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Ukraine Conflict Puts New Light on ESG and Indexes

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The war in Ukraine has shone a spotlight on ESG investing as nations, companies and financial institutions weigh their response to the conflict.

ESG index and ratings setters are under pressure to redraw their exclusion frameworks and also adjust their coverage in light of a welter of sanctions placed on Russian companies and the organisations that do business with them.

And the conflict’s impact on energy markets – with sanctions extended to some of Russia’s vast oil and gas reserves – has illuminated the delicate balance between energy security needs and the decarbonisation pledges of many countries.

While the exposure ESG investors have to Russia is limited, the crisis has raised questions about responsible and ethical investing around the world and especially into markets under authoritarian rule. Russian assets in ESG exchange traded funds (ETFs) largely exist within emerging market (EM) structures, and even within those they make up a small percentage. EM ETFs make up just 3 per cent of all ETFs, meaning Russian assets account for a thousandth of all ESG ETF allocations, said Shaheen Contractor, ESG Research Analyst at Bloomberg Intelligence.

While many investors have pulled out of Russian assets as a demonstration of their ethical stances, those who have invested in Russia-linked ESG funds may not be able to escape for some time. Sanctions placed on the country have effectively closed its markets, making it impossible to divest from some Russian assets. Even if the markets were to open, limits placed by the West on trade with Russian, the devaluation of the rouble and the flight of investors have made it difficult to sell.

“When it comes to ESG, hands are largely tied until the markets open, after which there still might be poor liquidity – you can’t assume you can always sell in such a situation,” Contractor told ESG Insight.

Index Questions

MSCI has already thrown Russian interests out of its financial indexes, and the same questions are being asked of ESG indexes. Sustainability ratings providers have been criticized for not removing Russian assets in 2014, when Moscow annexed eastern parts of Ukraine. They are under pressure to do so now.

Sustainalytics, for instance, is reportedly reassessing its ESG risk ratings and country risk ratings for Russia and MSCI has downgraded the country to the lowest level in its ESG rankings.

The conflict has at least raised a glimmer of hope for ESG investors and data providers. Observers are generally agreed that the impact the war is having on energy markets will accelerate the global transition to renewables. But there will be pain first.

Russia’s vast oil and gas resources have tied Moscow to the international financial system for decades. But as the west rolls out sanctions on President Vladimir Putin’s government, including on the purchase of fossil fuels, the energy security of nations reliant on Russian oil and gas, especially Germany, may dent their ESG strategies. The question being asked is do countries continue to reduce their reliance on fossil fuels in pursuit of net-zero goals that won’t be reached for decades and risk years of blackouts for millions of people? Or do they return to the wells and pumps to quickly fill the energy gaps caused by the severance of Russian supplies?

Already governments have sought help from Gulf oil states to supplement hydrocarbon supplies lost from Russia. Germany is mulling the refiring of coal power stations and the UK is considering lifting its ban on fracking to ease the pain of withdrawal from Russian fossil fuels.

Adeline Diab, Director of ESG Research (EMEA & APAC) at Bloomberg Intelligence, is confident the medium-term outlook will be positive.

“In the short term this conflict may weigh on the climate agenda,” Diab told ESG Insight. “But I believe that in the midterm it will massively accelerate the move to clean power, especially for countries that still rely on fossil fuels as we realize how the energy transition and energy security can fuel each other and help achieve important objectives for independence.”

New Lens

While ESG has found a new focus in the past few weeks, some observers fear the market chaos that has followed the invasion may lead to a distortion of the understanding of what ESG means.

That’s been most vividly highlighted in a growing debate over whether defence investments can now be considered ESG investments. While Skandinaviska Enskilda Banken’s (SEB) decision to end its weapons exclusion policy hasn’t been framed as a change in its ESG strategy, the idea of weapons investment being a “responsible” decision has won some traction.

Citi analysts, for instance, wrote that defence stocks were being “increasingly seen as a necessity that facilitates ESG as an enterprise as well as maintaining peace stability and other social goods”. It also suggested that weapons manufacturers would be included in the European Union’s Social Taxonomy.

Bloomberg’s Diab said such debates were unnecessarily clouding the view of the ESG space.

“We are witnessing some confusion regarding what ESG investing means at the moment,” Diab told ESG Insight.

“We need to differentiate ethical investing – excluding sectors based on values – from ESG investing – which aims at assessing companies’ environmental, social and governance risks without judging sectors per se – when speaking about the defence sector and ESG investment strategies.”

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