ESG investing seen in new way after invasion

As investors across the U.K. and Europe address their Russian holdings following the Feb. 24 invasion of Ukraine, the crisis also is causing a rethink of ESG-related risks and the lessons to be learned for other emerging markets such as China.

"The crisis is likely to serve as an additional wake-up call for investors to take ESG risks seriously," DWS Group said in a March 4 CIO alert. Russian assets have long traded at discounts because of environmental and governance concerns, the alert said, and the recent (market) collapse illustrates "how severe the impact of such risks can be when they are finally fully priced in."

As the Ukraine conflict highlighted dramatically, global investors using indexes cannot always control where they invest until a situation becomes untenable. For Russia, that moment came a week after the invasion when index providers MSCI Inc. and FTSE Russell cut Russian equities and bonds from widely tracked emerging markets indexes, after investors called the Russian market "uninvestible." Two weeks later, MSCI ESG Research downgraded Russia's ESG government rating to CCC, the lowest rating possible, due to risks from the impact of international sanctions and Russia's "financial isolation."

While many pension funds and other asset owners are now scrambling to sell Russian holdings at any price, their exposure was already low through sustainable fund portfolios because of high levels of ESG risk and fossil fuel involvement, said Jon Hale, director of sustainability research for the Americas at Morningstar Sustainalytics in Chicago. Among the sustainable emerging markets funds that Sustainalytics tracks, only one has Russia exposure higher than 4.9%, 10 have less than 1% exposure and four have none.

It's not a political aversion, said Mr. Hale, "it's just that few public companies in Russia are attractive ESG investments," particularly since the fossil fuel industry makes up roughly half of Russia's market capitalization.

For investors in emerging markets, he said, the bigger question is China and other autocratic regimes. "It's easy to remove Russia from emerging markets portfolios, even if the removal is only symbolic at this point. That's not the case with China," he said.

With China making up nearly 30% of emerging markets indexes, the question of whether investors want to keep putting money into a system that lacks democracy, freedom and human rights "should be on the table for discussion," Mr. Hale said.

ESG investing covers a lot of topics, from energy and climate change to diversity and human rights. Investors assess ESG risks to their portfolios depending on their specific policies, and then decide where they want to be.

Some asset owners had already started moving away from Russia, driven by their ESG policies. The £57 billion ($76.4 billion) BT Pension Scheme, London, started working with money managers in early 2022 to minimize exposure because of governance concerns and ownership rights associated with Russia.

Responsible investment policies can work as an early warning system. Even before the invasion, the 128 billion Danish kroner ($19.4 billion) pension fund AkademikerPension, Gentofte, froze investments in Russian government bonds and shares in state-controlled companies because of an internal policy against infringing on a state's sovereignty. The invasion left it "no alternative" but to exclude Russia altogether, CEO Jens Munch Holst said.

For Norwegian pension fund Kommunal Landspensjonskasse, Oslo, with 901.3 billion Norwegian kroner ($101.8 billion) in assets, a KLP prohibition against a war of aggression was a factor in its decision to exclude 22 Russian companies and sell 500 million kroner in Russian assets after the country violated Ukraine's sovereignty.

Government sanctions, including those placed on Russia and state-controlled interests by the U.S., U.K., Canada and Europe make the decision easy for asset owners whose policies require them to follow their governments' lead when sanctions are imposed.

Norway's Government Pension Fund Global, Oslo, with 12.34 trillion Norwegian kroner, managed by Norges Bank Investment Management, froze its Russian investments at the request of the country's finance minister. The estimated 2.5 billion Norwegian kroner in Russian investments currently on the books might be "essentially worthless," said Trond Grande, deputy CEO for the sovereign wealth fund, at a March 3 news conference.

In the U.K., The Pensions Regulator cautioned pension fund trustees to be vigilant about the Ukraine situation and ensure that their portfolios "remain aligned" with investment principles, including ESG considerations.

The €539 billion ($607 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands, had already reduced its Russian holdings to less than 0.1% by the time of the Ukraine invasion after placing Russian government bonds on its exclusion list because of an EU arms embargo in 2014.

Another reason for ABP's small holdings was fossil fuels. Last October, the Dutch plan stopped investing in stocks of fossil fuel companies around the world, citing "insufficient opportunity" for shareholder engagement to accelerate the energy transition. It would reinvest that money in renewable energy strategies, said ABP, which is selling all €520 million of Russia assets now.

As investors promote energy transition to reduce climate risk to their portfolios and the European Commission seeks energy independence from Russia, that "could be one silver lining of this catastrophic war," said Emanuela Vartolomei, founder and CEO of All Street Research in London, a fintech company with an ESG rating platform. "More divestments like this can only be good for Europe in the long term."

The EU imports 90% of the gas it consumes, with 45% coming from Russia, which also provides 25% of oil imports and 45% of coal imports. On March 8, the European Commission took the first steps toward energy independence from Russia before 2030 and a faster clean energy transition. The plan, REPowerEU, calls for diversifying gas supplies, conducting a faster rollout of renewable gases and replacing gas in heating and power generation.

"The quicker we switch to renewables and hydrogen, combined with more energy efficiency, the quicker we will be truly independent and master our energy system," EC President Ursula von der Leyen said in a news release.

Spiking energy prices caused by the conflict should also make renewables more attractive, industry analysts note.

"There may be some potentially interesting consequences of the higher conventional energy prices and the current conflict in Ukraine from an energy transition perspective," said Alex Monk, London-based portfolio manager of the Schroder ISF Global Energy Transition Fund.