The invasion of Ukraine has created a massive shift in how the world views and treats Russian assets. From sanctions on foreign reserves to removing Russian equities from portfolios and indexes, the world’s response has been swift. For the most part—aside from increased volatility—investors have been insulated from the carnage.
That is, except for investors in environmental, social, and governance (ESG) investing.
The Russian-Ukrainian conflict has thrown ESG investors for a loop. It has not only affected Russian holdings, but whether they can and should be accepted into ESG indexes and funds. While some pundits have called this the death knell for ESG and socially responsible investing (SRI), the conflict has certainly thrown cold water on the ESG movement.
Ultimately, it makes due diligence and regulation even more important when it comes to ESG.
Be sure to check out our ESG Channel to learn more.
Hidden ESG Risks
One of the main ways the world has begun punishing Russia for its invasion of Ukraine has been on the financial front. This has been done via a correlated effort from the European Union, the United States, and other nations via economic sanctions, closing airspace to Russian aircraft, removing Russia’s ability to tap its $630 billion in foreign reserves, and shutting out Russian banks from the SWIFT global financial network.
These efforts have basically removed Russia from the world in an economic sense and made the nation ‘uninvestable.’
For ESG investors, this has been a surprise shock. Based on history and other factors, most investors would be surprised to see that Russian assets feature prominently in several ESG funds. But that’s exactly what was going on. Analysis by Bloomberg of roughly 4,800 ESG funds representing more than $2.3 trillion in total assets, about 300 were directly exposed to Russia via bonds and equity holdings just before Russia invaded. That’s roughly $8.3 billion worth of assets.
Worse still is that ratings for these assets were pretty solid on the ESG scale. Bloomberg found that 13 of the ESG funds held assets that met the “very highest level of sustainability” by Europe’s Sustainable Finance Disclosure Regulation. Nearly 140 funds held assets that were in the “promote ESG characteristics” category.
Additional data from CIBC Capital Markets shows that the big four Russian energy companies— Lukoil, Novatek, Gazprom, and Rosneft —accounted for about 0.2% of global ESG holdings. While that may seem small, it’s more than double the size of investments in Canada’s energy market. Russia features more prominently than Canada on ESG scores.
Changing What’s OK
The next piece for the Russian ESG puzzle doesn’t have to do with the nation itself, but what managers feel comfortable investing in under ESG rules. Most ESG/SRI indexes follow exclusionary screening. That is, they remove ‘bad’” firms that either don’t score well or ignore entire industries. One of the biggest exclusionary sectors in ESG has been weapons and defense contractors.
However, with the unprovoked invasion, several ESG managers have started to rethink that position. Swedish financial group SEB—one of the largest managers of ESG funds—was the first. Starting in April, SEB will allow six ESG funds to hold stocks that generate more than 5% of their revenue from defense/weapons businesses. This completely reverses its previous policy of no defense stocks.
SEB isn’t alone. Several other banks and asset managers have recently made similar decisions or calls, with Citigroup saying that “defending the values of liberal democracies and creating a deterrent, which preserves peace and global stability” qualifies defense firms to be in ESG funds.
More Due Diligence Needed
For investors in ESG, this creates a muddle that they need to wade through before investing in the theme. It also poses some other interesting questions.
The first issue—Russian assets in ESG funds—is already being worked through. MSCI has begun the process of removing Russian stocks and bonds from its indexes, including its ESG tracking benchmarks. FTSE and other index providers are doing the same. However, the question now exists about Chinese exposure in ESG benchmarks. China’s historical take on human rights and other social issues has many investors questioning its inclusion in ESG metrics in the wake of Russia’s removal. That’s a much bigger issue given China’s larger weighting in ESG funds.
Second, the fact that Russia was in there in the first place, and now the addition of weapons firms, makes a call for better screening disclosure. ESG continues to be the wild west of fund management. That can’t continue and investors need to know what they are buying.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Bottom Line
The Russian invasion of the Ukraine has brought many ESG issues to light. And these issues must be dealt with for ESG to continue growing. Better screening due diligence and perhaps a touch of regulation would allow investors to know exactly what they are buying and how it can affect their ESG portfolios.
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