Today’s Key Takeaways: What counted as the right thing to do before Russia invaded has suddenly switched. “Since the war, carbon emissions are suddenly much less of a concern, while energy-price-induced poverty is more of a worry.”
War in Ukraine Reveals Flaws in Sustainable Investing
James Mackintosh, The Wall Street Journal, March 27, 2022
The public mood keeps changing, and what counted as the right thing to do before Russia invaded has suddenly switched
Russia’s invasion of Ukraine has upended geopolitics and, for many in the West, provoked moral righteousness. For investors who prided themselves on trying to do the right thing with their money, it has revealed fundamental flaws in the booming business of environmental, social and governance investing, known by the acronym ESG.
Here’s the problem: ESG is trying to gauge the sensitivity of companies to the public mood, either for moral reasons or because the public matter as customers, suppliers, and employees of the companies. But the public mood keeps changing, and what counted as the right thing to do before Russia invaded has suddenly switched.
Before the invasion, the focus of most in ESG was on carbon emissions, with many also excluding defense stocks, especially makers of “controversial” weapons such as nuclear and cluster bombs and land mines.
Since the invasion, Western governments have put their efforts to cut carbon on hold and become major suppliers of weapons to Ukraine, cheered on by their voters. Nuclear deterrence is a topic of conversation again in the face of Russian threats, and it’s not obvious that ESG investors really want to ditch nukes. Yet, what’s the point of refusing to invest in nuclear-weapons suppliers unless you want them to shut down? It’s like eating meat but refusing to finance an abattoir on moral grounds.
This about-face has left ESG investors in a bind. At least one fund manager who had excluded weapons manufacturers on moral grounds has added them back in, and plenty of others are considering whether to change.
“There are a number of discussions with investors who, in light of events with Russia in the Ukraine, are considering how they approach investment towards defense companies,” said Baer Pettit, president and chief operating officer of MSCI, which sells ESG ratings and indexes.
ESG ratings didn’t pick up the risks around Russia. European companies with big operations in Russia before it invaded Ukraine had significantly higher overall ESG scores and human-rights scores than those that stayed away, according to analysis by academics Elizabeth Demers, Jurian Hendrikse, Philip Joos and Baruch Lev.
The ESG score gave no guide to the company response, either. In the first 12 days of the war—before sanctions forced action—lower-rated companies on Refinitiv’s combined ESG score did more to suspend or divest their Russian operations than those with higher ratings.
This isn’t just a temporary problem for ESG caused by Russia. The defects the war exposed run through both the main approaches to investing on supposedly “sustainable” grounds.
Whose morals? The first approach to ESG is to try to do good with your money, and almost every ESG fund tries to imply it does this, at a minimum excluding producers of controversial weapons and the most-polluting forms of coal. Marketing materials are filled with pictures of sunflowers and green fields.
But what counts as acceptable behavior changes rapidly. Russia’s invasion of Ukraine has shown ESG investors what should have been obvious, that a country can’t defend itself without weapons, and that means funding weapon manufacturers. Even nuclear weapons—banned by almost every ESG fund—suddenly seem a lot more attractive as a deterrent against Russia.
Soaring oil and natural-gas prices as a result of Russia’s invasion and sanctions have prompted about-turns from Western governments, too. Just five months after hosting the Glasgow climate summit at which world leaders agreed to phase out fossil-fuel subsidies, the U.K. is cutting taxes on road fuel and trying to shield households from energy costs, while encouraging Gulf states to drill more oil. The U.S. is calling on frackers to pump more, and some European countries want price controls.
Decisions about how much to give up now to prevent global warming in future should be made by society as a whole through governments, not by a bunch of well-meaning rich people. The same goes for whether companies should sell alcohol, cigarettes, or lottery tickets, or supply elected governments with unpleasant weapons.
Which risks? While investors in ESG funds mostly think they are trying to do the right thing, many funds use ESG scores purely to spot risks to the share price. Under this approach, followed by both MSCI and Morningstar’s Sustainalytics, if a company can do bad things without any effect on its stock, it should not lower the ESG score.
“We’re focused on the material environmental and social issues that we think might have a financial impact on the company,” Michael Jantzi, founder of Sustainalytics, said recently. Sustainalytics plans separate “impact” ratings later this year to assess companies on their effect on the environment and social issues, even where they pose no threat to investors.
The approach makes intuitive sense. Investors should try to anticipate policy shifts by governments, since new taxes, regulations and sanctions have huge business impact. They need to pay attention to changing consumer priorities; customers worried about carbon emissions might change eating habits, travel, and shopping behavior. And boycotts of companies that say or do the wrong thing are becoming more common.
But there are two fundamental problems with using ESG scores to spot risks. First, it’s hard to tell in advance which issues will matter to the stock price, and ESG scores move slowly.
Public mood keeps changing, and what counted as the right thing to do before Russia invaded has suddenly switched.
Since the war, carbon emissions are suddenly much less of a concern, while energy-price-induced poverty is more of a worry. Equally, investing in or trading with Russia is widely regarded as a moral outrage, even where it remains legal. Oil major Shell even apologized for buying a cheap shipment of Russian crude, something explicitly excluded from sanctions at the time.
Second, even if the scores perfectly captured nonfinancial risks, it makes no sense simply to buy stocks with higher ESG scores, as ESG index funds do. Risk alone is no basis for investment because it has to be compared with the stock price.
Sure, riskier stocks should have a lower price, and less-risky stocks a higher price. But if the price already reflects all the risks, and more, a dirty and immoral company should be a solid buy on this approach.
At least one ESG fund manager who had excluded weapons manufacturers on moral grounds has added them back in. The site where a shopping mall had been in Kyiv, Ukraine.