The morning after Russia’s invasion of Ukraine, Canon Angela Tilby on Radio 4’s ‘Thought for The Day’ gave a thought-provoking appraisal of the collective disbelief that the West’s pillars of freedom and democracy could be rolled over "so quickly and so brutally".
"Everyone seems now to be regretting our readiness to accept influence and investment from non-democratic powers, but why did we do so in the first place? … What really undergirds our much-trumpeted western values?", she probed.
While Tilby was hinting at the fragile spiritual foundations of our institutions, similar questions are being posed to the investment management industry. Were investors wrong to exclude armaments companies from portfolios on ethical grounds? Do elevated fossil fuel prices rejuvenate the investment case for extractive businesses? What does the future of European energy independence mean for the climate transition? And, does the invasion of Ukraine demand a rethink of ESG, given the failure to acknowledge governance risks in Russian assets?
A call to arms?
Charity investors have long been at the forefront of designing ethical exclusionary policies, often a function of their public profile and the scrutiny placed on them by donors, beneficiaries and interested parties. While the focus has shifted to positive impacts derived from stewardship and active company engagement, over 70% of our 480 charity clients retain some form of ethical exclusion.
Exclusions typically focus on ‘sin sectors’, where little social value can be derived or the reputational risk of owning a company is high: tobacco, alcohol, adult entertainment, gambling, predatory lending and armaments. Yet the war in Ukraine has prompted a reconsideration of the armaments industry’s social licence.
Sweden’s SEB Bank finds itself at the heart of the debate. From 1 April, the company will allow investment in armaments stocks, marking a U-turn from one year ago when its sustainability policy mandated a blanket exclusion.
Ultimately, ethical exclusions should align with each charity's mission and objectives.
A recent sustainable finance report commissioned by the EU also sought to reconsider the labelling of the armaments industry as ‘socially harmful’. The European Parliament’s Committee on Foreign Affairs stressed that new guidelines should not pose obstacles to the ‘crucial’ funding of the eurozone’s defence industry. Public opinion about armaments will inevitably evolve in response to the humanitarian crisis caused by the war, western European governments’ decision to send arms to Ukraine and Germany’s creation of a €100bn fund to overhaul its military. While this influx of capital may prompt questions about these businesses as potential investment opportunities, how should charity trustees consider the ethical credentials of armaments companies?
Firstly, the issue is more nuanced than it might seem. The European Commission’s report suggests reserving the ‘harmful’ label for companies that contravene international treaties or conventions on the production, use and deployment of weapons. Negative portfolio screens allow for such detail and charities can choose to exclude controversial weapons (this typically relates to indiscriminate weaponry like land mines and cluster bombs), weapons producers or those that derive revenue from components or related services.
Secondly, there are legitimate concerns over corruption in the industry and it is difficult to track where ‘authorised weapons exports’ end up. Some charities may decide that weapons should play no part in society. Others may not have the opportunity to defend a certain policy stance, which may necessitate a blanket exclusion.
Ultimately, ethical exclusions should align with each charity’s mission and objectives. The ethics of a military charity may differ from those of a religious order, a university or conservation charity. Trustees must separate personal views from the interests of the organisation they represent, as the two may not be aligned. Finally, we urge pragmatism. Excluding too great a portion of the investable universe will have repercussions for risk management and return expectations; a prudent balance must be achieved.
Oil & gas back on the menu?
Some commentators have criticised investors who exclude companies involved in fossil fuel extraction. Again, the arguments are finely balanced.
The narrative pre-dates the war in Ukraine, but the conflict has exacerbated existing trends. Despite COP26 and growing awareness of the climate emergency, demand for oil and coal significantly overshot the incremental supply of renewables in 2021. Expectations of interest rate rises, passive fund outflows and exponential growth in competition for clean energy contracts caused many renewable energy companies’ share prices to fall. The energy transition went into reverse as the world turned to fossil fuels to reinvigorate the global economy and emissions peaked.
European sanctions of Russian energy exports prompted a further rise in oil and gas prices and, given the short-term challenges facing the renewable energy sector, raised the question of whether investment in fossil fuel companies might now be desirable. However, the EU’s commitment to cut Russian gas imports by two-thirds within a year shows the direction of travel for European energy independence and the importance of green energy infrastructure. While the proposals require greater reliance on coal and nuclear power in the short term, the European Green Deal commissioner has laid out how the EU can still cut greenhouse gas emissions by at least 55% by 2030 and achieve net zero by 2050.
It is clear that the renewable energy asset base will need to increase rapidly, and the sale of carbon permits could support this much-needed investment. Proceeds from their sale totalled 30bn EUR in 2021, double 2020’s total, illustrating the role the carbon Emissions Trading System (ETS) market could play in diverting capital towards renewables.
There will be challenges, including higher input prices and rising financing costs, but the narrative that Russia’s invasion could stall the global transition to greener energies now appears less plausible. The recent increase in oil and gas prices – and the share prices of energy companies – is tempting for some investors, but longer-term risks abound. The balance sheet write-downs at many of the oil majors in 2020 are unlikely to be one-off events and the most recent disclosures in their accounts show that the energy transition dramatically increases the risk of stranded assets.
Our core approach is to identify whether these companies represent compelling thematic investment opportunities with strong growth drivers over a multi-year time horizon. Ultimately, if oil and gas companies can transition to a net-zero aligned world in a profitable manner, we would consider investing in them.
Whilst we are sympathetic to those who choose to implement a wholesale exclusion of the energy sector, our preferred approach is to view engagement and divestment as complementary. Divestment carries risks and can over-simplify complex issues. All industries have a responsibility to align with a net-zero pathway and the world will continue to require oil and gas over the years ahead.
Finally, it is important to remember that despite the surge in commodity prices, as at 28 February, oil and gas comprised only 4.2% of global equity markets, equivalent to the market cap of Apple. Choosing not to invest in the energy sector is a decision of diminishing significance. There are many compelling investment opportunities elsewhere.
ESG investing: a folly?
The invasion of Ukraine serves as a stark reminder that investing, particularly with an ESG lens, is complex. The investment industry’s response to the invasion has been wide ranging but often lacklustre, featuring too-little-too-late responses and loose commitments to end new investments or divest from Russia when possible.
The same problems inherent in excluding whole sectors also apply to nations. Does exclusion of Russian assets also require exclusion of Chinese investments on human rights grounds? Such a restriction might include multinationals with operations in China and companies that source goods or services from it, which could result in the majority of listed companies being excluded from investment.
Similarly, a ban would be a blunt and potentially misdirected policy for enhancing human rights:
- Not all companies operating in countries with challenging regimes are complicit in human rights abuses.
- Multinational companies frequently have higher standards of worker protection and can catalyse positive change, for example by raising standards among local suppliers.
- Multinational companies supplying these countries often bring higher-quality goods and services that contribute to better consumer outcomes in healthcare, financial services and the retail sector.
The expectation that corporates remove themselves from Russia carries similar complications. McDonald's has temporarily closed its Russian restaurants but pledged to continue paying its 62,000 employees in Russia. This is admirable, but when will it return and how does it manage that message? Similarly, is it right that Russian civilians are denied access to basic goods and services? Nestle, which has been criticised for not pulling out of Russia, has cited a responsibility to 7,000 Russia-based employees and its commitment to providing essential items to Russian people.
Ethical restrictions make a change of policy difficult to enact. Regimes, attitudes, behaviours and perceptions all change but inflexible rules provide little room for manoeuvre. A more flexible approach is to assess risk on an absolute basis wherever threats to capital are identified, and apply thoughtful company ownership and robust engagement to drive positive change. Consistency of process is critical and a concentrated buy-list of companies is helpful in gaining a deep understanding of each company’s operations and strategy. It is increasingly the role of investment managers to guide capital allocation within companies as well as between companies. This is much more difficult when using a quantitative approach on a universe of thousands of companies. To quote Research Affiliates’ Vitali Kalesnik: "in a world in which we have just been reminded that G can stand for governance at a state as well as a corporate level, you don’t want a bit of everything."
ESG standards vary across the regions in which we invest. We must navigate these complexities and identify opportunities that generate attractive, sustainable long-term returns through improving people’s lives. Where we identify concerns, we seek to drive positive change.