LGPS Challenges: Balancing Realpolitik and responsible investment

Elizabeth M. Carey warns of the perils of an ESG echo chamber as countries outside the West continue to invest in fossil fuels.

Anyone working with the LGPS probably feels steeped in RI (responsible investment), ESG (environmental, social and governance) factors, impact investing, TCFD (Task Force for Climate-related Financial Disclosures), Scope 1, 2 & 3 emissions, UN Principles for Responsible Investment and Sustainable Development Goals, and the exclusion vs. engagement debate along with myriad sustainability indices.

We could be forgiven for thinking that the rest of the world sees things similarly, especially now that the US has re-joined the Paris Climate Agreement.

With the UK hosting COP26 this autumn, a real prospect exists to agree some meaningful targets. Such an outcome requires us to look out from behind ESG-tinted glasses to confront events unfolding beyond the edges of Western capital markets.

Vostok

The story of Vostok Oil illustrates how large swathes of global industry remain far removed from the shift towards ESG and RI that practitioners in the Western capital promote.

Vostok leads a peloton of Russian state-controlled industry players, undertaking a colossal investment (estimated at RUB 10trn, or over $130bn) to expand Arctic oil and gas production. Through this development, Russia intends to transform the 5,770km Northern Passage into a competitive shipping route between Europe and Asia.

Vostok Oil will allow Rosneft to deliver 30 million tonnes of oil via the Northern Passage by 2024. Shipping volume is expected to increase four-fold. In short, Vostok Oil resembles a New Deal style project rather than a commercial venture. The Russian government expects the project to generate around 400,000 new jobs. It will require fifteen new towns to be built in Siberia, a region historically missing out on economic development.

Material Changes

Where a sector like oil and gas lies at the heart of a national economy, it seems unlikely that TCFD metrics or other ESG, or RI, considerations—as they are understood in the UK pension industry—will provide compelling motivations for state-controlled companies to make material changes in their business models.

Strategically important companies like Rosneft, Gazprom, Equinor, Saudi Aramco or even the Chinese National Oil Company serve their state owner-masters by delivering hard currency, creating political leverage through trading dependency, and securing fuel for national populations, all of which strengthens the current regimes. Strategic national objectives, rather than return on invested capital or share price performance, drive investment decisions.

Despite not adhering to Western capital efficiency measures, state-controlled energy companies have no trouble attracting external debt and equity capital.

Where a sector like oil and gas lies at the heart of a national economy, it seems unlikely that TCFD metrics or other ESG, or RI, considerations—as they are understood in the UK pension industry—will provide compelling motivations for state-controlled companies to make material changes in their business models.

In late 2020, Rosneft sold a 10% stake in Vostok Oil to a subsidiary of the privately held commodities trading house Trafigura Group for around €7.3bn, effectively valuing Vostok at €73bn, higher than Rosneft’s equity market capitalisation of €54bn.

The Trafigura stake gives Rosneft ready access to commodities markets for Vostok’s future Arctic hydrocarbons output.

Neither falling oil prices nor investor pressure, nor even TCFD disclosure requirements, will lead strategic national operators to reduce investment in, and extraction of, fossil fuels—in sharp contrast to claims made by BP, Shell, Chevron, Total and lately even Exxon.

Even Norway’s state oil company Equinor continues to drill in Arctic oil fields just west of the Vostok Oil project, notwithstanding Norway’s claims to be one of the first countries to submit an enhanced emissions reduction target under the Paris Climate Agreement.

ESG veneer

Far from ignoring ESG, state-controlled energy companies increasingly use ESG to cast a more acceptable veneer over their activities, perhaps to distract from what is really happening.

Rosneft recently published its carbon management plan for 2035. The slick ESG pages of its website talk about research into renewables and show pictures of trees newly planted. Gazprom, the Russia natural gas producer that is building the Nordstream2 gas pipeline to Germany, likewise features impressive environmental and social responsibility pages on its website.

Operators like Rosneft and Gazprom appear to be harnessing Western focus on ESG to build a façade for state-sponsored industrial plans that blend Soviet-style cross-sector planning with wild West capitalism reminiscent of 1990s Russia.

Separate worlds

To our way of thinking, the Vostok Oil project hits E, S and G for all the wrong reasons. Vostok is a reminder that steeping ourselves in the nomenclature of TCFD, ESG and RI, plus shifting investment portfolios towards companies with better ESG metrics—while good things to do—will probably not change behaviour where that is most needed.

An Arctic oil exclusion criteria may make LGPS investors feel better, but it is unlikely to impact the two companies most actively involved because of their limited free floats (Rosneft’s 21% , Equinor’s 33%). This is a case of living in separate worlds.

Vostok Oil highlights an uncomfortable dilemma: helping an autocratic Russian regime build out a shorter route between Asia and Europe might actually help to reduce the CO2 footprint of the global shipping industry and reduce other social risks, namely piracy.

If done properly, it could be positive for the environment if Russia and neighbouring countries could agree that only a limited number of ships using the latest generation of pollution-minimising engines could enter the Northern Passage.

In effect, Russia, Canada, Norway, the US and Greenland/Denmark could agree to allow only ships that meet the highest, and constantly rising, environmental standards to enter the Northern Passage, thereby raising the “E” bar for the industry as a whole.

On the other hand, the Northern Passage could easily bring congestion and a concentration of maritime pollution to an environmentally sensitive region that is already disproportionately suffering the consequences of global warming.

Scientists have established that temperatures are rising faster in the Arctic and Antarctic than average across the World. Russia’s rapidly melting permafrost has led to fires on the Siberian tundra. Burning bogs transform a naturally occurring carbon sink into a greenhouse gas producer, which has a double-whammy effect on global warming.

Realpolitik

We who believe in RI and ESG principles must develop more realpolitik responses to developments like Vostok Oil and Russia’s broader plans for the Arctic.

Making real progress on combatting climate change requires engaging with leaders of regimes that do not subscribe to our version of democratic values. Leaders like Putin or Mohammed bin Salman, along with their close circles of friends, must come to realise that their own longer-term flourishing runs parallel to, and not counter to, taking concrete actions to meet the Paris Agreement targets.

Institutional investors may need to adopt a more pragmatic mindset and realise that developments like the Northern Passage, even if undertaken with ESG principles in mind, could be very “un-G” and “un-S” because they divert State-owned assets to benefit those in power.

Reducing global demand for fossil fuels must be a national-strategic priority for the UK and all governments that seriously wish to restrict global warming to 1.5°C. The ultimate solution requires accelerating the shift towards electrification using renewables, and making the global oil price fall even faster via a lower demand curve.

Although this will take decades, petroleum-dependent regimes should be encouraged to eliminate unnecessary greenhouse gas emissions (i.e., flaring), accelerate development of carbon recycling and capture technology, and ultimately diversify their economies away from fossil fuel extraction and production.

LGPS officers, councillors, advisors, MHCLG and UK pension regulators must similarly learn to gaze beyond the investment landscape of Western capital markets and lend their support to leaders making difficult choices as they chart a path towards success at COP 26.

Equinor is already building up its renewables portfolio to replace its declining hydrocarbon reserves. Saudi Aramco invests in carbon capture and recycling, while also promoting mangrove tree planting, which its researchers claim are far more efficient CO2 sinks than terrestrial forests.

We should try to pull state-owned oil companies faster towards a world beyond petroleum, for example by forming new joint ventures that harness their engineering and technological prowess to advance greener renewable energy generation, CO2 capture and storage, and appropriate transmission grids.

Choices

In some cases, those involved in investing LGPS assets may need to choose between E, S and G.

Despite our views of Russian activities in the Crimea, Georgia, the Ukraine, or the poisoning of the Skripals and Alexei Navalny, the West could nonetheless decide to work constructively with Moscow and Beijing to use the Northern Passage to reduce shipping carbon and pollution, but do so in a way that delivers a net environmental gain.

COP26 will require joined-up cooperation across industry, government and regulators to create opportunities that motivate hydrocarbon-dependent regimes to make strategic choices more in line with Paris Climate Agreement goals.

LGPS officers, councillors, advisors, MHCLG and UK pension regulators must similarly learn to gaze beyond the investment landscape of Western capital markets and lend their support to leaders making difficult choices as they chart a path towards success at COP 26.

If the boundaries of RI and ESG are drawn too narrowly, we may find ourselves in an echo-chamber of like-minded parties who grow increasingly detached from developments in the real world. As the Vostok Oil example shows, rather than depriving state-sponsored enterprises of capital, we would simply deprive ourselves of any possibility to exert a positive influence. We must take care not to let ESG and RI-tinted thinking become the walls of our own Potemkin Village.

Elizabeth M. Carey, CFA, works as an independent advisor and research analyst for local government pension schemes. She spent much of her previous career working in corporate finance and capital markets in New York and London, and subsequently worked as an in-house M&A banker for GE Capital in London. The views expressed in this article are her own.

Photo (cropped) by Annie Spratt on Unsplash