One of the many consequences of Russia’s invasion of Ukraine has been the questions it poses ESG investors. The environment, social issues and corporate and global governance have been all impacted in a multitude of ways. In many ways it is the first challenge to the accepted practice of ESG investing.
Wren Sterling’s own ESG investing panel consists of Royal London, King & Shaxson, Legal & General Investment Management (LGIM), Liontrust and Tatton Investment Management. We asked them for their perspective on this difficult issue, where they stand on the key points, and also where they see opportunities in a changing world.
Money Matters: How can managers assure their clients that their ESG investments (ethical, social, governmental focus) are not directly or indirectly benefiting Russia and other unfriendly states?
Royal London: The easiest way for fund managers to do this is to look at the geographic exposure of the companies where they are invested, and the end-customers who are being served in those jurisdictions. For the companies in which we invest, we’d be deeply concerned by any evidence of actions harming individuals or oppressing human rights. However, if the customers are the ordinary people who live under these regimes, and the products which are sold offer those people a safer, cleaner, healthier and more sustainable life, in our view these operations can have a positive outcome for those citizens, and it may be appropriate for a company to continue operating in Russia.
Liontrust: If we look at our portfolios and exposure to Russia and Ukraine, in terms of direct impact, we have nothing whatsoever. We also have negligible indirect impact from either economy (this is not zero, however, as some companies will have very small revenue exposures to Russia).
Tatton: It is difficult to provide a comprehensive analysis of each company’s exposure and links to the Russian government, we currently have c.6,000 lines within our portfolios and rely on the underlying investment managers to assess the risks and exposures to Russia, though some may not be as obvious as they seem.
We have been assessing the risks associated with the invasion of Ukraine in the same way we assess other geopolitical events, we have stayed in close contact with relevant managers, as well as discussing the situation regularly at our weekly meetings.
King & Shaxson: We have never had any direct equity exposure to Russia and indirectly very little oil, gas and mining, which is the main focus within Russia.
We take a holistic view of geographical asset allocation, considering the economic exposure of any investment rather than just its place of listing. Therefore, rather than seek investments for the sake of global exposure we will only seek investments where they make a genuine positive impact either domestically or globally, and not at the expense of important social and environmental factors.
Money Matters: Is there a way to ethically invest in industries such as defence, which will be in demand now?
Tatton: Traditionally, many ESG approaches seek to avoid defence industries given their negative impacts on life and infrastructure when used. However, Micael Johansson, the head of Sweden’s SAAB Group – which initially developed the now largely UK-built NLAW anti-tank missile used to repel Russian tanks – argues that investors may not fully understand the role of defence companies and in his words, they seek to keep “people and societies safe”. We haven’t changed our stance on this sector, as it is hard to avoid the reality that defence companies still result in the loss of people’s lives.
Royal London: In our view, no. While we can understand the need to provide weapons to a country defending itself from foreign aggression, it’s impossible to assess how those weapons might end up being used over the long-term. There is also the potential for weapons made by Western companies to end up in the hands of governments, groups and individuals with values that run contrary to the human rights and fundamental freedoms which we tend to enjoy in the Western world.
King & Shaxson: In bespoke portfolios, through our values-based questionnaire, we ask probing questions under the human rights section to understand how clients feel about non-harmful defence devices. Weapons will always be excluded, whether in good or bad hands, because it’s impossible to control.
We have not seen any change in perception among our clients, but we are aware some people are posing the question. We feel this could be a little bit contrived and emotional, understandably. We do benefit – we all want the army services in a flood or emergency, and there are spin off benefits from the technology, but we are careful.
Liontrust: While we recognise and accept the need for armaments for defence and peacekeeping, their ability to be used for aggression and oppression renders them socially unacceptable. We exclude companies that are major producers of full weapons systems or critical components of these, as well as any with confirmed involvement in ‘controversial’ weapons, defined as anti-personnel mines, cluster munitions, biological or nuclear.
“As long-term investors, we see any short-term weakness as an opportunity to add, and we remain committed to the belief that investing sustainably will produce better long-term returns as well as a better world.”
Money Matters: How has your ESG fund performance tracked over the last 12 months? Is it in line with your expectations?
King & Shaxson: From an investment perspective the sectors that served us so well in 2018/2019 and 2020 have underperformed in 2021 as reflation trades favoured sectors outside of our mandate (Large Banks, Oil and Gas, Mining etc). This was not unexpected, and we added more defensive UK funds and reduced global equity exposure to the portfolios last year in anticipation of this, two out of the three performed as expected and one has disappointed us.
On a 12-month basis, the fund-based model portfolios over year have done well against peer group and very well within the direct equity models.
Tatton: Our ethical models have performed solidly, despite recent volatility and the pressure faced by growth sectors from rising bond yields and expectations of higher interest rates that can also impact longer maturity bonds. In the twelve months to the end of March 2022, we believe our risk-rated ethical portfolios performed well, returning -0.2% at the lowest risk end and 8.5% at the highest risk level.
Our Balanced [60/40] portfolio returned 3.9% net of our DFM fee and fund charges. We understand there may be times when these portfolios come under pressure relative to our standard models, such as those environments where defence and energy stocks perform well, as we saw over the first quarter of the year.
Royal London: Over the last 12 months, performance has been somewhat better than we would have expected, given commodity prices. Typically, we underperform at times of rising commodity prices as we do not invest in the oil & gas and mining sectors due to environmental concerns. Performance lost in the last 12 months from these areas has been more than offset by good stock selection in other areas.
LGIM: In terms of the recent performance, the funds performed in line with expectations and their respective risk profiles, and we will continue to manage our funds so that they can withstand a number of different scenarios in the future rather than just bet on a single outcome, asset class or region, following our mantra of ‘prepare, rather than predict’.
Liontrust: The last 12 months has been challenging for our quality growth investment style, with longer-duration companies hit harder by fears of inflation and interest rate hikes intended to control it. The primary reason for weaker performance from our funds has been a marked change in market leadership, with value sectors recovering strongly. Investor confidence in the near-term outlook for these sectors has been supported by increases in interest rates, commodity price rises and inflation as economies emerge from pandemic-supressed economic conditions.
We believe our ability to focus on the long term is one of the few remaining competitive advantages in markets (referred to as time arbitrage). We also feel that during periods of stress, time horizons typically shorten. It is therefore crucial for us to retain this focus on the long term – we are acutely aware this would be an almost impossible task without our clients continuing to support us in doing so.
Money Matters: The conflict has thrown fresh emphasis onto renewables and phasing out reliance on energy from Russia. How much do you expect this to strengthen the case for renewables, especially when the cost to transition will need to be met through taxation at a point where the cost of living is in the spotlight?
LGIM: Fossil fuels such as oil and gas will still constitute a significant share of the global energy mix for years to come, however it is important we engage with companies to help them on the journey to low-carbon economy, and make Net Zero a reality while considering a Just Transition. Going forward we expect economies around the world to further diversify their energy sources, with a rising share of renewables. However, given the long-term horizon and uncertainties involved, we again prefer to consider a range of possible outcomes with different micro and macro implications when we analyse the potential impact on our multi-asset portfolios.
Tatton: The German Finance Minister, Christian Lindner, recently referred to renewable electricity sources as “the energy of freedom”, when detailing their plans to accelerate low carbon and renewable energy production to 100% by 2035 [from 2040 previously].
UK Prime Minister Boris Johnson outlined the new energy strategy seeking to ensure that by 2030, 95% of British electricity could be low-carbon; and by 2035, a decarbonisation of the UK electricity system.
It could therefore be argued the case for renewables hasn’t just been strengthened, but that the debate is now largely settled, with the only questions being how quickly this can be done, what technologies will be involved and what it will end up costing. The UK now places greater emphasis on offshore wind – where the country has vast resources as an island nation, small modular nuclear reactors [similar to those you might find in a Vanguard-class Royal Navy submarine], and hydrogen [which when utilised simply produce heat and water vapour as emissions].
US Secretary of State, Janet Yellen, estimated that the global cost of meeting climate change obligations could be as high as $150 trillion. Government borrowing and perhaps direct taxation while important, are not the only sources of money to fund this transition. Governments around the world could provide certainty to investors, from pension funds, private equity and others through strong regulatory frameworks to encourage private investment into projects.
Royal London: We’d expect higher fossil fuel prices to reinforce the case for zero carbon energy production over time, both from an environmental standpoint and to improve security of supply. The UK has already made strong progress here, with nearly 40% of its electricity currently coming from renewable sources and a further ~15% from zero-carbon nuclear power on an annual basis.
Countries around the world will need to invest in new renewable generation capacity, but also in the underlying infrastructure that can use this electricity to power more of the global economy in the future. Different sectors also face different fuel challenges and some will require fresh policy approaches, particularly in areas like gas central heating in homes which made up over 20% of the UK’s total energy consumption in 2020: UK Energy in Brief 2021 (publishing.service.gov.uk)
King & Shaxson: As energy remains essential and the full social and environmental costs of fossil fuels have become more apparent, the renewable energy sector has regained much of the impetus that was lost when markets focused on reflation.
European policy was directed by vested interests to use Russian gas and this has backfired badly. The UK made itself hostage to the situation by removing gas storage in 2019. It helps that we are heading into summer and will use less gas.
The legacy of gas will take years to manage and the whole world is looking at the matter at the same time. To raise more local renewable production has longer term economic benefits beyond environmental but on balance of payments, less reliance on unreliable partners and local employment, but shorter-term costs. Renewable energy in the UK has been cheaper than nuclear for years, and the need for tax for renewable is less pressing than planning and development.
Whilst critics have highlighted the shortfalls in renewables during the recent energy crisis, it has only cemented our view that front loading investments in clean technology including battery storage, is vital for our transition.
Liontrust: We believe that higher energy and commodity prices should increase the willingness of governments and businesses to invest in renewable energy and focus more on improving their efficiency of energy use. With another disturbing report from the Intergovernmental Panel on Climate Change (IPCC) published recently, warning of the ‘irreversible’ impacts of global warming, the need to cut fossil fuel use is clear; the current situation in Europe reinforces the case for both the greater supply security renewables can offer and reducing reliance on many of the major oil-producing countries.
“We’d expect higher fossil fuel prices to reinforce the case for zero carbon energy production over time…”
Money Matters: Nobody wants to be seen to be profiting from misery but there’s also no denying the world has changed significantly in recent months. How do you see opportunity for ESG funds in a changing world?
Tatton: Vladimir Lenin once remarked, “there are decades when nothing happens and there are weeks when decades happen”, and the events since late February may yet prove this statement accurate. In response to the conflict in Ukraine, democratic nations in Europe, the US and across the world rapidly came together at a pace many might have thought impossible by drawing upon old and new alliances to come up with short and long-term solutions. ESG principles, funds and portfolios may stand at the nexus of these solutions, especially in the area of energy security, renewable energy, technology and the access to sources of commodities from friendly nations needed to underpin future economic growth. Investors also see more companies each day outline their commitments to ESG principles than ever before. This not only potentially expands the opportunity set but also provides more data allowing investors to undertake more detailed comparisons between different companies and sectors in terms of their ESG progress.
King & Shaxson: Whilst fossil fuels enjoyed a boom as both a beneficiary of global reflation, and then furthermore from the sanctions placed on Russia, it has also sped up the desire for renewable energy on a global scale.
The wider benefits of independence and localised production of renewable energy are increasingly apparent. In the short-term, this will be inflationary, but going back to the past is no longer an option.
Liontrust: If you examine how change happens, there tend to be three actors at work: first, an understanding is developed of the issue and likely ways to resolve it discovered (air pollution is harmful to health, for example), then society/government lay the groundwork for action – via new regulations, taxes and other incentives – and finally companies take advantage of the opportunity to develop, commercialise and distribute solutions. This moves the dial of the possible and accelerates the process. What is interesting from an investment point of view is that the businesses involved in this triangle tend to experience strong and persistent demand growth and face less competition due the novelty of the product or service they are delivering.
We continue to believe human ingenuity, cooperation and desire to improve our lives leads to solutions and that profit-making companies backed by capital from investment managers have a big part to play. It is reasonable, though, to ask whether this model will work for such enormous challenges as climate change, biodiversity collapse or increasing inequality. On climate change, for example, we have been aware of the issue for over 30 years, and yet the latest IPCC report, issued in February 2022, shows greenhouse gases at record levels and that we are already experiencing some of the predicted extreme weather-related impacts.
With over 80% of global energy still coming from fossil fuels, is this not a challenge too far for the system outlined? We believe not. Change is rarely linear and when a cheaper, better solution is developed, it can displace the old at an exponential rate. Progress has been slow, but we are confident the rapid growth in renewables and adoption of electric vehicles is exactly one of these exponential transitions.
Royal London: While the global outlook has undoubtedly changed, for funds like ours, the need to invest into companies which are helping to make the world a cleaner, healthier, safer and more sustainable place has never been more paramount. Many of the most important sustainability issues, from tackling global biodiversity depletion to developing next-generation and personalised medicine to combat long-term health conditions are just as pertinent today as they have always been.
LGIM: It is increasingly important to integrate ESG into the investment process across investment solutions, including those without an explicit ESG mandate. However, what we are seeing now is that the world of ESG is a complex and a nuanced one, where conventional wisdoms, rules of thumb or overly-simplified narratives may not be very helpful.
We sympathise with clients that might find this new landscape rather confusing and the worries of ‘greenwashing’ could jeopardise the unlocking of the potential that ESG investing might bring. This is why we understand how important it is to be fully transparent when it comes to articulating our ESG approach. We believe it is vital we clearly explain what ESG metrics underpin our in-house LGIM ESG score and how we see ESG in the context of other portfolio risks that we manage as well as investing opportunities that may arise. It is our view that well-governed companies that manage all stakeholders, including the environment, are more likely to deliver sustainable long-term returns.