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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