Russia Sanctions and the Balkanisation of ESG

Written By Haider Mannan

Russia’s invasion of Ukraine is rapidly exposing hidden risks in much of the investing world. Environmental, Social and Governance, or ESG as it is more commonly known has collided head-on with the Russia-Ukraine issue and is widely being regarded as the most important issue to face ESG.

The ESG investing label describes a style of investing by investors or investment managers; with a multitude of interpretation and implementation differences underlying the label.

There are two primary ESG investing camps, make a better world, or be a better investor. Within these camps, myriad implementation methods take the form of outright exclusion, best-in-class inclusion, potential for improvement, engagement and impact investing among others.

“The first casualty when war comes is truth” — Hiram Warren Johnson

In 1918, US Senator Hiram Warren Johnson is purported to have said, "the first casualty when war comes is truth" — in the world of modern investing, it is the integrity of ESG investing that has been shaken. There are some tough questions being asked of ESG in light of the current crisis; including the ability of ESG investing to fulfil the topical investment desires of investors. Most urgently, can ESG investing be at odds with investors’ investment philosophies given the current geopolitical backdrop?

Russia’s invasion of Ukraine has exposed a risk to all ESG implementation methods. Investments in state-owned corporations that are involved in human rights abuses, by way of directly or indirectly supporting an autocratic regime's war, ought to be excluded under norms-based violations.

However, sovereign risk coverage and analysis for ESG investing purposes is nowhere near comprehensive or evolved to pre-empt the types of political risks being exposed in the Russia-Ukraine crisis; nor is the ESG investing world remotely prepared to deal with risk from other autocracies, chiefly China and Saudi Arabia, until a red-line is crossed.

Meeting Point - ESG & Sanctions

In 2014 the US, EU and other sanctions regulators imposed a range of sanctions on Russian companies and individuals in connection with the annexation of the Crimea and Russia's involvement in a military conflict in Eastern Ukraine. The sanctions targeted any individual or entity responsible for undermining the democratic processes or institutions in Ukraine, or that threaten the peace, security, stability, sovereignty, or territorial integrity of Ukraine. The writing was already on the wall but went largely ignored by the ESG investing circle in particular.

The sanctions implemented in 2014 were only the beginning and have steadily increased every year; the tally stood at more than 500 companies and over 300 individuals at the end of 2021. For a political crisis that played out for so long and quite publicly in the global media, it had surprisingly little effect on investors' attitude towards holding the very securities that are now being branded as ethically questionable investments in Russian state-owned corporations.

Since February 28, 2022 — global sanctions regulators have imposed sanctions of extraordinary proportion on Russian entities — at the time of writing the tally of sanctioned Russian entities stands at over 700 entities. In comparison, as part of the re-imposition of U.S. sanctions against the Iranian regime, in its largest ever single-day action the US sanctioned more than 700 individuals, entities, aircraft, and vessels on November 5, 2018.[1]

Russia has now surpassed Iran’s long-held record to claim top place in the sanctions risk league tables.

Extraordinary times and volumes for global sanctions

Source: OFAC SDN, EU, UK, UN Sanctions Data, Sayari, BigTXN Global Sanctions Monitoring

Hard or Soft ESG Policy?

As a consequence of these new sanctions in the context of the Russia-Ukraine crisis, compliance departments across the investing world are reviewing and updating their investment blacklists. These additions are linked directly to sanctions imposed by global regulators, and compliance with these is compulsory.

Some investors have historically preferred to implement blanket investment restrictions of any security holdings or issuances of specific domiciles. Russia has been added to these ‘domicile-to-reject’ lists. This is a compliance issue outside of ESG investing policies. Should this crisis not lead to an overhaul of responsible investing policies involving, among other things, input from compliance in order for firms to demonstrate their ability to pre-emptively incorporate exclusions by country-level policies with ESG investing approaches?

It should, but there will be resistance to setting hard ESG policy definitions, leading to careful tweaking of policies in context of Russia for two main reasons: 1) Hard ESG restrictions for Russian entities may be in conflict with ESG restrictions on Chinese and Saudi Arabian entities on a norms and moral basis, and 2) there exists a conflict between the necessity to follow publicly disclosed ESG policies and the investment managers’ fiduciary duty to maximise investors’ returns. The inability to purchase highly under-priced assets on an exclusions list exemplifies this conflict.

Most common domicile-to-reject rules affect the sovereign bond issuances and securities issued by entities domiciled in the following countries:

Democratic People's Republic of Korea
Democratic Republic of the Congo
Eritrea
Guinea-Bissau
Iran
Iraq
Lebanon
Libya
Mali
Somalia
South Sudan
Sudan
Yemen

Source: BigTXN Global Exclusions Monitoring

Below the Surface of Sanctions

To highlight the extraordinary regulatory nature of imposing and processing hundreds of new sanctions designations in a short period of time, financial sanctions specialists will readily acknowledge, that imposing sanctions on just 50 corporate entities on a single day is well above the average.

While big banks, with their streamlined workflow and evolved efficiency, are able to able to quickly and precisely identify and implement new sanctions on this scale, many investors and investment managers are not experienced or equipped to do so on such short notice.  

Exposure to sanctioned-by-law entities can present financial, legal and reputational risk.

According to well understood and legally mandated rules, sanctions apply to any business directly or indirectly controlled by a sanctioned entity or individual. The complexity of analysing the ownership networks of entities is further complicated by the application of the “50 Percent Rule” — businesses that are majority owned by sanctioned entities, but do not appear on a sanctions list, are subject to the 50 Percent Rule as defined by OFAC and its EU equivalent — therefore they are considered “sanctioned-by-law.” Exposure to these sanctioned-by-law entities can present financial, legal and reputational risk.

Those with the necessary data and resources will thoroughly follow ownership chains as far down as they extend and across every jurisdiction by collecting, validating, and analysing all reliable documentation — corporate records, securities and regulatory filings, company websites and press releases, among others.

Unfortunately, the better part of the financial services and investment world do not have the necessary data and resources — to precisely identify the entities at risk among opaque and at times deliberately well-hidden linkages in ownership structures — meaning that securities of sanctioned entities are not restricted effectively and the door is left open to enforcement actions and penalties from sanctions regulators.

The Sisterhood of Sanctions, Exclusions and Divestments

Just as the female warrior is claiming her place and being championed in the Russia-Ukraine conflict, so are sanctions being celebrated for their immediate and intended economic effect as noted by the FT's Jonathan Guthrie, ".. sanctions are sometimes dismissed as token gestures. In this case, they are doing real damage and could trigger a recession".[2] While sanctions result in legally mandated investment restrictions, exclusions can take on a legal nature too.

The Dutch Authority for the Financial Markets (AFM) illustrates the legal nature of exclusions in its ban on investments in controversial weapons; which applies to companies that produce, sell or distribute cluster munitions, or essential parts thereof.[3] Contraventions of the ban result in fines of between €500,000 and €1 million; the AFM also reserves the right to refer the case to the Netherlands Public Prosecution Service.

What constitutes a controversial weapon varies by region, country and institution, with some investors focusing on chemical and biological weapons, cluster munitions and antipersonnel landmines, while others include nuclear weapons, incendiary weapons and blinding lasers in their definition. — MSCI

The effect of exclusions can however be just as crushing as sanctions — as demonstrated by the outcry of defence companies’ executives in November 2021 — when Alessandro Profumo, president of ASD and chief executive of the Italian defence group Leonardo told the FT: “.. banks and investors are cutting ties with the [defence] industry”.[4]

The protests from the executive ranks of defence corporations are not completely without merit — investors in some cases resort to wholesale sector-based exclusions — primarily due to the lack of a conventional taxonomy by which to consider investment opportunities that carry less ESG risk.

Instead, they choose sector-based exclusions to bracket the risk of inadvertent investment, in companies whose products could effectively give rise to reputational and quite possibly legal hazards.

Controversial Weapons Taxonomy

Source: BigTXN Controversial Weapons Monitoring Methodology

Leaving aside the protests, merited or not, and the well-meaning exclusionary efforts, the practice itself of controversial weapons exclusions, has stirred to life a serious debate in the Russia-Ukraine context — which in turn is leading to an ignominious volte-face for ESG. Counterarguments are being thrown around to support the case for ESG investors to 'engage' with manufacturers of controversial weapons to bolster the European Union’s defence capability.

Under ordinary circumstances it is uncertain as well as unlikely that engagement with a weapons manufacturer, will somehow result in a change of heart. Could we therefore imagine a scenario where production of munitions which can kill or maim civilians and/or unintended targets, is reduced or eliminated to the financial detriment of a producer, or that the weapons produced will kill or maim gently and humanely as opposed to violently? This would in effect be counterintuitive to the spirit of engagement, which would hope to achieve an improvement in financial materiality for positive change.

Furthermore, at a time when many an index product is being launched in the name of climate transition and Paris-alignment — as per standards set out for European Union’s Paris-Aligned Benchmark (PAB) products, the UK's FCA in it's minimum standards requirements — mandates that administrators of PABs have to exclude companies involved in any activities related to controversial weapons.[5] The same principles apply to ETF issuers — as highlighted by Tabula’s recent issuance of Europe’s first Euro high yield bond Paris-aligned climate ETF.[6]

Accordingly, by using the Russia-Ukraine crisis to encourage responsible investors to fund the producers of controversial weapons in the name of national security, is as patently lazy as it is preposterous.

Connected to sanctions and exclusions, and extending on the point of climate, meshed in environmental and social conscience, we arrive at the moral imperative for divestment — in the run-up to COP26 and post-summit the fossil fuel sector began to feel the brunt of investors’ pledges to fully or partially divest their portfolios of fossil fuel related holdings. In the Russia-Ukraine context, fossil fuel divestment is taking on a significantly more powerful meaning — given that Russia is the world's largest exporter of oil to global markets and the second largest crude oil exporter behind Saudi Arabia.[7]

A coalition of NGOs and social and environmental activists around the world are demanding action and asking financial institutions, dubbed the Putin 100 to cease their ties to Russian oil, gas and coal — and commit to divesting from existing assets and not providing new financing, investment, insurance coverage and other financial services to companies which make up the core of Russia’s energy industry.[8]

The fossil fuel divestment movement has found a new voice in an echo chamber that was being flooded out by the oil and gas industry’s lobby groups who generally oppose a sharp transition to alternative energy systems — for the intended positive climate outcome, this new voice could usher a counterbalanced divestment approach as the global oil markets rearrange themselves — to placate both sides of the debate.

Equality and Order - Where and When There is None

In the history of ESG investing there has not yet been an event which has tested the principle, method and application of investing, against such a furious tide of sentiment generated by a war and regulatory forces.

It should therefore not come as a surprise that most of the issues we are confronted with, emanating from the Russia-Ukraine crisis, be it national security, activist interests, an energy crisis or other yet to be observed systemic issues — are those risks which are not adequately covered or understood under existing ESG investing frameworks. These risks are deeply interconnected and are currently solved by sanctions, exclusions and divestments — the connection, integration and monitoring of which could yield a better understanding of sovereign risk for the new world order of ESG investing.

Ask any head of stewardship when they last engaged with the management of a company in Iran? The obvious answer to this question cuts short the justification for diverting too much misplaced enthusiasm for any specific type of ESG investing style over another.

“Grouping and mutuality of countries and peoples in the Balkans is the only road that leads to economic, national and political liberation.” — Dimitrije Tucović

In the words of one of Serbia’s greatest thinkers and social theorists, Dimitrije Tucović, who in 1950 said, “grouping and mutuality of countries and peoples in the Balkans is the only road that leads to economic, national and political liberation” — as it was then for the Balkans, so too it is today for ESG, as a movement, and as a federation of myriad investing approaches.

Unless we re-group and re-order ourselves to accept as a first principle, that ESG cannot be held hostage by any single system of values or style of investing — the Russia-Ukraine crisis will serve, in more than one way to exploit our divisions and expedite the Balkanisation of what is already a fragile union.

Authored by Haider Mannan with support and contributions by Brian Kozeliski, CAIA, CFA, FRM

Haider Mannan
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