The war in Ukraine exposes shortcomings in sustainable investments

Russia’s invasion of Ukraine has turned geopolitics on its head and provoked moral justice for many in the West. For investors who prided themselves on doing the right thing with their money, it has exposed fundamental flaws in the booming business of environmental, social and governance investing, known by the acronym ESG.

Here’s the problem: ESG tries to gauge companies’ sensitivity to public sentiment, either for moral reasons or because the public matters as companies’ customers, suppliers, and employees. But public sentiment is constantly changing, and what was right before Russia invaded has suddenly changed.

Prior to the invasion, most ESG companies focused on carbon emissions, with many also excluding defense stocks, particularly makers of “controversial” weapons like nuclear and cluster bombs and landmines.

Since the invasion, Western governments have shelved their efforts to cut carbon emissions and have become major arms suppliers to Ukraine, cheered on by their voters. Nuclear deterrence is back on the agenda in the face of Russian threats, and it’s not obvious that ESG investors are genuinely intent on abandoning nuclear weapons. But 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 fund a slaughterhouse for moral reasons.

This reversal has left ESG investors in a bind. At least one fund manager who excluded gun manufacturers on moral grounds has reinstated them, and many others are considering switching.

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“There are a number of conversations with investors considering how to approach investments in defense companies in light of events in Ukraine with Russia,” said Baer Pettit, president and chief operating officer of MSCI, which sells ESG ratings and indices.

ESG ratings have failed to capture the risks surrounding Russia. According to an analysis by academics Elizabeth Demers, Jurian Hendrikse, Philip Joos and Baruch Lev, before invading Ukraine, European companies with large operations in Russia had significantly higher overall ESG scores and human rights ratings than those that stayed away.

The ESG score also gave no indication of the company’s reaction. 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 higher-rated companies.

This is not just a temporary problem for ESG caused by Russia. The shortcomings exposed by the war run through both major approaches to investing for supposedly “sustainable” reasons.

whose morals? The first ESG approach is to try to do good with your money, and almost every ESG fund tries to imply this by at least excluding the makers of controversial weapons and the most polluting forms of coal. Marketing materials are filled with images of sunflowers and green fields.

But what is considered acceptable behavior is changing rapidly. Russia’s invasion of Ukraine has shown what should have been obvious to ESG investors that a country cannot defend itself without weapons, and that means funding arms manufacturers. Even nuclear weapons – which almost all ESG funds are banning – suddenly seem much more attractive as a deterrent against Russia.

Soaring oil and natural gas prices as a result of the Russian invasion and sanctions have also prompted Western governments to turn around. Just five months after hosting the Glasgow climate summit where world leaders agreed to phase out fossil fuel subsidies, the UK is slashing road fuel taxes and trying to protect households from energy costs while Gulf countries encouraged to produce more oil. The US is asking frackers to pump more and some European countries want price controls.

Decisions about how much to give up now to prevent global warming in the future should be made by society as a whole through governments, not by a bunch of well-meaning rich people. The same applies to whether companies should sell alcohol, cigarettes or lottery tickets, or supply unpleasant weapons to elected governments.

What risks? While most investors in ESG funds think they are trying to do the right thing, many funds only use ESG scores to identify risks to stock prices. Both MSCI and Morningstar follow this approach‘S

Sustainalytics, if a company can do bad things without affecting its stock, it shouldn’t lower its ESG score.

“We are focused on the material environmental and social issues that we believe could have a financial impact on the company,” said Michael Jantzi, founder of Sustainalytics, recently. Sustainalytics plans separate “impact” ratings later this year to assess companies for their environmental and social impact, even if they pose no risk to investors.

The approach makes intuitive sense. Investors should try to anticipate changes in government policy as new taxes, regulations and sanctions have huge business implications. You need to be mindful of changing consumer priorities; Customers concerned about CO2 emissions could change their eating, travel and shopping habits. And boycotts of companies that say or do the wrong thing are becoming more common.

However, there are two fundamental problems with using ESG scores to identify risk. First, it’s difficult to predict in advance which themes will matter to stock prices, and ESG scores are slow to evolve.

Since the war, carbon emissions are suddenly much less of a concern, while poverty due to energy prices is of more concern. Likewise, investing in or trading with Russia is widely viewed as moral outrage, even if it remains legal. Oil company Shell even apologized for buying a cheap shipment of Russian crude, which was specifically excluded from the sanctions at the time.

The consequences of the tough economic sanctions against Russia are already being felt around the world. WSJ’s Greg Ip joins other experts in explaining the significance of what has happened so far and how the conflict could transform the global economy. Photo illustration: Alexander Hotz

Second, there’s no point in simply buying stocks with higher ESG scores like ESG index funds do, even if the scores perfectly capture non-financial risk. Risk alone is not an investment basis, because it must be compared with the share price.

Of course, riskier stocks should be priced lower and less risky stocks should be priced higher. But when the price already reflects all the risks and more, a dirty and immoral company should be a solid buy for this approach.

At least one ESG fund manager who had excluded gunmakers on moral grounds has reinstated them. The site where a shopping mall was located in Kyiv, Ukraine.


Photo:

Daniel Ceng Shou-Yi/Zuma Press

Write to James Mackintosh at james.mackintosh@wsj.com

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