Environmental, Social and Governance & the War in Ukraine

27 May, 02:57 PM

I have been asked numerous times how far increased focus on Environmental, Social and Governance(ESG) considerations input into my out-of-consensus call that Russia would invade Ukraine back in late 2021, and then the eventual invasion in February 2022.

ESG is certainly increasingly important to what we do as asset managers, and at Bluebay it is an integral part of our investment process. All securities we hold are ESG rated and we have an ESG input into all investment decisions. It counts/weighs on all decisions we make as asset managers.

We are in a world where ESG is certainly vogue, and it is probably the biggest change to come to our industry in the last twenty years - well it is in terms of client interest and industry-wide investment/headcount addition in ESG activities.

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A lot of bold claims are made about ESG and, in particular, ESG's ability to impact investment performance, and actually be a force for positive change through investor engagement with issuers.

I think though it is important to be realistic here, if only so as not to set too ambitious goals or targets for ESG, and hence not to be ultimately disappointed. The risk then would be a backlash against ESG.

 As a starting point, I would underline that ESG, and particularly the S and G components, were always integral parts of the investment process and decision set prior to the formal incorporation of ESG into asset managers' processes.

Understanding social challenges/pressures and evaluating the effectiveness of "governance" were always critical to a sovereign analyst's opinion-shaping process. I would accept that E was the poor relation, and the upsurge in the importance of the ESG acronym has led to a long-overdue and much needed greater focus on climate change and E in investment processes. 

 Actually, arguably, now if anything the "S" and "G" components are the poor relations in ESG input into investment processes - both difficult to figure out, and often very subjective. Which country for example has a worse human rights record, and how to measure that?

And how should asset managers risk weight countries with poor human rights records, when actually very often our own governments seem to have no problems in working/financing these same countries, seemingly putting political stability ahead of human rights considerations?

It is all very hard stuff - analysts are now expected to know all angles of a particular country - politics, fiscal, monetary, the balance of payments, and also in-depth knowledge of the social, governance, and E settings of a country, and to try and evaluate all these relative to others, their peers, but also the direction of travel. They are expected to have a much better moral compass than do our own governments at times.

On the specific call on whether Russia would invade Ukraine, I have to say that new ESG considerations did not really drive the call. I would have made the same call a decade ago with the same information set. In the end, I guess this shows that it is about a good overall credit call and ESG considerations were always part of that info set.

I have long argued that a defining war between Ukraine was coming, actually, I warned of the risks of this back in 2015. For me, the Minsk 1 & 2 peace deals were not sustainable, as there was not really a clear winner and loser, and neither side really got what it wanted out of these deals. Post Minsk 2 both sides re-armed and prepared for this war. I just had the view that when two sides begin a rapid re-armament and when underlying core issues are not resolved, future conflict and war are kind of inevitable.

Perhaps you could argue that a long track record of ESG deterioration for Russia weighed on my decision - I would indeed argue that a long track record of Russian misbehavior/aggression, suggested a trend of deterioration in the relationship with the West, and Ukraine in particular - see here the Russo-Georgian war of 2008, Transdniestr, Abkhazia, South Ossetia, Litvinenko, Crimea, Russian intervention in Donbas in 14-15, Skrypal, Navalny, et al.

All this suggested to me that escalation in Russia - NATO relations, and particularly with Ukraine was likely, actually inevitable.

Interestingly, some people have countered that there was evidence of improved governance in Russia since 2014, and they highlight their fiscal and monetary policy. Indeed, the CBR under Nabuillina is often hailed as an example of this - capable technocrats running an uber orthodox and extremely credible policy mix.

But I would even challenge that. Given the weak growth drivers in Russia, and subdued inflation in the run-up to the war, the tight monetary and fiscal policies run by Russia seemed perverse in my view. Why? Russia had low inflation, low debt, a current account surplus, and a small fiscal deficit, with plenty of fiscal and BOP buffers ($650bn in FX reserves), and yet trend growth was just 1-2%.

If this was any other economy one would have argued for policy loosening to pump prime growth. But Nabuillina et al ran what I described back in 2015 as “Fortress Russia” economic policies. Hawkish monetary and fiscal policies were maintained in Russia because Russia was preparing for war, this war. What other explanation is there? This also added to my decision set.

I guess this shows that sovereign credit analysis is not just about the numbers, it is not all about objective data evidence, but there is a largely subjective and holistic element. You cannot just take a snapshot of the macro, it's the all-around story, and ESG is part of that.

So ESG was not THE thing that drove me out of consensus investment call, but it was always part of the info subset, going back a decade, we just did not really call it ESG back then.

But I would argue that the increased importance of ESG helped me sustain negative Russia call for longer than perhaps would otherwise have been the case. I had long held my hawkish views on Russia but I was more able to argue for a cautious investment approach to Russia because of the increased importance of ESG to the investment process.

Sanctions risks and human rights abuses, encouraged others to take my views more seriously, as simply looking at Russia's macro balance sheet would have suggested that being long Russia was a no brainer - indeed, many investors got Russia totally wrong as they put too much weight on the macro balance sheet.

ESG has also I think been a key factor in driving Russian assets’ under-performance since the onset of fighting.

Indeed herein many people argued that even if Russia was going to escalate in Ukraine, the Western sanction impact would be minimal and hence the impact on Russian macro ratios, ability, and willingness to pay would be limited. Their argument was hence it still paid to be king of Russia.

But the reality has been something far different and compared to expectations the sanctions regime is much more extreme. On February 23, if you had asked what sanctions would be imposed on Russia as a result who would have expected;

  •  CBR assets frozen;
  •  Banks cut off from SWIFT;
  •  Russia kicked out of investment indices;
  •  Russia suspended from the BIS;
  •  OFAC not allowing Russia to service its external debts, and is likely to default now coming with the failure to extend the general license which lapses today.
  •  And real discussion now about an energy embargo, and if not that then perhaps price caps and tariffs on Russian commodity exports.

Many of these were imposed because Russia crossed moral red lines - not honoring Ukraine’s sovereignty and territorial integrity, extensive human rights abuses even talk by Biden et al of Russian genocide against the Ukrainian people.

Russia’s actions were seen as morally repugnant by the bulk of the world community - look how many nations backed the UN motion condemning the Russian invasion. ESG momentum built up against Russia and pushed Western governments to do more on the sanctions front.

And then there is the new sanctions angle seen in this crisis - that of “self sanctioning”. Why have 1,000s of Western companies decided to quit Russia despite no specific sanctions prohibiting their specific business activities in Russia?

Unlike Iran sanctions where the international business has tended to keep to the letter of the sanctions law. In the case of international business, it seems like the rise of ESG globally has meant these businesses have weighed the reputational risks of doing business as being now just too high because of Russian abhorrent behavior.

ESG was the driver I would suggest herein. And all this will likely cripple the Russian economy going forward - ESG failings will acutely damage Russian credit risk, and investor perceptions.

And I would think here that ESG concerns related to its unprovoked invasion of Ukraine will make Russia uninvestable for Western business for many years to come and certainly as long as Putin remains in power. Western businesses pulling their operations in Russia will take a very long time to get over the huge P&L hit from exiting - I guess partly as they failed to call the ESG story.

So perhaps my big take on ESG from this crisis is the power of ESG in leveraging up the power of sanctions and how quickly credits that cross moral rubicons can become uninvestable. The hope I guess is that other countries which might be thinking of invading other countries - China on Taiwan - will look at the risks related to ESG and think twice.

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