Ukraine War May Lead to an ESG Rethink

    Stockholm (NordSIP) – Russia’s invasion of Ukraine has rightly prompted global condemnation and concerted efforts to impose punitive sanctions on the perpetrators.  The priority for governments must be to deal with the ongoing humanitarian crisis and help the Ukrainians to defend themselves.  Meanwhile, the situation has compelled many sustainable investors to re-examine their Environment, Social and Governance (ESG) strategies and frameworks.  One week into this crisis, NordSIP explores some of the main issues that have come to light, including insights from asset managers as they seek to respond to the rapidly evolving events.

    Russian gas – buyer beware

    Already the subject of fierce debate among investors and policy makers since the European Union’s (EU) proposed inclusion of gas and nuclear within its sustainable taxonomy, Russia’s actions have brought the matter of the European energy mix to a head.  As EU Commissioner for Energy Kadri Simson expressed it during an International Energy Agency’s (IEA) event held today, March 3rd, the war in Ukraine “has made Europe’s dependence on Russia’s gas supply painfully clear”.  The IEA event was organised to launch their 10-point plan to reduce the EU’s reliance on Russian natural gas.  The plan involves non-green contingency measures such as increasing storage and finding alternative suppliers, along with a re-emphasis on greener investments in renewables and energy efficiency.  Point number 9 is so far the one that has caught the attention of the mainstream media: “Encourage a temporary thermostat adjustment by consumers”.  Although the IEA acknowledges that the European Green Deal would not allow it, they also mention the additional potential of a short-term reintroduction of legacy coal and oil capacity.

    Fossil fuels – engage or exclude?

    Many ESG strategies advocate for the inclusion and active engagement of companies in so-called hard-to-abate sectors to help accelerate their transition to a low carbon economy.  The argument is that companies with a large current carbon footprint have the strongest potential to dramatically reduce the warming impact – or Implied Temperature Rise (ITR) – of the overall economy if they take significant steps towards transitioning their value chains.  As many ESG-focused investors scramble to offload Russian energy sector holdings, some sceptics are expressing concerns that a certain complacency in the face of negative social and governance factors may have been played a part in these allocations.  It may also simply be the result of the inherent difficulty of balancing multiple, disparate ESG-related goals within the same portfolio.

    Dirk Hoozemans, fund manager of the Triodos Pioneer Impact Fund told NordSIP that they have chosen to avoid investing in Russia based on their view that “governance is a major issue in a totalitarian regime”.  Hoozemans prefers to exclude all fossil fuels rather than attempting to engage with those firms. He may feel justified in his view that “oil and gas producers or pipeline providers with exposure to Russia are most at risk from the current conflict” and his long-term strategy to focus on green energy is echoed by Commissioner Simson’s statement during the IEA event that Europe imperatively needs to “boost home-grown renewables to get us out of this trap”.

    In a comment that reflects the current lack of clarity most managers are struggling with, Lewis Grant, Senior Global Equities Portfolio Manager at Federated Hermes, told NordSIP that “energy and utilities remain challenging sectors, despite surging oil and gas prices. Companies across all sub-sectors with exposure to Russia are clearly the most vulnerable, facing write-downs or write-offs and fundamental shifts in supply chains.  Many of the large global players have such exposure, with the major service providers particularly exposed.  There is limited visibility into the extent of many companies’ Russia exposure and the extent to which rising prices will offset potential losses, thus we anticipate volatility will remain elevated.”

    While he believes that fossil fuel companies active in other areas such as the North Sea will see a short-term boost from the Ukraine conflict, Grant agrees with Triodos’ Hoozemans that “longer term, high oil and gas prices and a renewed focus on energy security will accelerate the energy transition, with the potential to benefit companies across the renewables space, particularly in Europe (where over 30% of oil and gas has previously been supplied by Russia).  These stocks have rallied in the last week on this outlook, although we remain cautious given the industry’s previous sentiment-led boom/bust cycles.  While long term there will be an increase in demand, investments in renewables have long lead times and in the short term the elevated commodity prices will present a challenge to margins.”

    ESG investors should not ignore sovereign red flags

    Russia’s invasion of Ukraine looks likely to galvanise and accelerate ongoing global efforts to transition away from fossil fuels with a view to reaching environmental targets and increasing countries’ energy autonomy.  It has also prompted an urgent re-evaluation of the role of expert sovereign ESG analysis in investment decisions.

    Writing today, March 3rd in the Financial Times, former Ukraine Minister for Finance Natalie Jaresko emphasises the need for the global business community to “understand that nurturing, upholding, and protecting freedom and democracy is part of their ESG responsibility”.  “The Russian invasion is an unprecedented risk event in recent market history,” Federated Hermes’ Grant commented.  Nevertheless, the sheer scale of investors’ exposure to Russia, including many with explicit ESG credentials, has prompted many to re-examine their geographical allocation guidelines.  As Jaresko puts it in her FT article, “given that they have vociferously professed the virtues of ESG, will they walk the walk when it comes to the serial social and governance violations that this invasion represents?”.

    Country exclusions will always remain controversial and may be considered a blunt instrument by some.  However, Russia’s actions may well compel ESG-minded investors to take a closer look at the proliferation of increasingly autocratic regimes around the world that are stifling political freedom and regularly breaching human rights.  The application of more stringent social and governance criteria along these lines would undoubtedly lead sustainable investors to seriously reconsider other significant allocations in their portfolios.

    A crisis within a crisis

    Away from the human catastrophe that is unfolding in Ukraine, Russia’s resulting political isolation gives rise to longer-term concerns about the world’s ability to mitigate the climate crisis.  As a signatory to the Paris Agreement and the 3rd largest historical emitter of CO2 according to Carbon Brief, a complete lack of co-operation from Russia would be highly detrimental as the world aims for net-zero.  The price of carbon permits within the EU’s emissions trading scheme has also fallen since the start of the invasion, effectively making it cheaper for companies to pollute.  Current circumstances clearly do not allow it, but the eventual resumption of engagement activities with Russian industry on the part of the sustainable investment community may play an essential role in averting the longer-term threat of further death, population displacement and conflict represented by climate change.

    Richard Tyszkiewicz
    Richard Tyszkiewicz
    Richard has over 30 years’ experience in the international investment industry. He has worked closely with major Nordic investors on consultancy projects, focusing on the evaluation of external asset managers. While doing so, Richard built up a strong practical understanding of the challenges faced by institutional investors seeking to integrate ESG into their portfolios. Richard has an MA degree in Management and Spanish from St Andrews University, and sustainability qualifications from Cambridge University, PRI and the CFA Institute.

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