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E-MailMarco Becht is Professor of Finance at the Solvay Brussels School of Economics and Management (ULB), and Kazunori Suzuki is a Professor at Finance at Waseda University. This post is based on a recent paper by Mr. Becht, Mr. Suzuki, Julian Franks, and Hideaki Miyajima. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy (discussed on the Forum here); The Specter of the Giant Three (discussed on the Forum here); and Big Three Power, and Why it Matters (discussed on the Forum here) all by Lucian A. Bebchuk and Scott Hirst.
The Principles of Responsible Investment (PRI) is the largest responsible investor network globally. It has 738 asset owner signatories, including the largest in the world, the Government Pension Investment Fund (GPIF) of Japan. Signatories commit to investor stewardship by incorporating ESG issues into investment processes (Principle 1) and to being active owners through engagement and voting (Principle 2). The PRI is not prescriptive about how signatories fulfil their commitment. Asset owners can either implement the principles directly or instruct their asset managers to do so.
There is evidence that many asset managers do not live up to their promises and that their actions have limited impact. There is a significant disparity between the reported ESG actions of institutional investors in the U.S. and their actual implementation (Gibson, Glossner, Krueger, Matos, and Steffen, 2022). Similarly, commitments to engage from passive managers are often viewed as lacking in substance (Bebchuk and Hirst, 2019). The managers hold many positions and compete on fees. Meanwhile, engaging companies through private contacts and meetings is costly. In addition, some view index tilting through divestment and engagement as substitutes to engaging, not complements (Broccardo, Hart, and Zingales, 2022).
The objective of this research is to provide new evidence on ESG engagement and index tilting in the context of a natural experiment conducted by GPIF of Japan. To contribute to securing its long run investment returns, the fund became a PRI signatory in 2015 and developed two related strategies to encourage corporate improvements in ESG. First, in 2018, GPIF gave its largest passive manager (Asset Management One, “AM One” hereafter) a mandate to ‘improve the overall market through stewardship activities’ by setting medium- to long-term goals, largely for engagement activities in order to achieve ESG milestones. AM One was remunerated separately for these engagements.
Second, in 2017, GPIF adopted two best-in-class ESG indexes from FTSE and MSCI, namely the FTSE Blossom index and the MSCI Leader index, which rewarded improvements in ESG scores with index inclusion and thereby provided additional equity investment through portfolio tilting. Index inclusion and exclusion were determined by the ESG scores produced by the index providers. This strategy of using ESG scores for index inclusion had been pioneered by Amundi in 2011, in collaboration with the Swedish AP4 pension fund and the Fonds de Réserve pour les Retraites (FRR) in France (Andersson, Bolton, Samama, 2016).
To measure the performance of engagements initiated by GPIF’s remuneration strategy, we use private data on engagements from the remunerated asset manager (AM One) to evaluate the impact of the engagement program using difference-in-differences (DiD). We compare the difference in ESG scores between companies that were engaged (the treatment group) and companies that were never engaged by GPIF’s asset manager (the control group) both before and after the beginning of the engagement program. The results suggest a statistically significant treatment effect, indicating that engagement had a measurable impact on FTSE scores of overall ESG and the E (environment) pillar; the incremental change relative to the control group was 0.21 for the overall score and 0.29 for the E score on a scale of 5. However, the effect on MSCI scores was smaller and, with the exception of G, not statistically significant. While our paper uses the ESG scores of the respective leader indexes, AM One did not use those scores for targeting or evaluation. AM One structured its engagement program, initiated in 2018, around 20 designated ESG engagement themes. Progress was self-assessed through an eight-stage milestone system.
We note that AM One’s engagement themes are not consistently reflected in MSCI and FTSE scores. For example, in some cases, AM One engaged on issues that MSCI considered relatively unimportant and were not included in their scores. Therefore, progress on these topics was not reflected in improved MSCI scores. FTSE pillar scores reflect a wider range of topics and place more emphasis on a company’s disclosure quality. As a result, FTSE scores show more significant improvement from better disclosure than MSCI scores. Using several case studies as illustrations, we also find that MSCI materiality weights were inversely correlated with milestone progress and higher theme scores. Thus, the impact of improvements in MSCI scores was offset by reductions in their materiality weights. The justification for this approach was that higher scores suggest lower risk and therefore lower materiality. Our case studies confirm that the difference in results between FTSE and MSCI at the pillar level is likely to be influenced by the scoring methodologies.
As for GPIF’s second strategy of adopting two best-in-class ESG indexes, we investigate the price reaction of demand shocks caused by ESG index inclusions and exclusions. We use event study methodology to analyse the extent to which inclusion in the FTSE Blossom index and the MSCI Leader index generated abnormal returns. We show that abnormal returns from index inclusions and exclusions are around 2%, being positive for inclusions and negative for exclusions. This contrasts with the findings of Berk and van Binsbergen (2022), who report no significant abnormal returns from inclusion or exclusion in ESG best-in-class indexes in the United States. We also found anecdotal evidence that inclusion in the Blossom and MSCI Leaders is considered prestigious. Companies issued press releases and put-up social media posts when inclusion or reinclusion in the index was announced. The press releases always referenced adoption of the Blossom index by GPIF.
Finally, our research evaluates the joint impact of GPIF’s engagement and index tilting programs in a test where we treat all Japanese companies as the treated group and a set of foreign companies from 26 stock markets as the control group. This test is useful because in the first test, referred to above, our treated group consisted of those TOPIX companies engaged by AM One and the control group included those TOPIX companies not engaged by AM One. However, the control group is likely to include companies engaged by other asset managers, including those that were not remunerated by GPIF. The result of this second test is more striking than the first. We find that FTSE scores for TOPIX 500 companies improved significantly more than the scores of other stock markets, such as Germany, France, the United Kingdom and the United States. Overall, the findings suggest that engagement can have a measurable impact on published ESG scores. This effect was likely aided by combining remunerated engagements with financial and reputation incentives provided by best-in-class index inclusion.
