The war in Ukraine exposed the flaws in the environmental, social, and governance (ESG) frameworks being used by some institutional investors. Roughly $150 billion of debt is at risk of default because of sanctions, forced divestitures, and the lack of access to US dollars. We believe that these securities should have never been included in ESG-focused portfolios.
How Does a Sanctioned Country Pass the ESG Screen?
Russia was first sanctioned for its actions in Crimea by the United States in March 2014, and within two weeks the European Union, Canada, and Australia all followed suit. In fact, four rounds of sanctions took place in 2014 but Russian securities were still being purchased by large institutional investors. Global investors like Pimco, Calpers, and Blackrock have significant exposures to Russian equity and debt securities, including those of major oil and gas companies like Gazprom.
We believe that the role of the index data providers, and the heavy reliance on their ESG ratings by large investors, also contributed to the losses. For example, Russia had its ESG rating lowered several weeks after the war started. Russian equities and bonds where removed from indices roughly two weeks after the invasion, when Sberbank and Gazprom shares were halted in London after plunging 99% and 94% respectively.
Based on our research, 11 of the top 15 sustainable emerging markets funds had exposure to Russia, with one fund holding a 5% allocation. Data from Bloomberg show that ESG funds held roughly $8.3 billion in Russian assets including state-owned firms such as Rosneft and Sberbank.
Fossil Fuels and Poor Governance Did Not Deter Investors
We believe that Russia's economy and stock market, which is highly fossil fuel and resource dependent, should not have passed ESG screening criteria. In fact, half of Russia's market capitalization are fossil fuel companies.
While we acknowledge the qualitative analysis that is necessary when applying ESG criteria, it is unlikely that a company like Gazprom (or mining companies) would score high for ESG. The inherent business model for fossil fuel development and mining, along with the heightened risk of government corruption from state ownership, should have excluded these issuers from ESG-focused strategies.
Notwithstanding the environmental and social concerns from oil, gas, and nickel mining, most companies in Russia (and even the sovereign) would have a low ESG score for governance. The country has high levels of corporate and political corruption, and the linkages between the government and the oligarchs further increases the risk for investors.
Our Outlook for ESG
The headline risk for many prominent investors because of their investments in Russia will cause them to revisit the importance of ESG, and lead to the development of more robust ESG frameworks.
Regardless of which ESG criteria fund managers adopt, they need to be aware that ESG factors are continually evolving, and that qualitative analysis must be used to supplement ESG data from service providers.
The ESG framework at Ashton Global excludes the securities of gaming, oil and gas, mining, alcohol, defense, and tobacco issuers. We exclude these industries from our ESG portfolios because of the potential for negative social and environmental effects. Contact us to learn more about how we construct ESG and impact investment portfolios.