Beyond ESG

Jun 21

Why sustainability is just one part of business success

By Jesper Koll

The Covid-19 pandemic has helped turbocharge a change in global investor priorities to investment strategies based on environmental, social, and corporate governance (ESG). Total assets invested in ESG funds more than doubled last year and now account for one-third of the approximate $150 trillion of global investment assets.

It all makes good sense. Yes, companies are supposed to make a profit. But to ensure the profit is sustainable and contributes to future generations, corporate leaders are now held accountable for raising standards and for the overall impact of their actions on the environment, society, and all stakeholders of their enterprise.

Japan has been a pioneering advocate of ESG investing. Most importantly, the Government Pension Investment Fund went beyond merely advocating and talking about the importance of ESG and actually allocated ¥1 trillion of its portfolio to help seed-fund domestic ESG funds. Make no mistake—ESG investment is Japan-style Capitalism 2.0. Unlike the United States, Japan’s management philosophy never thought of profit maximization or capital efficiency as goals sufficient to achieve sustainable prosperity.

So, the good news is that single-minded pursuit of profits and greed is out, and a high-minded and morally aspirational management style is in.

Beyond Simple ESG

This sounds good. Indeed, many of my naturally cynical investor friends suggest that ESG stands for “everything sounds good.” But the real challenge is that both the relentless pursuit of profits and ESG-focused strategies must go hand in hand.

The research is very clear. Study after study confirms that implementing best-in-class ESG measures is totally insufficient to achieve a company’s outperformance (against peers). First and foremost, a traditional sales growth and profit strategy must be in place. However, among companies with high capital efficiency, those that also have exemplary ESG strategies in place are outperforming their peers. Clear-speak: an ESG focus alone will not make you a good company; but it does help you become a truly great one when combined with a firm focus on profits.

Here, corporate Japan has much work to do. If the ESG focus does not, at the same time, trigger a greater focus on improving capital efficiency and profitability, Japan Inc. is poised to remain a global underperformer.

The biggest obstacle is the absolutely astounding cash hoardings accumulated. Listed companies currently hold record cash balances equivalent to about 160 percent of gross domestic product (GDP), up from about 40 percent 10 years ago. In comparison, the global runner-up is the United States, where listed companies hold cash to the tune of about 55 percent of GDP.

Of course, any company will want to hold a cash buffer for tough times, and a war chest to buy a competitor, a new business, or expand. But surely hoarding the equivalent to 160 percent of national income is excessive and has led to almost half of all listed companies holding as much cash as they have shareholder equity.

The link to high-minded ESG priorities is this: how can it be good governance to prioritize hoarding cash over paying your key stakeholders, your employees? Because yes, corporate Japan ranks very low when it comes to distributing profits back to its employees.

Specifically, workers’ compensation is barely 33 percent of corporate value-add in Japan, significantly lower than the 48 percent in the United States and 78 percent in Germany. Yes, Japanese companies are extremely kechi (stingy) when it comes to paying their workers.

Why does the leadership of a multi-stakeholder, for-profit enterprise choose to hold more of a zero-return asset rather than invest in one of its stakeholders where there must be a positive return?

Productivity Deficit

To add insult to injury, all corporate leaders agree that, yes, Japan must boost productivity. All too often, productivity gets confused with process efficiency. Just trying to save costs and streamline process efficiencies may get you higher efficiency—and even higher profit margins—but if you use these profits to simply hoard cash, your productivity of capital is unlikely to go up.

You’re sweating your workers and your factories harder and harder, only to add a dead-weight, zero-return asset to your balance sheet. Return on assets or return on capital will stay flat at best, despite greater efficiency (and, probably, ever unhappier and frustrated employees). To raise productivity of capital and labor, you’ll need to invest in future returns by, for example, buying better productive capital (e.g., technology) and— most importantly—mobilizing better use of human capital within your enterprise (e.g., pay for performance).

All said, we should very much welcome the newfound global focus on ESG and multi-stakeholder investment. But we must stay razor-focused on improving the overall efficiency of our business, incentives, and, in particular, rewards of our employees. ESG alone is insufficient to raise Japan’s global competitiveness.