Commentary

Divesting from Russian Investments

Gordon Tveito-Duncan, Head of ESG Technology at GaiaLens, outlines the challenges for asset owners and managers in assessing their exposures and options.

One of the key questions which asset owners have been asking of their asset managers with greater regularity over the last three months since Russia began its invasion of Ukraine, is: ‘how do we assess our level of exposure to Russian investments and how do we reduce unacceptable exposure with a view to protecting investors’ savings and remaining in line with our declared ESG goals?’.

To divest or not to divest?

Asset owners with very clear stances on preventing conflicts, with their inevitable human suffering, human rights abuses, death, and destruction, have felt compelled to sell out of Russia-linked investments, even if heavy financial losses had to be crystallised to achieve that.

Understanding levels of exposure to Russian investments in aggregate, across all mandates is one thing. Another is establishing the liquidity levels of those investments which enable rapid divestment. However, allocators’ work does not end there. It’s also important for them to investigate the web of companies connected to those investments in their supply chains to see if those firms are in fact more directly linked to the funding or prosecuting of Russia’s invasion of Ukraine. This work demands forensic, real-time data collection, analysis and scoring against specific ESG criteria.

This is particularly challenging work given the current state of ESG integration. GaiaLens’ own market research of 200 of the largest asset owners based in the US and Western Europe commissioned earlier this year found that just a quarter of all asset owners have fully integrated ESG scoring into their existing investment manager selection processes. Furthermore, only 29% have made requests for all their existing asset managers to present their ESG strategies and plans to them at time of asking in January 2022, just a month before the War in Ukraine started.

As asset owners look more widely at possible exposures, some may decide that they need to soften their stance on holding some defence stocks, especially as regards supporting the supply of weaponry which is helping the Ukrainians defend themselves against Russian tanks and missiles. We have seen some defence stocks rallying since late February. We have also seen a hardening of attitudes against emerging markets investments, especially where there is compelling evidence that many organisations in specific countries are either state owned or effectively act as extensions of the state. Let’s explore all this in more detail.

ESG winners and losers

A minority of asset managers which already have robust ESG frameworks in place for investment selection have been the ‘investment winners’ out of the War in Ukraine because they began divesting out of Russia months or even years before the conflict in Ukraine began. Many began the divestment process because of evidence of systematic human rights abuses and corruption led from the very top. Others saw the writing on the wall following Russia’s invasion of Crimea back in 2014. Their ESG frameworks aided them in making these investment decisions.

What the War in Ukraine emphasised was the need for a sophisticated and robust ESG approach which could effectively act as an early warning system for divestment. One other knock-on effect has been the increased scrutiny of, most particularly, emerging market country exposures, controversial weapons manufacturers and fossil fuel firms. Last month’s Bfinance report, entitled ‘What are investors thinking now?’, highlighted the need for increased scrutiny ‘on the role of state-owned companies and companies that otherwise act as extensions to the state’.

Most ratings agencies have withdrawn credit ratings on Russian entities and Russian debt instruments have been downgraded to junk bond status. Some very large asset owners screened out Russia as a whole several years ago, including Canada’s largest pension fund, CPP investments, and Sweden’s Alecta. Sweden-based Private Bank J. Safra Sarasin began divesting out of Russia following its 2014 invasion of Crimea.

However, others have not done so well. For example, Norway’s sovereign wealth fund, operated by Norges Bank Investment Management, is perhaps the largest known asset owner loser as its NOK27.4 billion (£2.3 billion) holding in Russian debt fell in value to just NOK2.5 billion (£210 million) by early March 2022 after it elected to sit on its Russia positions. It has since been ordered by the Norwegian government to offload its stake.

The same may well happen in the US where a number of states are threatening to enact ‘divestment bills’ which will force asset owners to sell their Russia-linked holdings. The California State Teachers’ Retirement System (CalSTRS) still held US$500 million of Russian investments in early March. It has since announced a freeze of new investment in Russia and assessment of its real estate investments there. Some 36 asset owners around the world have made public divestment commitments at an estimated €5.2 billion of Russian investments which asset owners have divested out of already or plan to sell down as a result of the War in Ukraine.

Bfinance’s snap poll of 418 investors (including 139 pension funds, 82 insurers, endowments, family offices, sovereign wealth funds and wealth managers), completed in early April, found over half (52 %) had no direct exposure to Russia. Of the remainder, 5% had fully exited exposure by the end of March 2022, and 17% confirmed the only reason they had not exited was because of illiquidity or lock up issues.

On the retail asset management side, the UK’s Daily Telegraph reported on 5 March that over £1 billion of retail investors’ money was trapped in Russia-focused funds (run by the likes of Liontrust, BlackRock, Schroders, and JP Morgan) which had to be suspended following the closure of the Russian stock exchange at the end of February.

In parallel, Russia received nearly double average fossil fuel revenues generated during the first two months of the Ukraine-Russia War to 24 April. Total energy receipts topped €62 billion, knocking any market divestment ‘losses’ into a cocked hat.

ESG scoring should have sounded warning

The NGO Transparency International’s Corruption Perceptions Index can be used as a guideline to adjust ESG scores of countries which are corrupt. Many energy companies like Gazprom and mining companies like Nornickel already generate substantial negative externalities from an environmental perspective. Social pillar-wise, many tend to have poor human rights records as well. Robust ESG scoring systems should have flagged or blacklisted these sorts of companies years ago.

It’s important for the investor community to build a comprehensive map of business relationships with Russian entities and businesses supplying those Russian entities. By now, asset managers will no doubt have had to provide Russia exposure reports to the asset owners they have mandates with. It’s then up to the asset owners to aggregate all these reports, assess the exposures and direct investment changes in a timely manner. Increasingly, there is specialist support available from service providers offering these kinds of consolidated views, aggregating and objectively scoring against specialist ESG factors like exposure to risk of Modern Slavery abuses.

Now the War in Ukraine looks set to be a protracted conflict, it remains important to stay on top of developments to avoid becoming desensitised to emerging evidence of war crimes and to maintain a well-informed/watching brief as regards the speed and types of divestments that need to be made.

A divestment plan may need to respond to events on the ground as reported by eyewitness news reports from authoritative news sources. This demands that asset owners have systems in place to ingest the latest reliable news information and use this to flag up implications for existing holdings, adjusting holdings’ ESG scores in near real-time. Most asset owners are not yet able to react quickly to crises.

Opportunity for deeper engagement

The War in Ukraine offers a strong incentive for asset owners and managers to accelerate the establishment of their ESG frameworks and scoring systems. It’s also an opportunity for deeper engagement with public companies, especially where they simply are not getting granular enough detail to assess their exposure to Russian activities and markets.

For example, many large public companies still report revenues by economic bloc such as Central and Eastern Europe (CEE) or Europe Middle East and Africa (EMEA), both of which sometimes include Russia.

What is really needed is a country-by-country breakdown. Deeper engagement may well be needed to encourage investee companies to report in this way. It’s more work for CFOs, but it’s critical for investors to assess exposure to the Russian market.

It is also important to consider the supply chains of companies to really understand whether companies are supporting the Russian war machine by providing materials or intellectual property, for example. Several NGOs and other not-for-profit organisations are compiling and tracking the supply chain records of larger organisations, producing extremely impactful research including assessing forced labour risks in global supply chains.

More relevant during wars however is the study of the supply chains in arms and weapons trading. For this purpose, it’s important to be up to date with output from the likes of Campaign Against Arms Trade (CAAT) and The Corner House. Both are focused on exposure of controversial weapons trading, underpinned by the CCW (Convention on Certain Conventional Weapons) which has a full title of the United Nations ‘Convention on Prohibitions or Restrictions on the Use of Certain Conventional Weapons Which May Be Deemed to Be Excessively Injurious or to Have Indiscriminate Effects’.

It covers land mines, booby traps, incendiary devices, blinding laser weapons and clearance of explosive remnants of war. The purpose of the Convention is to ban or restrict the use of specific types of weapons that are considered to cause unnecessary or unjustifiable suffering to combatants or to affect civilians indiscriminately.

ESG integration’s ‘wake-up call’

Despite the anti-ESG rhetoric which has been increasing over the last couple of months, it remains clear that for the majority of asset owners which have not yet completed their ESG integration projects, the Russia’s invasion of Ukraine has been a major wake-up call. It has highlighted the need for sophisticated and robust ESG scoring systems which act as an early warning system of exposure to the very real destruction of value, together with loss of life and excessive toll of human suffering – inevitable by-products of this grinding war of attrition.

Can their existing ESG systems judiciously pick their way through this moral as well as financial minefield and make sure no portfolios contain holdings which will be judged to be on the wrong side of history when the war is over? Some will never recover their value.

The war also highlights the need for an objective, AI-driven approach to ESG scoring which scans and analyses output from the media, research agencies, NGOs, and not-for-profit agencies, flagging up new risks which fall outside agreed ESG policies and strategies in real time. The need to gather, analyse and score as much information as possible, as quickly and objectively as possible, is critical in crises such as the Covid-19 pandemic and the War in Ukraine.

During these periods of crisis, there tends to be a great deal of noise, including propaganda and rumour. These must be sifted, their veracity established, and implications assessed – all in double-quick time. The speed as well as accuracy of this work is critical, especially because in crises markets behave more irrationally. There are more sellers than buyers and those still invested tend to overreact to events and see threats where none exist. Deciphering fact from fiction is part of what ESG frameworks and scoring systems must now be offering.

Finally, the War in Ukraine illustrates the need for the investment community and governmental organisations to co-operate more closely – as we are now discovering that whatever the investment community are doing to cut funding and materials needed to help Russia prosecute this war, many European countries are still far too dependent on Russian-owned energy reserves, which they must now wean themselves off.

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