Russia's invasion of Ukraine has starkly exposed the limitations of ESG in its current form, placing the moral imperative on government regulators to shape the future of responsible investing.
Russia’s invasion of Ukraine has sent the ESG industry into an existential tailspin, with investors clamouring to offload Russian assets. The extent to which the financial sector has been thrust into the spotlight has led critics of ESG to claim that the Ukraine war “bankrupts the ESG case”. This is because, to most, Russia has had obvious ESG red flags for some time. From its invasion and annexation of Crimea in 2014 to consistent repression of dissenting voices, most notably Alexei Navalny.
The question is, therefore, why were some ESG fund managers exposed to Russia in the first place?
ESG is not a moral movement
One of the core issues is that ESG is largely reactive, rather than proactive. The Ukraine war is an illustration of this. At the core, this is because ESG is an approach to risk management rather than a tool for genuine responsibility. An issue becomes an ESG issue when it poses a reputational or financial risk. We have seen this over the past years with the growth of the environmental movement and external pressure on investors prompting a huge growth in sustainability reporting, net-zero targets and more.
Until Russia’s invasion of Ukraine, investments in Russia were not deemed to pose a substantial risk and therefore were often deemed irrelevant regardless of whether they were socially responsible or not. Russia’s invasion has exposed the cracks in the narrative that ESG equals responsibility as it has a propensity to overlook sustainability factors which do not pose a risk to reputation or the bottom line. Since Russia’s annexation of Crimea in 2014 it has been under international sanctions. If ESG was about responsibility, Russian sovereign assets would have been excluded from ESG funds long ago.
There was of course a moral aspect for many to financial withdrawal from Russia in the days and weeks after the invasion began. PensionDanmark, a Danish pension fund, sold all its Russian government bonds and state linked companies in the weeks leading up to the invasion, with their CEO Torben Möger Pedersen quoted in Capital Monitor as saying “With the aggressive actions taken by Russia we have no desire to support the Russian regime.”
There was, however, a financial imperative as well. The Moscow Exchange (Moex), Russia’s benchmark stock index, was down almost 30% on 24 February, wiping out roughly $259bn in value. Both the assets and liquidity of Russian assets is decreasing. Robert Edwards from Morningstar is quoted in Capital Monitor as saying that Morningstar removed Russia from its indices because the stocks could not be traded, rather than for moral reasons.
ESG is not a moral movement, contrary to what its strongest proponents may have you believe.
The issues run deeper than the revelations from the aftermath of Russia's invasion. An investigation by Inclusive Development International and Alternative ASEAN network on Burma alleged that 344 ESG-labelled funds have exposure to companies tied to Myanmar’s military junta. This suggests that investment in these companies does not pose a high enough reputational or financial risk to prompt an exit.
As long as ESG is reactive and risk-based, it cannot truly be called responsible.
ESG ratings are part of the problem, rather than the solution
One of the reasons why ESG funds have continued to harbour Russian assets despite international sanctions and the repeated violations of international norms is because of their ongoing reliance on ESG ratings.
A leading ESG ratings provider downgraded its ESG rating of the Russian government from B to CCC in the aftermath of the invasion. Sasja Beslik, a sustainable finance expert is quoted in the FT saying: “This came eight years too late”, going on to say that ESG considerations related to investments in Russia had “nothing to do with morals”.
ESG ratings reflect the purpose of ESG investing. They identify the ESG factors of countries and companies that are most likely to impact their bottom line. In this sense, ESG ratings are also reactive, rather than proactive, and about financial risk, not societal impact.
Regulation most be proactive, and data must support it
Duncan Austin in Responsible Investor argues that ESG, what he calls a ‘voluntary market-led solution’, is a fix that fails. It is not capable of providing the restructuring necessary to recalibrate the global economy towards long-term sustainability and responsibility.
He argues that “the business case is simply too weak and compromised a force to promote enough change fast enough. Instead, the moral case for sustainability is going to have to carry most of the load from here…”. We have seen that the market will not be the drivers of this moral case. So who will?
The answer is regulation. If the investment market is reactive when it comes to matters of sustainability, then it is the job of government regulators to be proactive.
It is essential that regulators are out in front on matters of sustainability, rather than reacting to them. We have seen this over the past years on environmental issues. The EU Taxonomy and SFDR represent important, proactive steps to direct investors on environmental sustainability. The same proactivity has not been shown, however, on social and governance issues. This was seen in discussions regarding the under-development EU Social Taxonomy regarding whether or not weapons should be classified as social, with the defence industry seizing the opportunity to insist that weapons are social. This has led many to argue that if defence stocks can be classified as ESG, then what is the point of ESG at all?
This illustrates the necessity for regulators to be out in front as the drivers of the moral case for sustainable investing. This will be no mean task, as it will involve considering the full and wide-reaching implications of investments and taking a stance on their significance. Considering the perspectives of the market is essential in the development of regulation, but ultimately it must be regulation which dictates how the market reacts, not the other way around.
Third-party insights providers also have a part to play in this. The case of Russia’s invasion of Ukraine illustrates the need to move beyond reactive ESG ratings based on financially material factors. We demonstrate in our recent white paper that to really understand the full sustainability of a fund, company and country you need to analyse it metric by metric. This kind of analysis creates a virtuous cycle with proactive investment guidelines in financial institutions and proactive regulation.. Granular disaggregated data facilitates ambitious standards, and ambitious standards encourage deeper exploration into company and sovereign responsibility.
Ultimately, there are no silver linings to the tragedy that is Russia’s invasion of Ukraine. The hope is, however, that by exposing the reactiveness of ESG and wider flaws in the financial system, we can take steps to avoid financially propping up corrupt, repressive, authoritarian and inhumane regimes, in the hope that something like this is less likely to occur again.