The war on ESG

The act of war is unsettling. Armed conflict brings with it an incalculable human cost. The multiplier effects of war extend well beyond the societal impact as we are witnessing in Russia/Ukraine, and extend to the geopolitics at play. Using the lens of ESG, we work through the potential spillover effects of a war on investments and its impact on investment performance.

In this note, we explore the following topics around the Russia/Ukraine war:

The question of moral investing is one of ethics that stem from investor beliefs. In practice, a negative screening approach would have initially excluded Russia and a divestment approach following the war would have meant exiting the region from a moral standpoint. Market participants have been quick to comment that ESG practices and funds should have avoided Russian investments, which can be seen as an attempt to invalidate the practice of ESG.

Moral investing or negative screened funds may be investable but their objectives are based on making a difference. This should not be confused with a portfolio constructed for the objective of investment performance. A portfolio which makes use of ESG to manage material risks could potentially have an adverse financial effect on investment performance.

December 31, 2007

February 28, 2022

Russia’s weight in the MSCI Emerging Markets Index dropped sharply during February 2022. At the start of the year, it accounted for just under 4% of the index. While this year’s decline is sharp, its weight in the index has been steadily decreasing since 2008 (10%).

At the onset of the 2008 global financial crisis, Russia was the fourth-largest emerging market country behind China, South Korea and Brazil. Since then, Russia’s weight has fallen due to the fallout effects of the 2008 recession and a decade-long series of economic sanctions that resulted in the depreciation of its currency. Today, Chinese, Taiwanese and Indian firms have taken share, pushing Russia (and Brazil) toward the rear of the pack.

The key takeaway message is that Russia’s weight in global indices has gradually declined as markets were pricing for financial material risks. This is based on its lower growth forecasts, waning contribution to global GDP and ESG-related risks. Any allocations made to the region – passive or active – would have been done in a measured manner that would not affect our portfolios and their long-term outcomes. The longerterm impact of a war on sanctions, oil prices, gas, wheat or corn (Russia’s key exports) is still early to tell, however we will be proactive in these discussions.

On the topic of money, if we held an investment in the MSCI Emerging Markets Index, based on autocracy or socialist rule, for example, we might find consideration for also exiting China. However, also considering that China accounts for over 30% of the index, exiting China could have significant off-benchmark implications for portfolios (risk of large tracking errors in performance outcomes). If we turn our attention to the role of foreign direct investment (FDI) for emerging markets, what might the potential implication for a country like South Africa be? South Africa, as a fossil fuelbased economy, could find itself locked out of much needed FDI should Europe or the UK apply divestment considerations on the grounds of an environmental rationale. The divestment argument cuts both ways.

ESG integration is not a label of morality, it is a market signal that can be tailored for several uses like risk avoidance, positive impact or financial materiality.

The response by Western nations to the escalating Russia/Ukraine war has predominantly been centred on economic sanctions being applied on Russia, such as freezing Russia’s foreign currency reserves and cutting off a substantial part of Russia’s financial system from 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 on natural capital, destroying arable land and water infrastructure. The impact of supply chain disruptions of gas into the UK and Europe has put their own climate ambitions and transition plans 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 country (Ukraine nor Russia) was known for good governance. According to the Transparency International’s Corruption Perception Index, Ukraine ranks 122nd and Russia ranks 136th out of 180, being the lowest in Europe. The war could likely further jeopardise good governance principles into the foreseeable future.

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 (LNG)3.

Sanctions and supply chain disruptions will have a sizeable impact on global food and energy prices resulting in inflationary headwinds on a backdrop of slowing growth – stagflationary.