ESG’s Russia Test: Trial by Fire or Crash and Burn?
My views on ESG are not a secret. I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society. That judgment may be harsh, but as the Russian hostilities in Ukraine shake up markets, the weakest links in the ESG chain are being exposed, and as the same old rationalizations and excuses get rolled out, I believe that a moment of reckoning is arriving for the concept. If you remain a true believer, I will leave it up to you to decide how much damage has been done to ESG, and what comes next.
The ESG Response To Russia
When Russian troops advanced into Ukraine in late February, the reverberations across markets were immediate. Stock, bond and commodity markets all reacted negatively, and at least initially, there was a flight to safety across the world. Since one of ESG’s sales pitches has been that following it’s precepts would insulate companies and investors from the risks emanating from bad corporate behavior, both ESG advocates and critics have looked to its performance in this crisis, to get a measure of its worth. I am not an unbiased observer, but the reactions from ESG defenders to this crisis can be broadly categorized into three groups.
1. The Revisionists
In the last decade, as ESG has grown, I have been awed by the capacity of some of its advocates to attribute everything good that has happened in the history of humanity to ESG. If these ESG revisionists are to be believed, if companies had adopted ESG early enough, there would have been no banking crisis in 2008, and if investors had screened stocks for ESG quality, they would not have lost money in the corporate scandals and meltdowns of the last decade. In the last week of February 2022, in the immediate aftermath of this crisis, there were a few ESG supporters who argued that ESG-based investors were less exposed to the damage from the crisis. That was quickly exposed as untrue for three reasons:
- ESG measurement services missed the Russia Effect: There is no evidence that Russia-based companies had lower ESG scores than companies without that exposure. In my last post, I looked at four Russian companies, Severstal, Sberbank, Yandex and Lukoil, all of which saw their values collapse in the last few weeks. When I checked their ESG rankings on Sustainalytics ranked each on February 23, 2022, each of them was ranked in the top quartile of their industry groups, though they all seem to have been downgraded since, with the benefit of hindsight. In a short piece in the Harvard Law Forum on Corporate Governance, Lev, Demeers, Hendrikse and Joos, highlight the absence of a Russia effect on ESG ratings with a simple comparison of ESG scores of companies with and without Russia exposure:
Unlike them, I will not argue that failing to foresee the Russian invasion of Ukraine is an ESG weakness, but it certainly cannot be presented as a strength.
- Following the ESG rulebook after the crisis has been a losing strategy: It is true that the emphasis on climate change that skews ESG scores lower for fossil fuel and mining companies would have kept you from investing in Lukoil and Gazprom, among other Russian commodity companies, but it would also have kept you from investing in other companies in these sectors, operating in the rest of the world. As I noted in my last post on Russia, that would have kept you out of the best performing sector since Russia invaded Ukraine. In short, if there is a lesson that this crisis has taught us, it is that treating fossil fuel producers as evil, when they produce much of the energy that we use, is delusional.
- ESG funds/lenders lost substantial amounts in Russia: Investment funds and lenders who have long touted their ESG credentials do not seem to have been less exposed than non-ESG funds, early reports notwithstanding. A Bloomberg Quint study of ESG funds uncovered that they had $8.3 billion invested in Russian equities on February 23, 2022, almost all of which was wiped out during the next few weeks. In fact, the saving grace for ESG funds has been the fact that Russia did not have a large investable market, for both ESG and non-ESG funds.
In the weeks after the war, hundreds of US and European companies have announced that they were leaving Russia, and ESG advocates have pointed to this exodus as evidence that its practices are now mainstream. I would push back against the narrative that these companies were giving up lucrative businesses, because of their consciences:
- Small presence in Russia: In my last post, I noted that the Russian economy represents a sliver (about 2%) of the global economy. If you add the reality that Russia has a closed economy, with well established barriers to outsiders, most of the US companies pulling out of Russia are not giving up much business to begin with. In fact, for companies like Goldman Sachs, whose primary business in Russia came from acting as intermediaries between Russian businesses/investors and investors in the rest of the world, there is a question of whether any business was left to give up, after sanctions were put in place. The companies with the biggest presence in Russia are oil and commodity companies, primarily involved in joint ventures with Russian entities, where the pull out may be designed to preempt what would have been nationalization or expropriation in the future.
- Risk Surge and Economic Viability: In my last post, I noted the surge in Russia’s default spread and country risk premium, making it one of the riskiest parts of the world to operate in, for any business. Many companies that invested in Russia, when it was lower-risk destination, have woken up to a new reality, where even if their Russian projects return to profitability, the returns that they can deliver are well below what they need to make to break even, given the risk. Put simply, exiting Russia makes economic sense for most companies, and it may be cloaked in morality, but it is easy to pick the moral path, when economics and morality converge.
- Suspension versus abandonment: It is telling that many companies that have larger interests in Russia, with perhaps the possibility that investing will become economically viable again, have suspended their Russian operations, rather than abandoning them. These companies will undoubtedly come under pressure from activists, who will try to shame them into leaving, but if that is the best that ESG can do, it is pitiful.
For those who continue to insist that the corporate reaction to the Russian invasion is a sign of moral awakening at companies, I propose a thought experiment. If China had invaded Taiwan, do you think that companies would have been as quick to abandon their Chinese holdings and business? Do you think that investment funds would have been so quick to write off their Chinese holdings? On a more personal level, would you be willing to give up all things “Chinese”, as quickly as you were willing to give up drinking Russian vodka? They are hypothetical questions, but I think I know the answer.
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