Following the recent publication of A Legal Framework for Impact (LFI) Japan: Integrating sustainability goals across the investment industry (the LFI Japan report), we are pleased to share key insights and themes from two related events: a webinar and round-table on how to integrate sustainability outcomes across the Japanese financial market. We invited PRI signatories, and stakeholders in responsible investment more broadly, to discuss this emerging theme. A recording of the webinar is available on the PRI website in both English and Japanese. The round-table was held as a closed event under the Chatham House Rule. Drawing on both investors’ and stakeholders’ views, the following takeaways from the events provide additional context for the report and the situation in Japan.
A Legal Framework for Impact: Project background
‘A Legal Framework for Impact’ (LFI) is a joint flagship project of PRI, the UN Environment Programme Finance Initiative (UNEP FI), and the Generation Foundation. The project seeks to identify and overcome barriers to a financial system that is consistent with international sustainability outcome goals, such as the Paris Agreement and the UN Sustainable Development Goals (SDGs). The project’s bedrock output, commissioned by the project group and authored by Freshfields Bruckhaus Deringer, is a 2021 paper which provides a legal analysis of the degree to which investors are currently permitted or required to pursue positive sustainability outcomes, and explores potential policy-level barriers and solutions. The project also aims to embed the report’s findings into policy and investment practice across five key jurisdictions: the UK, Europe, Australia, Canada and Japan.
LFI found that in the 11 jurisdictions analysed, including Japan:
- Investors are likely to have a legal obligation to consider pursuing sustainability impact goals where that can help achieve their financial objectives;
- Some investors can pursue sustainability impact goals for reasons other than achieving a financial return;
- Investors are legally required to pursue sustainability impact goals if the objective of the financial product commits them to do so.
In June 2023, the project group published the LFI Japan Report, exploring what local legal and market conditions currently prohibit further action to invest for sustainability. Japan’s policymakers and private sector are particularly interested in incorporating the SDGs and the Paris Agreement into their respective objectives. The LFI legal analysis supports this trend, finding that generally investors in Japan already have the legal freedom, and in certain cases the duty, to consider and pursue sustainability goals whenever doing so is consistent with their fundamental duties to pursue financial return. However, many investors remain unaware of the extent to which they are permitted or required to invest for sustainability impact; although Japanese authorities have made it clear that investors are permitted to consider ESG factors when these are relevant to financial returns, they have not treated investment for sustainability impact with the same clarity. The report therefore features five policy recommendations for Japanese regulators and policymakers, urging them to clarify the legal conditions and enhance the market conditions for practitioners to enable investors to pursue positive sustainability outcomes:
- Clarify the extent to which investors’ duties permit or require them to consider pursuing sustainability impact goals;
- Ensure better investor access to corporate sustainability-related information by updating existing rules, standards and guidance;
- Clarify when and how investors can use stewardship activities to pursue sustainability impacts, by updating the stewardship code, and through relevant implementation support programmes;
- Enhance transparency and market discipline on responsible investment claims by introducing rules and guidance on disclosures, labelling and classification;
- Ensure better communication between investment managers and their clients and beneficiaries on sustainability objectives and preferences by introducing relevant guidance.
LFI Japan webinar
The project team held a webinar to introduce the LFI Japan Report and to discuss its findings and recommendations with local experts. The webinar featured David Rouch from Freshfields Bruckhaus Deringer, Arisa Kishigami from En-CycleS, and Takeshi Kimura from Nippon Life Insurance Company. Selected comments from all three follow. The full recording is available on the PRI website in English and Japanese.
Overview of the LFI legal analysis from LFI co-author David Rouch
David explained that the LFI legal analysis aimed to answer a central question: are institutional investors legally required, or permitted, to tackle the world’s key sustainability challenges? Its authors therefore needed to conceptualise such an investment practice, so they developed the concept of ‘investing for sustainability impact’ (IFSI), which describes the kind of investment approach that was the subject of the legal analysis. IFSI is an approach where the investor acts to tackle the root cause of a particular sustainability risk, rather than altering its portfolio position in relation to such risks, as is typically the principal approach with ESG-integration. IFSI describes any activities through which an investor intentionally attempts (through investment decisions, stewardship or engagement with policy makers) to bring about assessable behavioural changes – among investee companies, policy makers or other third parties – that are aligned with positive sustainability outcomes.
He highlighted that investing for sustainability impact should not be mistaken for ‘impact investing’, a specialised approach that focuses on investment allocation and financing for projects with positive sustainability profiles, often on a small scale. Impact investing falls under the umbrella of activities consistent with IFSI, but is therefore only a subset of it. However, IFSI is an approach to investment activity that could, in principle, be relevant more widely across all investment types and all investors.
The authors found that investors are under a duty to consider the impact of sustainability factors on their overarching goals.
David explained that the lawyers involved in the LFI legal analysis across the report’s 11 jurisdictions, including Japan, were strongly in agreement about whether IFSI is permitted or required across the globe. Where IFSI can play an ‘instrumental’ role in achieving financial objectives, he notes, the authors found that investors are under a duty to consider the impact of sustainability factors on their overarching goals, including financial goals across a broad range of time horizons depending on the investor. Where a declining sustainability of a given sort poses a threat to achieving those goals, investors are under a duty to consider what, if anything, they can do about that. And where steps to bring about positive sustainability impacts can help to mitigate the threat, they must consider them and act accordingly.
Insights on outcome-related market infrastructure from Arisa Kishigami
Arisa agreed that more consideration should be given to IFSI, since it conceptualises investment alignment with sustainability outcomes on a broader scale. She highlighted one of the most valuable aspects of the LFI Japan Report: it comprehensively covers the complex landscape of sustainable finance policy in Japan. Japan’s Financial Services Agency (FSA) is already assuming strong leadership across sustainable finance policies; other ministries are also taking the initiative, especially on thematic financing frameworks. However, the LFI Japan Report suggests that Japanese policymakers are focusing largely on a narrower definition of ‘impact investing’. Arisa shared David’s concern that this falls short of the comprehensive approaches considered under IFSI.
Corporate sustainability reporting is an especially important aspect of the sustainable finance ecosystem, Arisa pointed out, and policy-level commitments to establishing standardised sustainability reporting are gaining strength in Japan. While this is significant progress, there is still market-wide concern that many companies may report only for the sake of compliance and focus on indicators that do not necessarily represent their material sustainability impacts.
Arisa cautioned that we must also be mindful of how impacts are highlighted at the policy level. While climate change and human capital have recently become prominent in sustainable finance policies, these are not the only areas in which companies should consider their impacts, and disclosure requirements should not restrict how companies address these wider impacts.
Insights from investor Takeshi Kimura
One company beginning to consider and address its wider sustainability impacts is Nippon Life Insurance Company. What can an investor expect when it begins to implement IFSI? Takeshi recalled that beginning to integrate the concept of ‘sustainability outcomes’ throughout Nippon Life’s responsible investment practices took several years. One important factor enabling Nippon Life’s journey to shift from ‘ESG-integration’ to ‘IFSI’ was coming to appreciate that while the SDGs and the Paris Agreement established clear sustainability goals, the gap between these goals and real-world outcomes is significant and likely to remain so. Takeshi notes that, as a universal owner, Nippon Life are concerned about how these sustainability outcomes will affect their portfolio in the form of system-level risks. Nippon Life are increasingly aware of how they can address these system-level risks, practising what LFI identifies as ‘instrumental’ IFSI. One such method is participation in collaborative initiatives, which have increased significantly in the past few years.
While the SDGs and the Paris Agreement established clear sustainability goals, the gap between these goals and real-world outcomes is significant.
As the LFI Japan report suggests, much remains to be done at the policy level to enhance Japan’s IFSI ecosystem and encourage more investors to practise IFSI. Takeshi highlighted how policymakers can play a bigger role in prompting investors to consider positive and negative sustainability impacts and outcomes in their stewardship engagements – not just ESG risks. He added that policy should also embed sustainability outcomes into beneficiary engagement, listening to beneficiaries to learn what is ultimately in their best interests.
Takeshi noted that according to the PRI in a Changing World signatory consultation, most signatories believe that taking action on real-world sustainability outcomes will become more important than the current standard of narrowly managing ESG risks. Just recently, Prime Minister Fumio Kishida’s Cabinet Office published an updated version of the Grand Design for the New Form of Capitalism. Takeshi observed that this policy is quite consistent with the outcome-integrated economic model the LFI framework advocates, and that policymakers can learn much from the LFI Japan report and its recommendations.
LFI Japan round-table
At the round-table event, local PRI signatories discussed the report’s findings and recommendations, with a focus on sharing insights at a more practical level. The round-table was held under the Chatham House Rule, so what follows is an overview of the key themes emerging from the session.
The need for better market infrastructure to support sustainability outcomes
- Although sustainability outcomes can be considered within the realm of investors’ duties, investors are constrained by the limitations of market infrastructure.
- It is especially important to note that current non-financial disclosure policies and practice do not sufficiently support investors to consider sustainability outcomes.
Participants appreciated that many Japanese companies are leaders in impact-focused disclosure, but also voiced concern that many more are still at the beginning of their sustainability-reporting journeys. They noted that even at a global level, there is a lack of disclosure frameworks that support impact-related indicators.
Investors also need better guidance on how to report sustainability impacts. For example, investors increasingly understand how to define and calculate the carbon emissions being avoided, but standards for sustainability themes other than climate change are relatively underdeveloped. As the market shifts toward greater emphasis on sustainability outcomes, it will become important for policy to support entire investment chains by ensuring disclosure is useful for everyone. This would include considering the utility of such disclosures to those investment chains’ beneficiaries.
The critical role of beneficiary engagement
- Investors managing pension funds are yet to receive license from many clients to pursue sustainability impacts.
- Pension funds, which are regulated by the Ministry of Health, Labour and Welfare, are largely not permitted to pursue sustainability outcomes within their existing duties.
- Japanese pension funds have not yet been prompted to engage with beneficiaries on sustainability preferences.
Participants mentioned that beneficiary engagement will be important, especially when considering whether IFSI can already be considered a part of investor duty. Although the LFI legal analysis provides confidence in the interpretation that IFSI can be required within investor duty, participants noted that it will be crucial to make sure that engaging in IFSI is in line with clients’ and beneficiaries’ preferences. This theme will become more and more important as we depart from the traditional form of capitalism in which investors have been strictly bound to interpret beneficiary interest solely in terms of financial return, and move toward enabling one that integrates broader interpretations.
That said, participants also noted concern that consumers in Japan who constitute beneficiary cohorts are largely unaware of financial investment, and even less aware of sustainability’s role in finance. There is only so much investors can achieve through beneficiary engagement if beneficiaries are unresponsive or disengaged from decision-making. In the short-term, investors can appeal to other investors and asset owners by clarifying the sustainability impacts and outcomes of individual strategies, but ultimately, policymakers need to take the initiative and provide sustainable finance education to a broader range of beneficiaries. This led to further discussion of what sustainable finance needs from policymakers.
The need for better guidance on what it means to pursue sustainability outcomes
- Despite a recent wave of frameworks and regulations addressing sustainability impacts, these largely focus on the specialised practice of impact investing, and do not sufficiently address sustainability outcomes at the portfolio level.
- Policymakers must clarify how investor duties should be interpreted in this space, in part to maintain coherence with the promotion of impact investing.
- There is an appetite for policy-level guidance on how market actors should understand sustainability outcomes at the broader portfolio level, rather than at the narrower level of impact investing.
The LFI legal analysis says that ‘investors have the legal discretion to pursue sustainability impacts, even if it compromises short-term performance, if they reasonably believe it will improve returns in the long term’. Participants noted that while this is theoretically sound, it is definitely not widely accepted in Japan yet, and the currently prevalent understanding of investors’ duties would require heavy policy intervention to change. Participants suggested that policymakers need not only to clarify that investors have such discretion, but also to support investors by facilitating changes in market mechanisms, such as those determining how investment fees are set. Policymakers and broader stakeholders also still need to consider various key questions: how investors should monitor and communicate sustainability impacts; how investors should consider short-term trade-offs in financial return; whether there are cases where investors are in violation of their fiduciary duty if they are not considering IFSI, and what happens next in that case.
Participants added that a similar point can be made concerning the wider Japanese market. Businesses and investors alike are bound by a duty to pursue economic value, and it is fundamentally the responsibility of policymakers to intervene so that the actors’ mindset and the systems they utilise are aligned with a more optimised risk profile that considers social and environmental values. What requires caution, however, is the degree to which policymakers define what is and is not aligned with sustainability outcome goals. Participants were, however, supportive of the LFI Japan report recommendations, noting their importance in starting these important discussions, and voiced expectations for policymakers to consider them in order to address some of the issues explored in the round-table session.
The LFI Project will use these insights and suggestions from the LFI Japan launch events to inform its future work on integrating sustainability outcomes into investment practices. For further information, please contact Kazuma Osaki.