kawasaki already possesses the state-of-the-art technologies needed for the mass transportation of hydrogen that could transform Japan into a hydrogen-led society. In April 2022, Japan’s 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 being 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 broader investment community, or to reposition itself away from its ‘heavy industry’ reputation. In recognition of this, Kawasaki has created a ‘Sustainability Promotion Department’ that will look to explain its clean energy initiatives more thoroughly.
The growing importance of ESG and social responsibility is an opportunity to identify hidden value in firms that are willing to tackle and resolve social issues. Moreover, the shift toward a decarbonised, more sustainable society is creating growth opportunities for companies with environmentally friendly technologies, especially in clean energy solutions. However, while companies everywhere are keen to demonstrate their ESG credentials, very few companies are capable of making a meaningful difference to the future direction of the world.
While companies such as Kawasaki possess the technology, the know-how and the resolve to drive this change, the technologies themselves are either still intangible – and yet to be represented in data – or are still experimental and not recognised as these company’s main source of profits. It is therefore understandable that global investors, even those with an ESG lens – are still overlooking such businesses. But these hidden value companies, driven by a combination of problem-solving innovative and deep-rooted sustainability principles, deserve a closer look.
References to individual stocks are for illustration purposes only and do not constitute a recommendation to buy or sell.