Impacts of the Ukraine conflict shows that exclusion rules can change quickly

As investors and companies exit the Russian market in droves, new criteria, such as the defence of democracy and non-dependence on authoritarian regimes, are giving new lustre to previously banned sectors.

Pace of divestment of Russia

These are unprecedented times in almost every respect, but not since the protest divestments of South African assets due to apartheid have, we seen such a scale of divestment of a particular market from investors and corporates. As a result of the Ukrainian war waged by Russia, not only are investors ensuring they minimise (wherever possible) their exposure to Russia, but scores of corporations are halting, divesting or writing off Russian businesses.

At the company level, it could be argued that this is a manifestation of stakeholder capitalism – it is being deemed irresponsible and socially unacceptable to continue to make profits in a country that is causing such damage and distress. A company cannot simply operate to maximise profit every day without consideration of the impact of the business, whether on the environment, society or on global politics. Every day more companies recognise this, from Michelin this week suspending their operations and halting all exports to Russia to BP, Uniqlo, McDonalds, and the big four accounting firms among many others.

The question being asked is whether sustainable investors should ever have had investments in Russia, considering the risks with governance, corruption and respect of international norms. Before the conflict started, investments in Russia were not abnormal for sustainable funds. Morningstar estimate that 14% of sustainable funds globally held Russian assets right before the war, a statistic that frustrates some investors and commentators in the market. Even more surprising was that ESG ETFs and funds held positions in Russian state-backed energy companies Gazprom PJSC and Rosneft PJSC, both widely recognised as corrupt, untransparent and highly pollutive.

At the same time, the defence and oil & gas industries are considered vital in the fight against Putin and the expansion of Russian power, industries that had been shunned by many sustainable investors. So, should exclusions still be applied, and can they be changed this quickly?

Exclusions – why are these applied?

Exclusions are still the most-often applied strategy for an ESG fund, although increasingly ESG integration is considered more valuable than excluding sectors or markets. Historically, exclusions were used most by religious endowments who wanted to be sure they were not profiting from ‘sin stocks’ and behaviours that their religion prohibited – alcohol, tobacco, pornography, gambling, weapons – but more recently it has been viewed as a tool to encourage change. The idea being that if more and more investors rally behind an exclusion, companies will come under pressure to change and be starved of capital.

While starving companies of capital may be an appealing strategy, realistically few of the companies in these industries rely on equity capital to fund their growth. Instead, it is organically funded thanks to strong cash flow generation, with surplus capital often returned to investors. Additionally, there continue to be many investors globally who are still willing to invest in these controversial companies; investors with fewer ethical restrictions or investors in the private capital markets who enjoy less public attention. Therefore, not only are these companies not starved of capital, but their exclusion by responsible investments could allow them to enjoy a shift of ownership to less demanding investors.

Non-Russian fossil fuels are now considered vital for energy independence

Nonetheless, as values increasingly are applied to investment philosophies, exclusions continue to be applied to a large proportion of sustainable investment. The start of war in the Ukraine has, however, triggered many questions about what exclusions should be made. Fossil fuel exclusions have seen increased application as investors grow more concerned about climate change. However fossil fuels from non-Russian sources are now fundamentally important for there to be any chance of shifting European reliance from Russia for oil and gas. President Biden is now asking the US shale gas producers to maximise their output – should these companies be excluded on environmental grounds, when they have the potential to provide a valuable social impact? The nuclear industry was already facing such a conundrum, but in reversal – nuclear can provide low carbon energy, but with perceived high social risk.

There is now a similar discussion on the defence industry, the most-often excluded sector, with an estimated 50% of exclusions affecting armament companies according to Eurosif. What was once viewed by some as a highly controversial industry profiteering from global conflicts and at risk of corruption, could now be considered a vital industry in opposition to Russia’s army.

On a country level, aside from invading another country, there are other ESG motivations to exclude whole markets. Tax havens are excluded by some investors, as are those run by authoritarian regimes. Both could be motivated by either ethics or ESG risk concerns. It is debatable whether these risks should result in blanket exclusions or should instead be reflected in country risk premiums. Risk management should be balanced if an investor is looking for impact, as it is in these markets that positive impact is most needed.

Exclusions have a place in the sustainable investment frameworks, but it should be accepted that their application will differ between investors, both on ethical grounds – what impacts and exposures are considered most important – and on ESG risk management grounds – dependent on the analysis of various factors. ESG risk management evaluations will change over time, and as we are seeing now so too can ethical motivations. As always, great care should be taken to explain the motivations for different actions, to ensure there isn’t confusion about the reasoning behind an exclusion and the expected impact that exclusion will have on contributing to a sustainable future.

But we do not believe that these potential position reversals demonstrate a weakness for sustainability, instead it is a key element of progress. As the world changes, different priorities emerge. As George Bernard Shaw once wrote, ‘Progress is impossible without change, and those who cannot change their minds cannot change anything.’