Over the past few months of the war, ESG practices have experienced strong critique. The prevailing theory being pursued by market participants is that funds or practices with the label of ESG should not have had exposure to Russian assets. Premal Ranchod, head of ESG research at Alexforbes, thinks that there is considerably more to the story than the calling out.
The act of war is unsettling and there are no winners when the impact brings an incalculable human cost with it. Investments and ESG, however, have factors in addition to the humanitarian crisis worth contemplating upon. Using the lens of ESG, Ranchod works through the geopolitik at play and the spillover effects of the war, known as the societal multiplier effect.
- Morality, materiality and money
The confusion arises when investors have misplaced moral beliefs with investment practices that has the objective of achieving outperformance. In practice, moral investments follow a negative screening approach, which avoids companies that don’t meet specific ethical requirements. It could have excluded Russia to start with based on poor governance, its exposure to defence sectors or autocracy. A divestment approach after the war would mean exiting the region from a moral standpoint.
In considering funds with exposure to Russia, emerging market assets and benchmarks, and those who use ESG integration practices with an objective of investment performance, Ranchod highlights the topic of financial materiality. This is illustrated through the MSCI Emerging Market index weights below.
Russia’s weight in global indices has gradually declined as markets were pricing for financially material risks. This is based on its lower growth forecasts, waning contribution to global GDP, and ESG-related risks. The above analysis shows a declining and less financially material component, but is still part of the standard (non-ESG specific) global investable benchmarks. Beyond the evidenced share price decline, longer-term negative impacts include the impact of:
- sanctions on the Russian economy
- oil prices
- the supply of commodities such as gas, wheat or corn (Russia’s key exports)
In considering divestment practices, we do not need to look beyond our borders. If global markets applied divestment of fossil fuel economies, South Africa could find itself locked out of much-needed foreign direct investment. The divestment argument cuts both ways.
In summary, ESG integration practices is not a label of morality; it is a market signal that can be tailored for a number of uses, like risk avoidance or positive impact or financial materiality.
- The economics of E, S, G
War has far-reaching effects. The response by Western nations to the escalating Russia-Ukraine war has predominantly been centered on:
- economic sanctions being applied to Russia
- freezing Russia’s foreign currency reserves
- cutting off a substantial part of Russia’s financial system with the global economy
Through the lens of ESG considerations, the spillover effects of the Russia-Ukraine war extend beyond financial and capital control consequences:
- A heavy destruction of the natural capital, destroying arable land, and water infrastructure.
- The impact of supply chain disruptions of gas into UK and Europe put their own climate ambitions and transition plan away from fossil fuels at risk.
- Widening inequality of citizens of both regions as they face rising food and energy prices.
- Prior to the conflict neither Ukraine nor Russia was known for good governance. According to Transparency Internationals Corruption Perception Index, Ukraine ranks 122nd and Russia 136th out of 180, which is the lowest in Europe. The war could likely jeopardise good governance principles even more into the foreseeable future.
Russia and Ukraine, together, supply a quarter of wheat exports and almost 15% of corn, globally. Russia is the world’s leading exporter of gas, exporting 197.2 billion cubic metres of pipeline gas in 2020, and 40.4 billion cubic metres of liquefied natural gas. Sanctions and supply chain disruptions will have a sizable impact on global food and energy prices, resulting in inflationary headwinds in a backdrop of slowing growth.
At a time when critics of ESG question its relevance (the war on ESG), Alexforbes, who has been championing responsible investment for more than a decade, is experienced in navigating the ESG conversation. Whether funds are labelled ESG or not, the practice has become an imperative for all savings and investment, most notably, the standard retirement fund in the market. Ranchod argues that ESG is not a definite and complete solution, but rather a tool which brings additional nuance to investments. It is a separate lens that works alongside and complements traditional investment risk and return considerations.