Investment implications of shifting sustainability standards

Thomas Mucha, Geopolitical Strategist
2023-09-14T12:00:00-04:00  | S2:E14  | 26:22

The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.

Episode notes

Director of ESG Research Carolina San Martin and Portfolio Manager Katsuhiro Iwai join host Thomas Mucha to discuss shareholder activism and today's evolving sustainable investing disclosure expectations, including new standards from the International Sustainability Standards Board. 


2:10 What the new sustainability standards call for

5:15 Reforms and other changes in Japan

8:05 Impact of new disclosure standards in Japan

10:00 ESG integration and active ownership at Wellington

11:40 Investor engagement examples in Japan

14:00 How the US, Europe, and China may respond to the ISSB

17:00 Investor attraction to markets that embrace sustainability

18:20 ESG changes and Japanese culture

20:25 How to improve investment outcomes

22:30 Delivering stewardship alpha


COLD OPEN | CAROLINA: And if you think about it, business models are going to have different topics that they’re grappling with. A financial services company like a Wellington, our people are really our biggest asset. So we’re going to be focused on our culture, attracting, retaining top talent so that we can create value. If you think about an extractives company, very different business model. Energy costs, maintaining that social license to operate by avoiding operational incidents, that’s going to be the most material in that case. So the definition of materiality depends on the business model, and it’s going to really influence how investors are valuing that company and its future prospects.

THOMAS:   Earlier this year, the International Financial Reporting Standards Foundation published two new sets of requirements that could change the way public companies disclose certain financial information. The standards, which were developed by the International Sustainability Standards Board, or ISSB, go into effect in January 2024. They require companies to report on sustainability issues that are material to business outcomes and corporate value. Now, the standard-setter here believes that how companies approach sustainability topics, like human capital, climate readiness, and so on, can have meaningful impacts on financial performance. While this development received relatively little press in the US, companies and investors around the world are paying very close attention. So here to discuss this shifting global landscape are Carolina San Martin, director of ESG research here at Wellington, and Katsuhiro Iwai, an equity portfolio manager who joins us today from our office in Tokyo. Katsu, Carolina, thanks for joining me today, and welcome to WellSaid. 

CAROLINA:Thanks, Thomas, it’s great to be here. 

KATSUHIRO: Thank you for having me, Thomas. 

THOMAS:   Now, Carolina, let’s start with you. So why are these new global sustainability standards so pivotal, and what do they call for?

CAROLINA:Corporate disclosure may not sound like the hottest topic, but I really believe that the launch of the new ISSB disclosure standards represents a seismic shift in how financial markets are going to be able to efficiently allocate capital. 

THOMAS:   How so?

CAROLINA:Well, I believe that they’re going to mainstream sustainability factors in the investment process more than anything that we’ve seen to date. And as you said, the US hasn’t been covering this so this may sound like an exaggeration. But I really do think that we’re going to look back at this as a pivotal moment in the further mainstreaming of sustainability factors. 

THOMAS:   What do they call for?

CAROLINA:So they’re simply asking companies to disclose the material issues that would influence an investor’s decision whether or not to invest in that company. 

THOMAS:   So how will all of this change the calculus for companies in terms of both financial reporting and dialogue with investors -- and as a part of that, who decides which information is financially material, and how do they do that?

CAROLINA:Sure. So let me answer your second question first, about who decides what’s material. And the answer really lies in the structure of the ISSB. So it sits, as you’ve mentioned, within the IFRS foundation that also is responsible for setting the standards for traditional financial statement disclosures. So it’s been very intentional with its mandate to meet the needs of investors. 

THOMAS:   So it’s part of a broader infrastructure here. 

CAROLINA:Exactly. And it took the materiality definition from the definition that’s used for traditional disclosures and that’s very simple. It says, “Information is material if omitting, misstating, or obscuring that information could reasonably be expected to influence investor decisions.”  So if companies are disclosing more on the issues that are going to really influence our decision on whether or not to invest on sustainability topics specifically, then it should be included in their disclosures. 

THOMAS:   So that implies it’s a pretty broad set of issues. 

CAROLINA:It is a broad set of issues, but importantly… this gets to, to your first question, how are they going to figure this out? - We are not starting from scratch. We have the Sustainability Accounting Standards Board, SASB. Those standards have been around for many years, they’ve already been adopted, embraced by the market, companies are already using them, and that has a very specific definition here that focuses on the industry. So an industry specificity to the materiality standard, which we think makes a lot of sense. We’ve been supporting the SASB standards for a long time because of that. And if you think about it, business models are going to have different topics that they’re grappling with. A financial services company like a Wellington, our people are really our biggest asset. So we’re going to be focused on our culture, attracting, retaining top talent so that we can create value. If you think about an extractives company, very different business model. Energy costs, maintaining that social license to operate by avoiding operational incidents, that’s going to be the most material in that case. So, the definition of materiality depends on the business model, and it’s going to really influence how investors are valuing that company and its future prospects. 

THOMAS:   Clearly, those industry differences matter here. Katsu, let’s bring you into the conversation here. Now, in many ways, Japan is at the center of this conversation. Shareholder activism has evolved, I’d say, tremendously over the past ten years in Japan. It continues to accelerate into today. Japan’s 2014 Stewardship Code and the 2015 Corporate Governance Code have sharpened the focus on issues like transparency, board independence, and share buybacks… you know, things that are key to boosting corporate value and overall economic growth. Now today, Japan’s securities regulator, the Financial Services Agency, and the Tokyo Stock Exchange are preparing to update and expand these codes. So what’s your view, Katsu, on the evolution of shareholder activism in Japan, and what’s driving these changes?

KATSUHIRO:     Yeah, thank you for the question, Thomas. So, you know, Japan has experienced a unique path toward activism because of its cross-shareholding structure and the name-brand-led capitalism. Now, this is referred to as the stakeholder model. However, in the 1990s, the burst of the economic bubble triggered changes in this ownership structure. The first wave of activism came to Japan in the early 2000s. The concept was new and revolutionary, but didn’t gain support from the market, simply because those activists tried to benefit from short-term profits without fully understanding the business model of targeted companies, and the regulatory environment was not yet fully supportive. What’s different this time is the second wave of activism has been led by the government as part of growth reform. You know, the double codes are for strengthening stewardship activity and engagement so that companies could improve capital efficiencies, sustain longer-term growth, and regain the ability to create innovation. You know, these reforms also brought in higher-quality activists with longer-term horizons. So as a result, shareholder returns in Japanese companies continue to improve, given by higher-quality corporate board. Next step includes better business-portfolio management because a big issue in Japan right now is many industries are unconsolidated and the profitability remains quite low. So currently the regulators are working on clarifying M&A and takeover guidelines and modernizing financial reporting, which is very relevant to the ISSB disclosure discussion here. So we believe the reform will continue to progress gradually but persistently with a strong policy support. I feel we are still in the mid-stage of the improvement cycle.

THOMAS:   The mid-stage? Okay. And the government is playing a much larger role in this process. So Katsu, as Carolina explained, the new global ISSB standards focus on the sustainability issues most relevant for investors. How do you think these standards will influence the changes taking place today in Japan?

KATSUHIRO:     Yeah. You know, driven by the corporate governance code, Japanese companies are already in the process of significantly enhancing sustainability disclosure, under Task Force on Climate-related Financial Disclosure, or TCFD in the annual financial reports, which are called Yuho or 10k equivalent in Japan. And that’s a reason why the recent reform has been successful: it’s a double code, applied positive implications of the Japanese people’s behavioral patterns, such as compliance with rules and groupthink. So based on this observation, I believe the ISSB standards requirement will help push ESG penetration even further in Japan, through the enhanced disclosure of higher-quality information in a more transparent way. And this way will make industry and the global comparisons much easier for global industries. So I would say one big area for improvement is we’d like to see more disclosure of how companies think they could utilize the information to implement their strategy and then enhance corporate value. You know, many Japanese companies have a very strong environmental technologies in the area of housing, autos, industrials, and materials, but they are not particularly good at telling the story of how their products could reduce, for instance, customers’ Scope 3 GHG emissions. So improving communication with the capital market is one of our team’s recent engagement items. 

THOMAS:   So, Carolina, you’re of course the director of ESG research here at Wellington. So, from your perspective, what does ESG integration and active ownership mean here at Wellington, and why do you see it as a means of enhancing financial value, singular, and not promoting external values, plural, at a company? 

CAROLINA:Well, the answer is simple. Our fiduciary duty to clients is our north star. And we see ESG integration and active ownership as essential tools in our toolkit to achieve our clients’ investment objectives. Our ESG integration philosophy comes down to two core beliefs. The first has to do with materiality -- that, we’ve talked a lot about already. We believe that material environmental, social, and governance issues are strategic business issues that can impact performance, and that’s why we have a team of dedicated experts to identify them, analyze them, and bring those insights to our portfolio managers so they can be taken into account in investment decisions for our clients. 

THOMAS:   How big is that team?

CAROLINA:That team is ten, now. And it’s global. We have team members here in Boston, in Singapore, as well as in our London office. Covering sectors globally. And importantly, they are all researchers, but the second tenet of our philosophy is that it doesn’t stop at the research, and that’s where the active stewardship comes in, which is a big part of our role as well. As our clients’ fiduciaries, we believe that it’s our responsibility to give feedback to companies when we see areas where they can improve. And here we use the tools of voting and engagement to do that.      Because if they can perform better on those E, S, and G issues that we think are really important and relevant to their financial outcomes, then our clients are going to benefit. 

THOMAS:   Katsu, without naming specific companies, can you give us a couple of recent examples where engagement by Wellington’s Japanese investors have helped increase the value of an investment?

KATSUHIRO:     Okay, sure thing. First one is a life insurance company. You know, its management was concerned about its low share price and the valuation multiples. We saw significant room for improvement in recognition of surplus capital, shareholder returns, discipline surrounding M and A, and reduction of cross-shareholdings. So we leveraged global resources, including our global industry analysts and ESG analysts, to conduct fundamental analysis and engagement. We actually sent an engagement letter to articulate our recommendations, referring to examples of improvements made by leading industry peers. The company has gradually been making changes such as increasing shareholder returns. The second example is a Japanese truck manufacturer. Here, too, our team, ESG analysts, and the global industry analysts actively used the proxy voting and engagement to help the company improve its value over the long term. In the period since October 2020, we sent three letters to the board alongside multiple engagement meetings. So patience is offering [a] key to success here, and our focus included capital return, balance sheet optimization for the structure, and the disclosure of decarbonization efforts. So there are several tangible outcomes, including significant improvement in shareholder return, as well as, you know, both independence and diversity. [The] company also established net zero emission with a reduction target and improved the climate disclosure in line with TCFD recommendations. So I do see, you know, these two examples show the power of engagement and active ownership in meeting client objectives. Most importantly, these improvements contributed to rerating of those two stocks; our engagement is outcome-focused, so we strongly believe successful engagement really contributes to stocks’ upside while minimizing downside risk. We utilize ESG engagement as offense and defense. 

THOMAS:   So Carolina, how about other major markets? The US, Europe, China. What do you think investors should expect in these markets in terms of changes resulting from these new ISSB standards?

CAROLINA:Sure. So there’s not one single answer to that question. 

THOMAS:   Okay.

CAROLINA:The first step since the standards were launched back in June was for The International Organization of Securities Commissions, or IOSCO, to approve them and say that they were suitable for all of the markets you mentioned to consider them. So that happened, but that was a big, important step for then local markets to get involved. And here, this is where we see the paths to adoption really vary. Some markets like Japan, Canada, Brazil, Korea, several markets have set up their own sustainability standards boards to assess suitability and take adoption from there. And I’m actually most optimistic about Asia. The way that that’s happening is different by market, but there’s the most momentum across the region. 

THOMAS:   Why do you think that is?

CAROLINA:That is a good question. But perhaps we can point to Japan as a leader here. They’ve really been the farthest ahead and put a stake in the ground before the launch of the standards to demonstrate their commitment. And they’ve already set the timeline for the comment period to start next year, and we’re going to see that move pretty quickly, I think. Picking up on some of Katsu’s comments, the fact that sustainability has already been embedded in the governance codes could be a reason why it’s almost pushing on an open door to bring these standards into that margin. 

THOMAS:   It’s becoming institutionalized. 

CAROLINA:Exactly. I really think so. China’s an interesting one, because we don’t have as much visibility on how that’s going to develop, but it’s a big market, important to the success of the standards, and the ISSB did establish an office there. And they’ve said that Beijing is going to be the hub in Asia. So that also contributes to the optimism of the region of ISSB continuing to gain traction there. I think we have to mention the US and Europe, the other two big markets, and notably, I don’t expect either of them to adopt ISSB formally, because they’re taking their own paths on sustainability disclosure. But the good news is I don’t think they’re going to stand in the way of the ISSB becoming the emerging global standard because they’ve been working to really ensure interoperability. So, the standards should talk to each other, and that’s super important for the efficiency gains to really be realized, and that’s the promise of this new global standards, and that efficiency gain will be both for investors and companies who are today facing multiple standards, it’s very costly to communicate to the market, and this is going to give them a really efficient way to do that. Katsu talked about storytelling, the importance of storytelling, and really using the standards as a way to articulate strategy. And I think that’s the biggest case for aligning with the standards, and we are encouraging companies to go ahead and adopt today; even if those local markets are going through the process and haven’t made it a requirement yet. There’s a real business case, because the alignment with the standards helps focus on those issues that are going to be most relevant to the business, and that’ll inform risk management, capital allocation, strategy setting in a way that’s going to benefit the companies longer term. 

THOMAS:   Carolina, you just mentioned risk management, you mentioned storytelling. Both of those intersect with my favorite topic: geopolitical risk and the great changes that we’re seeing in the geopolitical backdrop, and, of course, growing concerns about climate change, which is a related topic. So, to what extent do you think investors may be attracted to markets that embrace the ideas of sustainability, governance, long-term corporate value, climate migration, you know, these other issues that intersect with geopolitics?

CAROLINA:Yes, so I love that question, because we’ve talked a lot about regulation and frameworks… At the end of the day, it really comes down to the business case for thinking about these issues, because they are becoming so important to global markets. And it comes back to our philosophy of really thinking about these as strategic business issues. This isn’t a category off to the side; it’s about how companies really do business to generate value for their stakeholders. Given that backdrop you’ve just described, if investors see companies really focusing in on the topics, sustainability topics that are going to impact their financial outcomes long term, and then they have verifiable, comparable disclosures behind that, that’s going to build a lot of trust and confidence in investing in those markets. Ultimately, I think that’s the business case that we need to come back to. 

THOMAS:   So more visibility is just better for investors. 

CAROLINA:That’s right, and it helps us, as investors, allocate capital in the right way, so that we are valuing the companies appropriately, and then ultimately doing our job for our clients. 

THOMAS:   Katsu, is all this focus on ESG changing the broader culture in Japan, or is it the other way around? Are our changing attitudes toward social equity, fairness, environmental conservation, good governance, corporate responsibility -- are these shifts driving the actions of the regulators?

KATSUHIRO:     Yeah. This is a great question. So as we have reviewed, you know, Japan has balanced interest to various stakeholders for long time, including environmental and social aspects. You know, this was previously viewed as unimpressive, but actually meeting, albeit not beating expectations, in the world of sustainability, we think Japan’s virtue in the society and corporate culture will remain unchanged, and the rest of the world is catching up now. The one thing worth noting is Japan has been going through a lot of macro challenges over the past three decades, including slow growth, uncoordinated policies, and natural disasters. So now more countries are becoming like Japan. It’s a lot of discussions about similarities and differences between Japan three decades ago and China now. Importantly, you know, Japanese companies have found ways to grow their arms in such adverse environments by balancing various stakeholders. So finally, as we have covered in this podcast, there are a lot of things Japan could and should change within this framework, including better tapped-out efficiencies and higher long-term growth, as well as further improvement of ESG initiatives and transparency in disclosure. Those are regulators’ main focus right now. So we believe Japan’s virtue, resiliency, and change in the world of sustainability are what will make the Japanese equity market even more attractive going forward, compared with the rest of the world.

THOMAS:   Given growing appreciation that shareholder activism can improve financial outcomes in Japan, what do you think are the best ways to do that?

KATSUHIRO:     So, I highlight three approaches that our team is taking. You know, first is to seek broad opportunities. And our engagement agenda covers a wide range of topics, such as shareholder returns, business portfolio management, and communication with capital markets. You know, since ESG is under-penetrated in Japan, target companies should include both best practices and the potential improvers. So more than half of companies in Japan are positive in net-cash balancing, which is special situation, but the market has tended to give less credit to the value, especially less well-covered smaller-cap companies. And our experience shows that improving capital management tends to lead to significant variation rerating, as shown in the two examples I mentioned earlier. And second is integration with regional and the global perspectives. You know, since overseas investors drive the Japanese equity market, as suggested by the previous two examples, you know, collaborative engagement by utilizing global resources while leveraging scale is crucial for success. The third is understanding and applying Japan’s unique behavior patterns for engagement. So, in Japan, since change is often gradual and nuanced, identifying and encouraging change through regular company visits based in Japan is key to success. Also, I like to reiterate the importance of understanding and applying positive implications of behavioral characteristic, including groupthink and the compliance with rules. You know, recently, many companies are responding very positively to Tokyo Stock Exchange’s request to keep price-to-book ratio above one time, and this is one of great examples. You know, those are the three things that we are focusing on.

CAROLINA:So sometimes we refer to what Katsu’s discussing here as stewardship alpha. And as active managers, we really are in a privileged position to do this work, because we have deep fundamental research resources, and we see engagement as one of our competitive advantages. We have access to our portfolio companies, we have local market knowledge, as Katsu’s describing, and we have globally over 18,000 company meetings per year where we can bring that engagement message and have the opportunity to influence positive outcomes for our clients. Because we’re active, it also means that companies care about our opinion -- they’re often coming to us proactively and asking us for feedback, because we’re the marginal buyers and sellers of their securities. And importantly, I think being active is also a great place from which to lead constructive engagements. We’re not coming with a big stick. We are owners by choice, we are rooting for our portfolio companies to succeed, and when we bring our perspective on where they can improve, we’re really doing it with that positive intention. And finally, I think a unique aspect of how Wellington conducts engagements is that we’re bringing everyone together -- our portfolio managers like Katsu, our ESG analysts, our equity and credit analysts -- we’re all in the room together. That really helps companies see the different perspectives, and it helps us really understand the company from our different lenses. Everything I just described through the stewardship process comes back to materiality, the topic of the day, we’re really using these tools to focus in on what we think is going to be the greatest value for our clients. 

THOMAS:   So, 18,000 opportunities to help companies do the right thing. 

CAROLINA:There you go.

THOMAS:   Well, thank you both for illuminating such an important and pivotal topic going forward, and as Carolina said, not getting a lot of attention here in the US. We appreciate both of your insights and expertise on this topic. Again, Katsuhiro Iwai, equity portfolio manager, and Carolina San Martin, the director of ESG research at Wellington Management. Thanks both, for being on Well Said. 

KATSUHIRO:     Thank you. 

CAROLINA:Thank you. 


Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For  professional/institutional investors only. Your capital may be at risk. Podcast produced September 2023.

Wellington Management Company LLP (WMC) is an independently owned investment adviser registered with the US Securities  and Exchange Commission (SEC). WMC is also registered with the US Commodity Futures Trading Commission (CFTC) as a  commodity trading advisor (CTA) and serves as a CTA to certain clients including commodity pools operated by registered  commodity pool operators. WMC provides commodity trading advice to all other clients in reliance on exemptions from CTA  registration. WMC, along with its affiliates (collectively, Wellington Management), provides investment management and  investment advisory services to institutions around the world. Located in Boston, Massachusetts, Wellington Management also  has offices in Chicago, Illinois; Radnor, Pennsylvania; San Francisco, California; Frankfurt; Hong Kong; London; Luxembourg; Milan;  Shanghai; Singapore; Sydney; Tokyo; Toronto; and Zurich.     This material is prepared for, and authorized for internal use by, designated institutional and professional investors and their  consultants or for such other use as may be authorized by Wellington Management. This material and/or its contents are current  at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written  consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the  solicitation of an offer to purchase shares or other securities. Investors should always obtain and read an up-to-date investment  services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views  expressed herein are those of the author(s), are based on available information, and are subject to change without notice.  Individual portfolio management teams may hold different views and may make different investment decisions for different clients.  In Canada, this material is provided by Wellington Management Canada ULC, a British Columbia unlimited liability company  registered in the provinces of Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Nova Scotia,  Ontario, Prince Edward Island, Quebec, and Saskatchewan in the categories of Portfolio Manager and Exempt Market Dealer.   

In Europe (excluding the United Kingdom and Switzerland), this material is provided by Wellington Management Europe GmbH  (WME) which is authorized and regulated by the German Federal Financial Supervisory Authority (Bundesanstalt für  Finanzdienstleistungsaufsicht – BaFin). This material may only be used in countries where WME is duly authorized to operate and  is only directed at eligible counterparties or professional clients as defined under the German Securities Trading Act. This material  does not constitute investment advice, a solicitation to invest in financial instruments or information recommending or suggesting  an investment strategy within the meaning of Section 85 of the German Securities Trading Act (Wertpapierhandelsgesetz).   In  the United Kingdom, this material is provided by Wellington Management International Limited (WMIL), a firm authorized and  regulated by the Financial Conduct Authority (FCA) in the UK (Reference number: 208573). This material is directed only at eligible  counterparties or professional clients as defined under the rules of the FCA.   In Switzerland, this material is provided by Wellington Management Switzerland GmbH, a firm registered at the commercial register  of the canton of Zurich with number CH- This material is directed only at Qualified Investors as defined in the Swiss  Collective Investment Schemes Act and its implementing ordinance.  In Hong Kong, this material is provided to you by Wellington Management Hong Kong Limited (WM Hong Kong), a corporation  licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities), Type 2 (dealing in futures contracts),  Type 4 (advising on securities), and Type 9 (asset management) regulated activities, on the basis that you are a Professional  Investor as defined in the Securities and Futures Ordinance. By accepting this material you acknowledge and agree that this  material is provided for your use only and that you will not distribute or otherwise make this material available to any person.  Wellington Investment Management (Shanghai) Limited is a wholly-owned entity and subsidiary of WM Hong Kong.   

In Singapore, this material is provided for your use only by Wellington Management Singapore Pte Ltd (WM Singapore)  (Registration Number 201415544E). WM Singapore is regulated by the Monetary Authority of Singapore under a Capital Markets  Services Licence to conduct fund management activities and is an exempt financial adviser. By accepting this material you  represent that you are a non-retail investor and that you will not copy, distribute or otherwise make this material available to any  person.   In Australia, Wellington Management Australia Pty Ltd (WM Australia) (ABN 19 167 091 090) has authorized the issue of this  material for use solely by wholesale clients (as defined in the Corporations Act 2001). By accepting this material, you acknowledge  and agree that this material is provided for your use only and that you will not distribute or otherwise make this material available  to any person. Wellington Management Company LLP is exempt from the requirement to hold an Australian financial services  licence (AFSL) under the Corporations Act 2001 in respect of financial services provided to wholesale clients in Australia, subject to  certain conditions. Financial services provided by Wellington Management Company LLP are regulated by the SEC under the laws  and regulatory requirements of the United States, which are different from the laws applying in Australia.  In Japan, Wellington Management Japan Pte Ltd (WM Japan) (Registration Number 199504987R) has been registered as a  Financial Instruments Firm with registered number: Director General of Kanto Local Finance Bureau (Kin-Sho) Number 428. WM  Japan is a member of the Japan Investment Advisers Association (JIAA), the Investment Trusts Association, Japan (ITA) and the  Type II Financial Instruments Firms Association (T2FIFA).  WMIL, WM Hong Kong, WM Japan, and WM Singapore are also registered as investment advisers with the SEC; however, they will  comply with the substantive provisions of the US Investment Advisers Act only with respect to their US clients.  

©2023 Wellington Management Company LLP. All rights reserved.