Jul 21

ESG is a Must-Have in Russia, but Adds no Alpha

BNE Intellinews
May 25, 2020

This article is republished with permission from BNE Intellinews

If a Russian company doesn’t pay attention to its environmental, social and governance (ESG) score it will lose a large number of investors, but if it does invest what could be as much as billions of dollars needed to cut emissions and switch to a more sustainable development model it won’t earn any real reward.

Trying to chose between Scylla and Charybdis was never going to be easy, but with 2020 shaping up to be a super-climate year where CO2 emissions must start falling to prevent a climatic disaster, it is clear to everyone that the sea between the two monsters must be navigated.

Scandinavia leads the way, and Russia together with the US bring up the rear. But after Norway’s largest pension fund dumped all the shares it held in Norilsk Nickel in 2011 because it was polluting the Arctic, Russian corporates sat up and took notice. Change is coming.

ESG concerns first appeared in the 1990s but it wasn’t until 2015-16 that they really took over as a major investment theme, driven by Scandinavian fund managers. In the last year or so ESG has become a worldwide theme that companies ignore at their peril.

“Most funds that we surveyed confirmed the increasing use of ESG as an additional consolidated investment metric in their investment process and expect the trend to continue. In particular, Scandinavian regulation already prohibits most local fund managers from investing in ‘non-ESG compliant’ stocks; for London/Europe/US, it is more about awareness, albeit slow migration towards prohibition is possible,” leading Russian based brokerage BCS Global Markets said in a report.

The Scandinavian regulator has already enacted rules forcing fund managers to look at sustainability when making investments and has banned investments into companies that are not ESG compliant. The other big stock market regulators, especially in London, have not gone that far yet.

The writing is clearly on the wall and fund managers in Europe have begun to do their homework; the preference for ESG compliant stocks is high and failing to pay attention to sustainability is already reducing the pool of investors a company can sell its shares to.

But it is still early days. The whole “green finance” phenomena is still in its infancy. The Institute of International Finance (IIF) reported in a note on the greening of capital that ESG compliant or “green bonds” still only account for 1% of the total outstanding bonds, although their share is growing fast.

Rating ESG

Due to the youth of the business there is still no standard set of rules. As bne IntelliNews reported in its cover story, “The rise of environmental, social and governance”, earlier this year, even defining what is environmentally or socially compliant is difficult, although the guidelines for corporate governance are a lot more developed.

Currently the most developed rating of ESG is Morgan Stanley Capital International’s (MSCI’s) ESG rankings. The MSCI group produce a number of benchmark indices and launched an ESG ranking in 2010 that covers 7,900 global companies and 650,000 equity and fixed income securities. However, this effort remains largely focused on the developed world and the ranking of emerging Europe ESG scores already covers 100% of the MSCI EM index. The privately owned Sustainanalytics also provides well developed independent ESG scoring for 13,000 global companies dating back to 2013 along similar lines to MSCI.

Another way of assessing ESG scores could be to turn to the rating agencies, but here too things are only starting to get going. So far Fitch Ratings is the only one of the big agencies that launched a detailed ESG rating service at the start of this year and at the moment it is making all the rankings publically available.

“Fitch’s ESG approach fills a market gap by publicly disclosing how an ESG issue directly affects a company’s current credit rating. Fitch is the first credit rating agency (CRA) to systematically publish an opinion about how ESG issues are relevant and material to individual entity credit ratings,” Fitch said in a press release at the time.

So far, Fitch Ratings has published over 75,000 individual ESG Relevance Scores for over 5,250 entities worldwide, covering a variety of issuers including corporates, financial institutions, sovereigns and public finance.

This list includes 50 leading Russian firms starting with Aeroflot and ending with the X5 Retail Group. Ukraine’s only company ranked by Fitch is the national gas company Naftogaz, which scores better than most Russian companies. All the companies score mostly in the middle of the range of “minimally relevant to the rating”.

A poll conducted by BCS GM found that 70% of the Russian bluechips they surveyed said they intend to expand the resources they spend on ESG with the oil and gas and metals and mining sectors being the most active.

No alfa yet

All companies are now in the position where they can be penalised for not paying attention to their ESG score but the investment has yet to reach the point where a company is rewarded and sees the value of its stock rise if it has an especially good ESG score. In market parlance: there is still no alpha from caring about your ESG responsibilities.

Moreover, while fund managers are aware of the importance of ESG, if a company is still “killing kittens” as part of its regular business but is making fat profits then two thirds of professional fund managers will still invest in that company.

“We polled investment companies as to how rigid a role ESG compliance is relative to investment decision. We asked if ESG compliance prohibits investing in certain non-compliant stocks (or bonds), or is it more about awareness of the investment managers. Interestingly, out of 60% of funds where ESG plays a strong role, one third replied it is already a matter of prohibition; the remaining two thirds acknowledged it is rather about awareness, meaning, in simple words – if a portfolio manager knows that a company is killing kittens as a part of its regular business, but still generates positive returns to its investors, then it is still a viable investment,” BCS GM found in its survey.

Moreover, there is a strong geographic spread to prohibition on investing in non-compliant ESG stocks. BCS GM found that 43% of European firms (that includes Scandinavia) cannot invest into a company with a poor ESG score, whereas only 7% of UK-based funds can’t. And funds in Russia and the US have no restrictions on them at all.

There is also a spread in how important each of the three E, S and G themes are. Just under two thirds (62%) of managers said that governance was important – because it was already important before the whole ESG phenomena appeared – while 19% said environment was important and social aspects were the least important at 18%.

The widespread assumption is that there will be a premium added to stocks with good ESG scores, but the number is still so low that an improvement in ESG scores still can’t move the register.

“On the ability of the ESG theme to generate Alpha, i.e., outperform the market in the long-term, our survey drew a mixed response. Of those professional investors surveyed, only 28% believe ESG could outperform the market; however, others said the role of ESG is seen to grow significantly in the not too distant future. Also, interestingly, 57% of corporates acknowledge ESG as an Alpha generator. For the socially conscious, having money work in ESG-compliant themes without performance deteriorating can be reason enough to invest,” BCS GM found in its survey.

Cannibals with forks

While ESG scores have yet to make a noticeable impact on the market as a whole, there is one institution that has been following sustainable development investment policies for three decades already: the European Bank for Reconstruction and Development (EBRD).

The bank was set up following the fall of the Berlin Wall in 1989 and has sustainability goals as a core function written into its charter. And the bank has been consistently profitable despite investing into some of the most volatile and unpredictable emerging markets in the world. Investing just shy of €10bn a year each year the bank has rarely lost money: in following a rapid expansion the EBRD booked €261mn of losses in 1999 caused by the financial meltdown in 1998.

The bank’s net profit of €772mn in 2017 compared with €992mn in 2016 and an average for the last five years of approximately €620mn. The reduction was primarily due to lower gains on equity investments in 2017 of €332mn, versus €423mn in 2016.

The bank’s Russian business has been suspended – the bank can maintain existing investments, but there is a sanctions-induced ban on any new investments. Instead its focus has shifted to Turkey and Ukraine which have taken over to become its biggest countries of operation now.

The EBRD was a pioneer in ESG thinking as the idea of looking beyond the bottom line was still very new.

The idea of responsible investment was crystalised in a paper entitled “Cannibals with Forks: the Triple Bottom Line of 21st Century Business,” written by John Elkington, co-founder of business consultancy SustainAbility, in 1998. The triple bottom line is: plant, people and profit, which was an obvious precursor of the ESG ideas. The term ESG itself was coined in 2005 by Ivo Knoepfel, who penned a landmark study “Who Cares Wins” that was presented at a conference in Zurich.

It took another ten years for these ideas to really catch on but by around 2015 they became mainstream with the Scandinavians implementing them most forcefully; Norges, Norway’s biggest pension fund, implemented a set of sustainable investment rules in 2006. It is no coincidence that Greta Thunberg, the world’s most famous climate activist, is Swedish.

But the business is already big with $30.7 trillion of ESG related assets under management (using a broad definition) as of the end of 2018, up by a third (34%) from the year before, or about a third of all managed assets.

Russia in the firing line

Living in a country that literally spans half the globe, most of which is empty, the environment has never been very important to either the Russian authorities or its companies.

But that has changed now. After the Norges pension fund banned investments into Norilsk Nickel, one of the most attractive companies on the market for portfolio investors,  in 2011 due to Arctic pollution the management sat up and took notice. Since then it has spent over $2bn to clean up its emissions, despite the fact that this investment adds nothing to its bottom line. And the rest of Russia’s extraction industry has looked on nervously and also begun to put ESG policies in place.

Seven out of ten of Russia’s biggest firms now say they intend to invest into ESG in the hope of expanding their investor base. CEO of gold miner Polyus Gold Pavel Grachev estimates the pool of money targeting ESG compliant companies is currently worth $30 trillion.

“The ESG race for $30 trillion of investments is on,” Grechev said during the St Petersburg International Economic Forum (SPIEF) this summer.

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