Lasting lessons from Russia’s war on Ukraine

23 June 20227 minute read

AUTHORS

• David Nowakowski Senior Strategist, Multi-asset & Macro

• Thomas Dillon Head of ESG – Sovereign

Russia’s invasion of Ukraine has led to ESG receiving widespread flak. While much of the criticism is unjustified, the episode underlines how many issues related to ESG are complex and involve trade-offs. Investment approaches may need fine tuning, especially if the geopolitical landscape continues to change so rapidly.

Within days of Russian tanks rolling into Ukraine, market commentators were asking why ESG ratings agencies had failed to detect the risk associated with investing in Russia and why many funds with an ESG label had sizeable allocations to Russian equities and debt.

According to one story, about $9.5 billion in funds meeting European environmental, social and governance standards were sitting in Russian assets, often on the basis of ratings from companies such as Sustainalytics and MSCI which were arguably too positive.1

Despite most ESG rating agencies marking Russia down for its record on suppressing dissent at home and aggression abroad, MSCI, for instance, still rated the country’s sovereign debt BBB prior to the invasion. Even though the war and international reaction may have taken many by surprise, the fact this was swiftly cut to CCC struck most observers as an admission the original rating was too high

Even if they were not alone, ratings agencies’ failure to anticipate Russia’s belligerence is potentially awkward given they are supposed to focus on factors such as democracy, human rights and other social and governance factors. Some argue Russian assets should have been downgraded much more harshly from an ESG perspective immediately after the country occupied Crimea in 2014 – after which the Russian government was accused of extra-territorial killings and election interference.2 These are not just bad in their own right, but could hurt investors given the threat of escalating sanctions and the potential risk to their reputations.

Stuck in the muddle

Compounding the problem facing investors, there are more than 600 standards and frameworks, data providers, ratings and rankings that are working to measure ESG-related risks, according to the European Banking Federation, a lobby group.

The result can be significantly diverging outcomes with the same sovereign or corporate borrower considered high risk, medium risk or low risk if rated by three different agencies. The fact providers consider the methodologies proprietary information adds to the challenge of interpreting ESG ratings.

Regulators are calling for urgent work to clarify the myriad standards and practices being used to produce ratings

Regulators such as The European Securities and Markets Authority are calling for urgent work to clarify the myriad standards and practices being used to produce ratings.3 Likewise, the International Organization of Securities Commissions, whose members regulate the world’s securities markets, has called on ratings companies to provide greater transparency on how they reach their conclusions and regularly review their methodology.4

David Nowakowski, senior multi-asset and macro strategist at Aviva Investors, says while recent events may have exposed errors in the methodology or judgement calls used to generate individual sovereign borrowers’ ESG ratings, it would be wrong to conclude they are worthless, as some pundits appear to have done.

“After all, the invasion has shown just how important non-financial metrics can be,” he says.

Tom Dillon, head of sovereign ESG at Aviva Investors, believes ESG ratings can be a useful starting point for analysis, but there is a danger of placing too much faith in quantitative scores provided by ratings agencies given their limitations. Recent events have demonstrated the need for investors to incorporate their own qualitative analysis when appraising investment opportunities and risks.

One major problem is that since the quality of health, education and infrastructure all feed into a country’s ESG score, they tend to be skewed in favour of richer nations. Dillon believes at least part of the answer is to strip out any wealth effects to ensure countries’ ESG scores are more easily comparable.

Lessons for investing in other countries

The severity of the sanctions placed on Russia have led some to question the wisdom of investing in other countries without functioning democracies and with questionable human rights records, such as China and Saudi Arabia.

China is seen by some as the closest parallel to Russia given the two countries’ increasingly close ties – in February they issued a 5,000-word statement in which they vowed their friendship had “no limits” – and in view of Beijing’s historical claims on Taiwan, which parallel Moscow’s revisionism vis-à-vis Ukraine.

The risks of investing in totalitarian regimes is not always fully captured in countries’ ESG rankings

Dillon says the invasion of Ukraine has been an “eye opener” for many and resulted in a greater appreciation among investors as to just how material ESG factors can be. However, he acknowledges the risks of investing in totalitarian regimes is not always fully captured in countries’ ESG rankings and hence in the price of securities.

In China’s case, for example, the potential for government policy missteps, a business environment that is subject to abrupt overhauls, and the issue of the mass internment of Uyghurs, all argue in favour of a lower ESG score.

“If investors in Russia should have been compensated for the risk of sanctions, the same principle should apply to China too, where other ESG-related risks are not well captured in scores,” Dillon says.

Given what some perceive to be the increased risk of investing in China, at least one asset manager has reportedly started blacklisting Chinese assets after developing a new screening tool to catch ESG risks.

Nowakowski is far from convinced this is the right response. “It is a red flag when things score badly, but it just means you have to make some additional assessments,” he says. However, he warns that as the world becomes increasingly polarised, Western criticism of autocratic regimes is only likely to intensify.

ESG ratings may have to factor in that investing in countries such as China is becoming potentially riskier

David Nowakowski

Senior Strategist, Multi-asset & Macro

“Should deglobalisation gather pace, as seems plausible, demand for investments that are compatible with values that investors in liberal democracies hold dear is likely to grow. ESG ratings may have to start factoring in that investing in countries such as China is becoming less appealing and potentially riskier, even if that won’t be easier to do objectively on a consistent basis,” he says.

Corporate implications

While there may be flaws in sovereign ESG ratings, Nowakowski and Dillon believe another problem is that ESG-related country risk often fails to feed through into companies’ ESG scores.

The problem is especially apparent in the case of state-owned, or state-controlled, companies in countries that violate human rights. That said, it is not just emerging-market assets where there is a potential problem. Russia’s invasion has highlighted the need for ESG-related risks to be more accurately incorporated into securities issued by companies domiciled in developed countries but with sizeable operations in places with low ESG ratings.

Numerous developed-market firms have in recent weeks been forced to write off billions of dollars of investments amid public pressure to pull out of Russia and as Western sanctions made their operations untenable. In April, Shell announced it will write down the value of its Russian assets by $3.9 billion, while BP took a $25.4 billion charge after writing off its stake in Rosneft.

As with Russia, Western companies involved in China would be vulnerable if relations between China and the West continued to sour. Given China’s comparative economic importance, that could have severe consequences for some.

Western companies reliant on China for critical components could be under threat

An adviser to one of Germany’s leading automakers reportedly said in March that, while withdrawing from Russia was one thing, if there were pressure to withdraw from China that would be “close to an existential crisis”.5 China accounts for upwards of a third of sales at Volkswagen, BMW and Mercedes-Benz, and is a crucial market for a host of other multinationals. Western companies reliant on China for critical components could also be under threat.

“If the West were to impose sanctions after a Chinese invasion of Taiwan, the likelihood is China would respond in kind. That’s something which should be in your ESG view but is not going to be in your cashflow statement,” Nowakowski says.

The implication is not necessarily to divest completely from China, but to assess investments and their risks, and to compare them against other opportunities with the most objective information.

Carbon trade-offs

The fall-out from the invasion has led to soaring energy prices, causing hardship for millions. Although its effect has been felt globally, the impact has been most acute in Europe, a major importer of oil and gas from Russia. Across the continent, governments have felt compelled to step in with relief packages to shield households and businesses from some of the impact. Despite this, there are fears many energy-intensive European companies will be badly disadvantaged relative to competitors further afield where the rise in energy bills has been far less dramatic.

Meanwhile, EU leaders in March agreed several steps to reduce the bloc’s reliance on Russian fossil fuels. They include ramping up investment in renewables, accelerating hydrogen production, and building gas storage facilities and liquefied natural gas infrastructure.6

It will be years before the EU can cut its reliance on Russian fossil fuels entirely

However, in Nowakowski’s mind, while the war is likely to force many nations to accelerate their economy’s transition towards renewables, there are constraints on how quickly this can be achieved. Most analysts believe it will be years before the EU can cut its reliance on Russian fossil fuels entirely. In the meantime, it will be vulnerable to Russia turning off the taps.

According to a research note from Goldman Sachs, a rapid switch from natural gas to renewable power and the rise of electrification in the absence of energy storage infrastructure “poses risks to energy reliability”.

“Until the relevant energy storage infrastructure (networks and smart grids) and technologies (utility scale batteries and hydrogen) are ready to support an increasingly electrified energy economy, we argue that both natural gas and nuclear power have a role to play in the near term to enable a smooth energy transition and help avoid a power crunch,” the US bank’s analysts argued.

Energy security and the need to shield poorer members of society from the impact of soaring energy bills have suddenly become critically important policy goals. That has led to calls for fresh investment in fossil fuels as a short-term fix.

Perhaps predictably, some have questioned whether ESG investors have been too aggressive in blacklisting investment in new fossil-fuel projects as they tried to curb carbon emissions. In part, these arguments confuse ESG with sustainable investing, as recently explained by Aviva Investors’ CEO Mark Versey in Thick skins and tin ears: Facing up to the ESG backlash.

Sora Utzinger, senior ESG analyst at Aviva Investors, concedes recent events have highlighted the need to consider energy security as countries try to make progress in the energy transition. However, while investors may have paid insufficient attention to the issue of energy security, this is ultimately an issue for governments to address.

“Easing planning rules to enable renewable infrastructure to be installed faster and designing pipelines so they are compatible with zero-carbon gases are two steps that could be taken to address the issue without jeopardising net-zero ambitions,” she says.

There are often tensions and trade-offs, if not outright conflicts, between financial returns and ESG scores

Russia’s invasion of Ukraine may have highlighted an uncomfortable truth: namely that there are often tensions and trade-offs, if not outright conflicts, between financial returns and ESG scores, as well as other subjective considerations on morality, political views, and human rights. But it would be a mistake to reject it wholesale.

The point of ESG integration is to improve investment performance by better understanding the risks attached to different investment opportunities than by looking at standard financial metrics alone.

As Nowakowski says: “While there may be things to learn from recent events, far from undermining the case for ESG investing, the invasion of Ukraine has underlined how important getting your calls right on non-financial considerations can be.”

• 322701 - 30/06/2023

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