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Conflict Exposes Governance Risks and Due Diligence Flaws

Ratings, rights and renewables in focus as asset owners digest short- and long-term implications of the Ukrainian crisis.  

Russia’s invasion of Ukraine is leading to a rapid reappraisal of ESG risks by asset owners, including enhanced scrutiny of human rights and governance risks across portfolios, and a reaffirmed commitment to net zero targets.   

Investors and corporates are facing practical, legal and liquidity challenges as they seek to pull out of Russia at speed, driven by sanction compliance, human rights concerns and reputation risk.  

Large institutional investors such as Norges Bank Investment Management, Storebrand, Nest and the Church of England Pensions Board have announced exits from Russian investments, while many Western corporates have shuttered operations, McDonalds and Coca-Cola among the latest.   

Many sustainability-focused asset owners already had limited exposure to Russia, due to internal assessments of human rights and political governance risks, often informed by the UN Guiding Principles on Business and Human Rights (UNGPs).  

Ratings under review  

External ESG ratings may have also influenced exclusion of Russian investments from asset owners’ portfolios, but several have turned from ‘amber’ to ‘red’ since the start of the invasion on 28 February.  

Ratings providers including MSCI, Fitch and Scope have reduced credit and ESG ratings for Russia in recent days, noting sanctions and other factors accelerating the country’s financial isolation, leading to increased financial governance risks. Scope downgraded Russia’s credit rating to CCC on 4 March, reflecting increasingly likelihood of default.   

“ESG risks account for 20% of our sovereign risk assessment,” said Dierk Brandenburg, Head of Credit and ESG Research at Scope Ratings. “In the case of Russia, we downgraded our institutional and political risk assessment, including a multi-notch downward adjustment to capture the credit impacts of major capital controls imposed by the Russian authorities and the elevated geopolitical and sanction-related risks.” 

ESG ratings platform, which ranks companies’ performance against UN Sustainable Development Goals (SDGs) globally, downgraded the overall ratings of stocks listed on the Moscow Stock Exchange to zero, on grounds that investing in the securities cannot be considered to be in line with UN SDGs. This is an override of’s algorithms, which normally use AI to calculate sustainability ratings without human intervention.   

Romanian-born Founder Emanuela Vartolomei said she felt a “personal responsibility to take practical action” in response to the invasion. She said it was too early to be confident about investment scenarios for the region, but saw potential for “significant improvements” in the European political climate for renewable energy investment, particularly if more countries followed Germany’s increased commitment.   

But some questioned whether governance ratings should have already been clearer about the political risks under the leadership of Russian President Vladimir Putin. “In some respects, it’s strange to see governance ratings fall now, because we’ve known what Russia is capable of since at least 2014. One might expect governance ratings to change over time rather than overnight,” said a sustainable investment analyst at a large UK-based asset owner.   

Looking at the broader perspective, the analyst expected institutional investors to re-examine existing assumptions about investments in other jurisdictions with authoritarian regimes. “There are many open questions and it’s currently hard to reach a robust investment conclusion. If you were to apply lessons from [Russia’s invasion] across your portfolio, China would be the first one, but we’re not at that stage yet,” the analyst said.   

Rights in focus  

As well as complying with sanctions, corporates and investors should apply ‘enhanced due diligence’ to activities in Russia and Ukraine as a ‘conflicted affected and high-risk area’ (CAHRA), to maintain alignment with UNGPs, according to the Investor Alliance for Human Rights (IAHR).   

This means identifying all business and investment ties to the Russian state, including affiliated companies and other entities that are arming, financing or resourcing Russian violations of human rights laws. Firms and their shareholders should “consider the responsible termination” of such relationships if due diligence efforts suggest they cannot avoid causing or contributing to human rights harms, the IAHR said.   

“Due to the complexity of doing business in CAHRAs, there is no easy answer and companies need to start doing the hard work by mapping their business activities, relationships, and investments across their value chain,” said Anita Dorett, Director of the IAHR. “Any decision made to disengage or divest must be done in a responsible fashion, including scrutinising for any unintended human rights consequences.”  

Tim Clare, Director in Transactions and ESG Advisory at sustainability consultancy firm Anthesis Group, said investors needed to understand investee firms’ ties to Russia throughout their supply chains.   

“The biggest reverberations are going to be felt along corporate supply chains, as they look to untangle themselves from Russian suppliers,” he said. “How are companies replacing those business ties?”   

Recommendations for states and businesses were included in a report on implementing UNGPs in conflict and post-conflict contexts, presented to the UN General Assembly in October 2020, by the UN Working Group on Business and Human Rights. The working group has also prioritised efforts to incentivise responsible business and investor practice in CAHRAs in its UNGPs 10+ project 

The Heartland Initiative, a US-based non-profit, recently published a ‘Rights Respecting Investment in CAHRA’ methodology to help investors protect the rights of vulnerable populations while addressing material risks faced by companies.   

Regular due diligence  

IAHR’s Dorett said the current rush to reassess and withdraw from Russian investments is a reminder of the need for detailed and regular due diligence by corporates and investors of their exposures to high-risk environments.  

“What is happening now in Ukraine should be of no surprise based on what happened in 2014 with the annexation of Crimea. All the warning signs were there, and many companies and investors do not appear to have taken them adequately into consideration in their business decision making,” she said.  

Recent legislative initiatives have sought to increase the robustness of corporate due diligence processes as well as investor oversight, including a proposed European directive aimed at ensuring firms identify and mitigate risks to human rights and the environment arising from their supply chains.   

Julia Otten, Policy Officer at law firm Frank Bold, said strong due diligence laws can play a key part in ensuring firms scrutinise human rights risks across different jurisdictions. “Robust due diligence can make firms more aware of the political risks in their operations in high-risk countries, for example in terms of joint ventures, partnerships with state-owned enterprises and diversification of sources. In the present situation, such due diligence could have minimised their exposure to human rights risks and the costs of business disruption,” she said.   

The European Commission’s draft proposal has been cautiously welcomed, with some groups suggesting that its requirements are insufficient to embed due diligence firmly into governance structures and strategic planning.  

“The better that due diligence processes are connected to strategic decision-making, the easier it is for firms to respond to and address them,” said Otten. “To have an impact, due diligence obligations should be tied to directors’ incentives as well as strongly enforced in terms of sanctions and liability.”  

Renewables transition  

Asset owners have also responded to Russia’s invasion of Ukraine by emphasising the need for Europe in particular to reduce its reliance on Russian gas and to move more quickly to diversify its overall energy mix, underlining the importance of renewable sources.  

“The dependency on Russian oil and gas is clearly a big political risk. We must accelerate the transition and invest in renewables,” said Mark Fawcett, CIO of Nest, at the Pensions and Lifetime Savings Association’s (PLSA) digital ESG Conference 2022   

Yesterday, the European Commission outlined proposals to completely phase out use of Russian gas by 2030, reducing usage by two third before the end of the year. The plan includes interim measures to diversify and store gas suppliers, initiatives to mitigate the impact of rising energy prices on consumers and to reduce barriers to investment in a range of renewable energy technologies, including solar and green hydrogen.   

The EC proposals coincide with the release of the latest Global Energy Review from the International Energy Agency, which reported that CO2 emissions increased by 6% in 2021 to their highest ever level.    

Adam Matthews, Chief Responsible Investment Officer for the Church of England Pensions Board, acknowledged that the Ukraine crisis would initially add to uncertainties over the transition to renewables and the pursuit of net zero targets.   

“The reality is that there is going to be short-term instability as countries adjust to urgent energy needs, which may involve temporarily moving back into other fossil fuel assets as a means of energy replacement. But, long-term, this is ultimately going to speed up the transition,” said Matthews, also speaking at the PLSA event.  

Fellow panellist Maria Nazarova-Doyle, Head of Pensions Investments and Responsible Investments at Scottish Widows, said that institutional investors should be prepared to argue the case for a faster push for investment in renewables as the urgency of the present energy crisis increased calls for short-term alternatives that posed increased environmental risks.  

“The answer to the UK’s energy independence is to transition into renewables. But it seems a number of people are pushing for fracking, which is completely nonsensical and counterintuitive. I’m concerned it’s a line that might stick, however. It’s the responsibility of asset owners and other investors to change these attitudes and to push forward with the renewable energy agenda,” she said.   

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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