War threatens to undermine ESG-oriented investing

ON Mar 14, even as Vladimir Putin's war in Ukraine was roiling markets around the world, the Singapore Exchange and Oversea-Chinese Banking Corp unveiled a new index to help investors decarbonise their Singapore stock portfolios.

Dubbed the iEdge-OCBC Singapore Low Carbon Select 50 Capped Index, it excludes companies that are heavily involved in the fossil fuels sector and focuses on companies with low greenhouse gas emissions per unit of revenue.

The 50 stocks that comprise the index include local stalwarts such as DBS, UOB, OCBC and Singtel as well as Ascendas Reit, Wilmar International and Keppel Corp. Among the overseas-listed Singapore companies in the index are Flex and Sea. Their weightings within the index are capped to ensure diversification.

"In recent years, the financial sector has evolved from treating sustainability as part of risk management to now seeing it as a viable business strategy and direction," said Sunny Quek, head of global consumer financial services at OCBC, in a statement when the index was launched.

"We hope that our efforts will resonate with the wider community and create a green ripple effect amongst other financial players and industry leaders," Quek added.

Judging from market activity over the last several months, however, investors have been more excited by the traditional fossil fuel players than companies riding any green wave - or even a green ripple.

For instance, the iShares Global Clean Energy ETF has chalked up a total return (as of Mar 14) of minus 5.7 per cent since the beginning of this year; and minus 28.5 per cent since the beginning of 2021. The ETF's largest holdings include Vestas Wind Systems, Enphase Energy and Orsted.

By contrast, the iShares Global Energy ETF - which is heavily weighted towards oil giants such as ExxonMobil, Chevron, Shell and BP - has delivered a total return of 25.2 per cent since the beginning of this year; and 76.4 per cent since the beginning of 2021.

Fossil fuels in favour

The main tailwind behind these traditional energy stocks is the price of oil - which has been rising since Q4 2020 as developed economies began emerging from their pandemic-induced stupor.

With Russia's invasion of Ukraine, oil breached the US$100 per barrel threshold and prompted governments in the West to put the issue of energy security high on their agendas - potentially overshadowing, at least temporarily, the issue of transitioning to renewables.

In particular, the US government - which has banned the import of oil, liquefied natural gas and coal from Russia - has called on oil and gas companies to "work with Wall Street" in order to unleash its domestic energy production capacity.

This could mark a reversal of sorts in the attitude of investors towards fossil fuels.

Big oil companies have been under pressure from investors in recent years to curtail capital expenditure (capex) and direct their cash flow towards dividend payouts and share buybacks.

One reason is that the slump in oil prices after 2014 had lowered oil companies' profitability and the returns from their capex programmes.

Another reason was that there has been a growing investor emphasis on environmental, social and governance (ESG) considerations, and widespread conviction in the market that renewable energy will eventually eclipse fossil fuels.

Indeed, it was only last year that a tiny activist hedge fund called Engine No1 stunned the market by getting 3 directors elected to Exxon's board. Engine No1 wanted Exxon to adopt a returns-focused capex strategy and reposition itself to succeed in a decarbonising world.

Demand booms for weapons

Russia's assault on Ukraine might also be reshaping the attitude of investors towards another segment of the market often excluded from ESG-oriented funds - weapons makers and defence contractors.

Germany has pledged to spend 100 billion euros this year arming itself, and boost its annual military spending to 2 per cent of its GDP going forward. Among the weapons it has said it will acquire are US-made F-35A fighter jets.

Some analysts are now arguing that weapons makers - such as Lockheed Martin, which is the main contractor for the F-35A fighter jets - should not be excluded from ESG funds.

In a nutshell, their argument is that defending the values of liberal democracies and preserving global peace and stability are socially responsible activities.

This is a stretch, of course - yet, it reflects a very real concern among investors about being on the wrong side of the changing global order.

Earlier this month, Sweden's Skandinaviska Enskilda Banken (SEB) was reported to have allowed some of its funds to invest in shares of weapons makers and defence contractors. SEB is said to have relented as the war in Ukraine has resulted in some of its clients changing their minds on the matter.

Changing calculus for investors

These shifts suggest the seemingly widespread commitment to ESG-oriented investing rested on shaky foundations.

Everyone was happy to go along with it only because the opportunity cost seemed low. There was unquestioning acceptance of all the guff about companies doing well while doing good.

With the higher priority some countries are now placing on energy security as well as national security, this calculus is changing.

Given the current geopolitics, dirty fossil fuels and weapons of mass destruction suddenly don't seem so bad; and many investors might prefer to overlook their incompatibility with ESG principles than forsake the lucrative returns they are likely to yield.

So what is the future of ESG? To be clear, this column is not suggesting that investors abandon renewable energy companies in favour of traditional fossil fuels players.

With our planet getting warmer, renewables will be an important aspect of ensuring energy security besides fighting climate change. In fact, Britain's soon-to-be-announced "energy strategy" is expected to include initiatives to significantly expand investment in wind power among other things.

Yet, this could be a good time for investors to think hard about what focusing on ESG principles actually achieves.

Steering capital away from oil companies and defence contractors has not put an end to their existence. These companies still - unfortunately - serve a purpose, and appear to be on the brink of a period of elevated profitability.

Investors may well feel better about being exposed only to companies with the best ESG credentials. And, companies that properly monitor and manage environmental and social impact of their business activities might also be relatively good at mitigating long-term risks.

But investors should not flatter themselves by believing that mirroring some sustainable investing index will make the world a better place.