ESG and Impact Investing at War
The war in Ukraine has affected the ESG/Impact investing community in a number of major ways. First, through reduced inflows. The Institute of International Finance (IIF) reported that ESG funds saw inflows halve in Q1 2022 amidst Russia’s war in Ukraine, volatility in ESG heavy tech shares and higher oil prices diverting funds into non-ESG energy stocks. ESG Q1 fund flows of $75 billion were at their lowest level in seven quarters. IIF data also showed that flows into ESG bonds were also down sharply in Q1, dropping to $14 billion from $27 billion.
More importantly, Russian aggression has been fostering new intense debates on fundamental socially responsible issues such as whether defense stocks should be allowable in ESG/Impact portfolios or, at least, no longer be considered unsuitable as part of a negative exclusion policy. Does Europe’s new geopolitical reality and use in defending democracies force reversals or adjustments to investment firm ESG & sustainability policies?
The war has also become a wake-up call for social investors that their efforts and investment focus not only reside on a sector level. It has also renewed the question of investing into countries like Russia with autocratic governments. According to Bloomberg, ESG funds had at least US$8.3 billion in Russia before the invasion; having invested in Gazprom PJSC, Lukoil PJSC and Rosneft, among others. About 14% of sustainable investment funds are directly exposed to Russia, according to industry research firm Morningstar Inc. Just like social investors did not want their money invested in South Africa during apartheid, will the brutality of the Russian invasion be a catalyst to new restrictions being applied globally to the most autocratic governments? Should social investors consider whether politics and international conflicts should, to some degree, guide their investment decisions?
On another front, while government sanctions and divestment by corporations have demonstrated the power of the capital markets and the commitment of major companies to operate consistent with core values, this raises other investment issues. The main question that reveals itself through this war time environment is How do you calibrate a company’s actions? How do you balance doing the right things like exiting their operations in Russia versus accepting the financial hit that the company took in exercising their social conscience? To what degree do you quantify and reward/punish the net effect of a company’s decision? There will be increased pressure for ESG/impact funds to explain their rationale behind investment decisions as social investors will be questioning whether the money they have put toward environmental, social and governance goals is being well spent.
To dig deeper and get a better understanding of what is happening in the rapidly evolving social investment environment, the Institute for Innovation Development decided to reach out again to a cross-section of socially responsive asset managers – from ESG to impact to focused thematic strategies – and get their real world, in-the-trenches perspectives and thought leadership on these issues. We would like to thank Ultimus Fund Solutions – one of the largest independent fund administrators - who provided introductions to some of their socially responsive asset manager clients and that has created investment vehicles for all of them to enable more access for investors to socially driven investment options.
Let me introduce you to our panel and then we will jump into getting a true lay of the land on these vital issues from the following experts in this field:
Andrea Dalton, CFA, Portfolio Manager and Kristin Hull, Ph.D., Founder, CEO and CIO of Nia Impact Capital Capital, an asset management firm that invests at the intersection of social justice and environmental sustainability. Nia builds a portfolio of forward-thinking companies poised to play a key role in our transition to an inclusive, just, and sustainable economy.
Venk Reddy, Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management, a San Francisco-based asset manager established in 1983, offering both equity and fixed income investment strategies
Matthew Blume, Director of ESG Research & Shareholder Activism at Pekin Hardy Strauss Wealth Management, managers of the Appleseed Fund – a Chicago-based independent advisory firm providing funds and separate account strategies for investors that support their values through impact and ESG investing.
Zin Bekkali, CEO of Silk Invest, a London-based advisory firm that invests in listed equities across Global Frontier Markets – predominantly in Africa, the Middle East, Frontier Asia and Latin America – with a strong focus on impact investing and has been a signatory to the UN Principles of Responsible Investing since 2011.
Hortz: Do you feel that the war in Ukraine has reframed ESG/Impact manager and investor perspectives on certain issues? What are these areas and how are they being rethought or refined?
Nia Impact Capital: Human rights have always been a critical element of ESG investing, though it took Russia’s attack on Ukraine to force the topic onto our front pages. As with many ESG factors, the timing of many risk incidents is unpredictable and disregarded at the peril of both investment decisions and often the humans involved. This moment is equivalent to the tide going out, leaving it clear to see where both corporate and investment decisions weighing profit and human rights were too casually considered.
Osterweis: Autocratic governments and military aggression are not new to world history or to ESG investors. The biggest change to investor mindsets here may be in their definition of what countries or conflicts pose ESG (or even financial) risks. We suspect both traditional and ESG investors will rethink the chances that a government which previously seemed unproblematic or at least tolerable could be viewed as an aggressor or revealed to be a human rights violator virtually overnight. In some ways, this may favor companies who are willing to incur the costs of onshoring their previously outsourced business units proactively, which is (at least domestically) a stakeholder treatment issue which may have always been worth watching anyway.
In general, the willingness to take short-term pain for long-term gain is more likely to be a virtue than it has been in the past, which we hope will motivate companies to do so and will motivate investors to stop judging ESG based on short-term performance metrics. We cannot lose sight that ESG represents long-term risk, and it always has in our opinion. So, for ESG managers, I do not believe the war should have changed what we are looking for, just where we are looking; we must always continue to cast a wider net as we aim to identify potential risks to avoid.
PekinHardy: I definitely think the war in Ukraine and the economic and political fallout that resulted has created difficult new questions for some ESG/Impact managers to consider. For example, should ESG analysis extend to the country/national level? How would such analysis be carried out, given that most ESG metrics used for company analysis would not be relevant at the national level? What framework would be used? Should companies be held responsible for the actions of the governments of the nations in which they are domiciled? If so, who decides which governmental actions are “acceptable” and which are not?
At any given point in time, dozens of nations are engaged in conflict, so who decides which nations are worthy of investment and which are not? Given the complexity of these questions and their subjective nature, we believe these considerations should be kept separate from ESG analysis, but some ESG/Impact managers may grapple with such questions going forward.
Silk: The ongoing war in Ukraine is becoming increasingly a test for investors both on a country level and sector level. Past broad consensus on, for example, the filtering out of investments in weapon producers or less extreme energy companies is being rethought.
Hortz: Should political ideologies and geopolitical conflicts become a bigger part of ESG assessments? How then do you apply these issues into portfolio construction and stock selection? Should political risk and international conflict be a bigger part of ESG assessments?
Nia Impact Capital: For all investing, geopolitical conflict has always been a fundamental risk consideration. Political ideologies are only at issue to the degree they result in disregard for human rights, social rights and more recently, the environment. For any ESG strategy this is, or should be, an intrinsic element of stock selection and portfolio construction. While we may not achieve global agreement for standards in practice, it is incumbent upon investors to consider how their investments could be exploiting a differential in these rights and whether that is appropriate. Investors who view these compromises in human rights as opportunities should acknowledge the inherent risks and possible human rights violations in which they are participating.
Osterweis: First, a caveat: We are fundamental investors who prioritize risk mitigation and materiality, so we view this question through that lens. Geopolitical conflicts have always been something a good analyst should take into account. Where the conflicts are and what the consequences are may vary, but a good credit analyst cannot assume that a company’s creditworthiness is not related to who they do business with and where.
We saw this previously, with the Trump administration’s tariff war with China. Any company that was not nimble enough to pivot encountered real problems. Investors who were complacent about the growing animosity between the U.S. and China learned the hard way that what may have been a tolerable risk in the past is not an indicator of what should be a tolerable risk in the future.
The Russia/Ukraine conflict exposed just one more example of where investors held their noses because they were primarily focused on returns. It works until it doesn’t. If the mandate of a portfolio is to time the markets, I suppose the strategy might work over the short term. But if the mandate is to be consistent, and to better align performance and progress over time, then such risks should have always been on an analyst’s radar screen.
PekinHardy: Geopolitical/country risk analysis has always been an important part of the research process for any international investment. However, we have always viewed ESG analysis and country risk analysis as separate parts of the research process. ESG analysis is a bottom-up, company specific analysis, whereas country risk analysis is top-down and focuses on the broader geopolitical and economic risks of countries in which potential investments are located.
Our ESG analysis applies specific, quantitative screening criteria to companies with respect to their business involvement and looks at company-specific performance on various environmental, social and governance criteria. The nation of domicile is not a factor in this part of the process.
In my opinion, introducing screens or assessments based on purely ideological factors or taking sides in geopolitical conflicts would be incredibly difficult and fraught with risk. The world is a diverse place with an incredibly diverse set of perspectives, so trying to incorporate this into portfolio construction would create untold challenges for managers. Any attempt to do this would need to start with a clear delineation of the specific ideological factors and positions that are to be applied in the portfolio construction process so that investors have a clear understanding of the ideological positions that will be championed by the managers. There may be a market for such products, but that is not our area of expertise.
Silk: Assessing broad political risks should be a critical part of ESG assessments but that does not mean that you should automatically reduce or not invest in certain countries. Investing in stocks that are based in difficult or hostile political environments should in most cases being seen as an instrument of engaging with corporate leaders and building alliances. The Russian situation is quite unique and should not necessarily being seen as a base case for the future.
A missing point here is whether investors should allocate more resources to strengthen alliances with “neutral” Emerging and Frontier Markets. Western countries would benefit from a more assertive “Marshall Plan” approach and increase investments in Africa and Asia. In an increasingly deglobalizing and/or multi-polar world, governments and investors should use capital as a tool to sustain their natural liberal habitat.
Hortz: Where are your thoughts on whether defense stocks, producing weapons for free societies protection, should be considered as ESG/impact eligible investments? Is not pursuing national defense an ethical objective? And what about the positive public sector innovations (GPS, nano cameras, and touch screen) that have come from military research?
Nia Impact Capital: Ideally, we direct investment dollars into diplomacy and those companies playing a key role in our transition to a sustainable, equitable and fair economy that works for everyone, as inequalities are often a precursor to and a risk for geopolitical conflict.
That said, the sticky part of this question lies in how the profit motive adds an incentive to either wage war or to drive the “defense industrial complex.” Ideally, support for national defense and the profit motive would not entangle with negative consequences, yet the unfortunate reality is that they do.
Turning to the products and services, ESG investors must weigh logistics and consequences carefully. Communication or transportation services are quite different than weapons and fighter jets.
Government backed and public funded research in agencies such as DARPA have undoubtedly resulted in many valuable innovations that have found applications across transportation, healthcare and technology. We see no issue with government funding of such research and are equally supportive of the sharing out of that research across non-defense industries.
Osterweis: This is not the first time someone has had the opportunity to justify an industry for ESG window-dressing purposes. As a high yield bond investor, how we view companies with respect to ESG factors has always been important. I do not think it is helpful to label companies as good or bad. If one is truly trying to have impact, punishing a company for where they are now is hardly a progressive approach. We believe it makes more sense to pull capital from companies for not caring or trying to make progress and give it to those who are intentional about their goals to get better. This is very different from justifying the good a company does in what may be considered a vice industry.
The question to ask is not “Are they actually good?” but rather “Do they see their blind spots and are they trying to improve?” If the answer to the latter question is yes, and they successfully execute, then the investor’s capital has contributed to that progress and has had impact in the process, even in the non-voting world of fixed income. But it all comes back to the intentionality of a company to better itself, and not just in core products, but in all of the ESG factors that are material to the business.
Meanwhile, from a practical perspective and specifically as it pertains to defense and weapons, no amount of justification changes the headline and event risk associated with these companies which quite frankly makes them difficult investments for an ESG investor like us to consider.
PekinHardy: This is another really difficult question because it depends so much on a person’s individual perspective. While arguments can be made for building up military capability in order to pursue “humanitarian” objectives or for “defense,” this sort of thing always comes down to one’s personal situation. While some might consider one nation’s military engagements to be virtuous, someone on the other end of such action might think otherwise. And what one person might consider “defense,” another may find quite offensive. For this reason, we find it best to simply avoid investment in defense/weapons companies within our mutual fund so as to steer clear of this issue entirely.
The technology development argument is often made to justify defense spending, and there is no doubt that incredibly important technologies have emerged from efforts to enhance military capabilities. However, I think it can easily be argued that with the same resources at their disposal, governments, companies, and educational institutions could have developed the same technologies in the pursuit of peaceful objectives. Given the prevalence of cost overruns and the lack of efficiency in the defense industry, one might even argue that technological advancement in the pursuit of peaceful objectives could occur at a fraction of the historical financial cost and without the human cost.
Silk: A difficult question that could easily be a slippery slope. As a firm, we therefore believe that all defense stocks should still be off limit within an ESG/impact portfolio. Military research has contributed to public sector innovations, but those innovations or better ones could have been created if the same resources would have been allocated to other sectors.
Hortz: What other ripple effects of the Russia-Ukraine war do you feel will have profound consequences for ESG and impact fund managers and markets? Will this war trigger a faster transition towards clean energy?
Nia Impact Capital: As we are already seeing, Europe has connected the dots about their oil sources –as well as the fossil fuel pipelines running across borders. European funds are flowing toward renewable solutions, which in the longer term will diminish reliance and dependence on Russia and on its oil.
Unfortunately, the funding environment has tightened up, along with the slowing of the economy. That would appear to bode poorly for near-term acceleration of investments into clean energy.
One of the largest impacts will be an acceleration of the effort to pull sourcing toward more reliable and secure partners and sources. A positive from this situation is that companies and investors will continue to gain greater visibility into supply chains. Greater transparency would be one tremendous positive for all of ESG, impact fund managers, and markets.
Osterweis: With respect to clean energy in particular, this war has created a short-term supply shock. If someone invests in clean energy because of a short-term temporary effect, we believe they are setting themselves up for disappointment if the environment normalizes. That said, ESG has already had an impact on the energy space, but perhaps not only in the way we are discussing here. Sure, more investment has gone into clean energy, but there has also been a capital constraint on traditional energy investing. This is exactly the objective of many ESG investors who see themselves as voting with their money.
However, since oil and natural gas are commodities, the capital constraint inevitably leads to supply constraints which are more persistent and way more impactful than the short-term supply shocks from conflicts such as this one. Those supply constraints, in turn, drive the commodity prices up, again not temporarily but with a more constant upward pressure. This in turn makes inflationary pressures feel more persistent. But those higher commodity prices may also drive a better return for those who do choose to invest in that space or are already there, making them potentially more profitable and exacerbating the performance vs. progress perception.
Ultimately, such short-term catalysts tend to be counterproductive to long-term change, and while we expect there will be more awareness related to how concentrated the fossil fuel geopolitical power dynamic actually is, investors should not lose focus on the fact that making clean energy economically equivalent at all times is more long-lasting.
PekinHardy: There is no question that the disruption of global energy markets has caused investors and policymakers to rethink energy strategies. Energy markets were already under pressure prior to the Russia-Ukraine conflict, but the shutting off of Russian energy from global markets and the significant economic consequences of this disruption showed us just how fragile our current energy strategies really are. This definitely argues for some new thinking with regard to energy. This new thinking should most certainly focus on expanding the use of renewable energy sources and accelerating technological development within the renewables space in order to diversify away from more traditional energy sources. I also think it should put nuclear energy back into the spotlight as an important piece of the clean energy puzzle.
Looking at markets more broadly, I think the biggest impact of this conflict will be an acceleration of deglobalization. This trend was underway prior to the outbreak of war in Ukraine, but the Russian invasion and the huge impacts it had on markets and supply chains has pushed this process into overdrive. The world is bifurcating and becoming multi-polar, which will lead to a re-shoring of certain industries, a reshuffling of supply chains, and unfortunately, likely poorer international relations around the world.
Silk: Long term, the world could see a faster transition to clean energy, but investors should not underestimate that the current war may impact the potential available resources to finance transition. The incentive of transition has increased but the world may have less capital to deploy and the current inflationary pressures may structurally increase the cost of capital.
Hortz: How can an investment manager calibrate wide-ranging, sometimes conflicting corporate actions into an ESG/Impact score or profile? How do you factor in when a company does “the right thing” like exiting business in Russia versus the financial hit that the company took in exercising their social conscience?
Nia Impact Capital: ESG due diligence is complex and involves tracking many distinct aspects of a company business model. Every company has positives and negatives that must be weighed and compared in the course of determining its investment merit. As with traditional financial metrics, some ESG factors may be disqualifying, similar to an extremely high leverage ratio or collapsing margins. Also, just as in traditional financial analysis, not all portfolio managers will reach the same conclusions when looking at the same data. So, it should be no surprise that when analogous comparisons are made with ESG factors, there will be a range of opinions, especially when company factors are not at the extremes. While one investor may consider certain actions and factors disqualifying, others may view them as mitigated by offsetting positives elsewhere.
Osterweis: I think scoring is a widespread mistake in ESG investing. The notion that there are good companies and bad companies does not map to reality. It is incredibly oversimplifying, and, at least in fixed income, this is not an effective way to use capital to have a positive impact. As a result, we tend to focus less on how to “score” conflicting behaviors across various ESG factors and more on whether a company is intentional about making progress in each of the ESG factors which are material to their business. In this way, we can remove the dissonance created by the need to boil every issuer down to a number and instead make decisions based on that issuer’s maintenance or progress in a variety of areas.
Specifically, regarding the financial hit of exiting Russia as an example, this is a real issue for ESG portfolios right now because the market still cares most about short-term outperformance. But it is somewhat unfair to say that a company is exiting business in Russia to exercise their social conscience. There are always consequences to every action, and the uncertainty of the consequences of not exiting these businesses likely plays as big a role in the decision. We do not yet know how this will play out over time, and it rarely benefits investors to try to draw big-picture conclusions in the middle of an evolving situation. Given the risk of political, legislative, and grassroots repercussions, we are not convinced that companies who are standing by their Russia-related revenues will come out ahead in the long run.
PekinHardy: This really gets to the heart of the challenge of managing an ESG portfolio. There are simply some considerations that cannot be quantified, so incorporating them into some sort of score or grade is effectively impossible. This is an issue that ESG managers have been dealing with for a long time. It is simply unavoidable that certain factors are subjective, and two different managers can look at the same set of issues and come down on opposite sides. Or they may prioritize objectives differently.
Take, for example, a large energy company whose primary business is the production of fossil fuels but which also engages heavily in research and development around renewable energy. One ESG manager may see this company as an important part of the long-term solution to climate change, while another ESG manager may see this company as uninvestable. Who is right? It depends on your perspective. This sort of issue can materialize in a myriad of different contexts, creating huge challenges for ESG managers. This is why it is so important for ESG managers to be very explicit about their approach to ESG and which ESG objectives they will pursue and prioritize in their portfolio.
Silk: Sacrificing financial returns for ethical or social objectives should be supported but the more difficult question is assessing the negative social impact of certain actions. Exiting businesses in Russia may help the Ukrainians but may also drastically impact the lives of innocent Russians. Fortunately, many companies are taking this into account and have, for example, offered Russian-based employees a reasonable “termination” compensation.
Hortz: As a result of the challenges and issues brought up by the war in Ukraine, do you feel they can act to strengthen the ESG/Impact investment space going forward?
Nia Impact Capital: The Ukraine war has brought into the sunlight differences of interpretation and implementation of ESG/Impact investing. To the extent that highlighting these issues leads to a consensus that investors and practitioners must clearly articulate their approach to human and social rights in investment practices, it can only be a positive outcome.
Osterweis: I think the ESG/impact manager is going to have a near-term problem because of the war. We have seen several companies report lower earnings due to the loss of revenue from pulling out of business in Russia. This will most likely fuel the fire of ESG skeptics, who argue that performance and progress are not correlated. Unfortunately, the counterargument that a company could get hurt even more badly by grassroots boycotts or other business losses, while potentially valid, is unprovable. However, the silver lining here is that maybe the market will finally admit that ESG factors are risk factors, not performance factors, and that when viewed properly, the two are indeed aligned.
Being risk managers is not in the language of many investors nowadays, with fundamentals taking a backseat to beta and indexing, but ESG risks are mostly long-term risks. As long as most investors judge a portfolio by short-term performance relative to a traditional benchmark, these headwinds will persist, and this war has not helped change that perception. However, within the subset of the markets in which ESG investing is already a priority, we are optimistic that this conflict will shift investors away from the conventional wisdoms which have hurt the perception of ESG (e.g. negative screening, short-term performance) in favor of a longer-term approach in which performance and progress can be more in sync (e.g. integrated investment processes, long-term risk-adjusted returns).
PekinHardy: It has already had the effect of getting people to think much more critically about what ESG really entails and how it should be implemented in today’s world. Questions like those above are being asked widely for the first time. Where people ultimately come down on these questions remains to be seen, but I think it has the potential to fundamentally alter the way we apply ESG analysis going forward. It is my hope that ESG strategies will find more support and that more managers will be compelled to apply these factors in their investment analysis as a result of this episode, but we will have to wait and see on that.
Silk: The current war is a good test for the community and will help investors to develop new best practices in ESG/Impact investments.
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