The Conflict in Ukraine: An ESG Perspective

March 15, 2022—The international response to Russia’s invasion of Ukraine has been nothing less than swift and severe. The global community has rallied around Ukraine, cutting off Russia’s access to financial markets, consumers, and suppliers. As a result, the Russian ruble has devalued by over 30%. The Moscow stock exchange is down more than 50%–having been closed for the longest time since the 1998 crash—and many of Russia’s largest financial institutions are on the brink of insolvency. As investors focused on ESG (environmental, social, and governance) issues, we place heightened emphasis on the unlikely but still-material investment threats (“tail risks”) that are often overlooked in short-term analysis. The financial fallout of Russia’s invasion of Ukraine is an example of tail risks being realized. Due to the interconnectedness of the global economic and financial systems, we find parts of the market uninvestable for the foreseeable future. Key ESG trends that have arisen from the conflict are the impact of stakeholder capitalism within the geopolitical context; accelerated diversification of energy sources; and a changing outlook on the defense sector.

Stakeholder management in a geopolitical context

ESG is typically thought of as evaluating companies but the principles can also be applied to countries, as the management of relevant risks and opportunities can affect a nation’s long-term sustainability and competitiveness. In the case of Russia’s invasion of Ukraine, we find elevated ESG issues in asset classes and sectors. Russian sovereign debt is clearly problematic, highlighted by the country’s political dysfunction that calls into question its ability to govern effectively through the crisis. The negative global view of Russia’s aggression will continue to have an adverse economic and financial impact, casting doubt upon the value of their bonds. Belarus’ and Ukraine’s sovereign debt is also under scrutiny due to the severe pressure being applied to both governments. Key determinants of healthy economic growth have been challenged—including stability, institutional strength, and the ability to meet their populations’ basic needs. 

Sound ESG investing requires understanding that effective management of all stakeholders is essential  to achieve long-term success, through fostering mutually beneficial relationships among workforces, consumers, supply chains, and communities. If Russia were a company, its recent actions would provide ample rationale to exclude it from investment consideration. Let us expound. President Putin’s invasion of Ukraine has resulted in Russia being “frozen out of” the global community of nation-stakeholders. Seven of its major banks have been banned from the SWIFT network, largely handicapping the country’s ability to participate in global financial transactions. The Russian ruble has significantly devalued by 30.1%, from February 25, 2022-March 13, 2022, and now is worth less than $0.01^[1]; also, the cost of imports has risen. The associated effects on Russian equities are clear, with major indices having broadly divested themselves of these investments—now labeled uninvestable and reclassified from emerging markets baskets to “standalone.”^[2] The impact on the Russian economy and companies with ties to Russia has been devastating.

Russian Ruble– U.S. Dollar (RUB–USD)

Source: Bloomberg. Data as of March 13, 2022.

The impetus for diversification of energy sources

ESG investors have long believed dependence on fossil fuels is an underappreciated risk in the marketplace. The crisis in the Ukraine strengthens our view and we believe it will accelerate the timeline for decarbonization. The global energy mix is still largely dominated by fossil fuels, with Russia the third-largest international oil producer (after the U.S. and Saudi Arabia).^[3] Despite being a historical leader in the energy transition, the European Union (EU) relies heavily on natural gas, which it has included in its EU Taxonomy as a ‘transitional’ source of energy. In 2021, Russia provided 45% of the EU’s total gas imports.^[4] Though Western governments enacted broad sanctions against Russia in condemnation of the invasion, they initially excluded oil and gas to minimize the impact on energy prices and forestall potential rationing in Europe. Prior to the U.S. announcing a ban on Russian energy imports however, refiners, banks, and insurers have self-sanctioned, deciding to halt purchases and financing of Russian oil, driven by widespread uncertainty surrounding the conflict and the impacts associated for all stakeholders.^[5]

EU Imports of Natural Gas (2020)

Source: Eurostat. Data as of December 31, 2020. 

The continued dependence on fossil fuels has left countries and companies exposed to geopolitical risk, underscoring the need for a resilient infrastructure that can withstand shocks and volatility as we are seeing in the Ukraine today. This will likely cause an increase in spending to improve grid resiliency and diversify energy sources with an acceleration in green energy investment as these options become more price competitive. We are already seeing signs of this, with the European Commission’s release of its REPowerEU plan to make the EU independent from Russian fossil fuels “well before 2030,”^[6] presenting an opportunity for European utility companies with existing renewable energy exposure.

As the conflict evolves, we are growing more cautious of companies that are both overexposed to fossil fuels and lack alternative sources of energy. Overreliance on hydrocarbons will likely lead to years of costly investment as they seek to diversify their energy sources and upgrade their infrastructure in line with energy efficiency standards. Alongside any companies with significant operations in Eastern Europe, the key sectors and industries that will be impacted are automobiles, energy, utilities, and transports—all heavy users of hydrocarbons. On the contrary, we believe companies that have already begun investing in research and development for renewable, cleaner energy sources (such as wind and solar), are poised to make more green as these sources become more cost-competitive with fossil fuels.  As ESG investors, we incorporate into our analysis a number of factors that would be indicative of a company’s ability to manage risks associated with energy, including:

• Greenhouse gas emissions intensity per sales
• Carbon per unit of production
• For oil and gas companies—embedded carbon in total reserves, production mix; and energy intensity per MBOE (thousands of barrels of oil equivalent) produced

Evolving outlook on defense

The changing outlook on the defense sector in the context of the invasion is a key example of how ESG investing may differ from exclusionary approaches (often called socially responsible investing, or SRI). Our principal goal as ESG investors is to improve risk-adjusted returns by ESG risks and opportunities into our analysis. Prior to the invasion, we viewed the aerospace and defense industry to be exposed to a significant amount of risk. The industry is heavily regulated and has historically faced a high degree of scrutiny due to products sold in complex areas, which can result in reputational and potential legal peril. As active managers, we adapt and adjust to the world as it changes and take new information under consideration when making investment decisions.

Contrary to our initial view, we are increasingly seeing opportunities within the defense sector as a result of this conflict. The Russian actions have been vehemently denounced, with 141 out of 193 United Nation (UN) member-states voting in favor of a resolution demanding Russia’s immediate withdrawal from Ukraine^[7] and the Ukrainian ambassador having accused Russia of genocide—a clear violation of the UN’s goals of peace and justice. In this context, ESG investors have begun to accept the investment opportunity set for the defense sector that can now provide value by enabling populations to defend themselves, protect their lands, and fight for their freedoms.

Core narrative

We are often asked is it possible to do well (financially) while doing good (socially). The crisis in Ukraine is an example of how moral and ethical issues can have a clear financial impact and how tail risks can wreak havoc on portfolios. We believe integrating ESG issues into the investment process can help improve long-term risk adjusted returns to client portfolios by focusing on resilient businesses that are built to be sustained. The Ukrainian crisis highlights some important elements of ESG investing. Whom you do business with matters and long-term stakeholder management is always more important that short-term investment profitability.

[1] Russia’s ruble worth less than 1 cent after West tightens sanctions – CBS News

[2] MSCI Removes ‘Uninvestable’ Russia From Emerging-Market Indexes – Bloomberg

[3] Oil Market and Russian Supply – Russian supplies to global energy markets – Analysis – IEA

[4] Questions and Answers on REPowerEU (europa.eu)

[5] Russia Scrambles to Maintain Oil Sales, Lifeblood of Economy – WSJ

[6] Joint European action for more affordable, secure energy (europa.eu), March 8, 2022.

[7] General Assembly Overwhelmingly Adopts Resolution Demanding Russian Federation Immediately End Illegal Use of Force in Ukraine, Withdraw All Troops | Meetings Coverage and Press Releases (un.org), March 2, 2022.

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