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Aaron White, vice president of sustainable investments, CIBC Asset Management.
The Russian invasion of Ukraine is concerning on several fronts. Firstly, the humanitarian crisis and its impact on the people of Ukraine. And second, the elevated geopolitical tensions that are rattling global markets as investors seek to understand the short, medium, and long-term implications of the conflict. With soaring commodity prices combined with the social and humanitarian impact, many investors are asking how the conflict will affect the environmental, social, and governance landscape. Let’s examine how ESG investing played a role in identifying the risks of the conflict and what this means going forward for ESG ratings and analysis.
The ESG analysis of sovereign entities has been up until this point reliant on factors heavily correlated with GDP. Factors, such as primary energy consumption, food security, labour freedom, human rights, political stability, government effectiveness, rule of law, and gender inequality are examples of inputs that are important when assessing a country’s ESG risk. These considerations are very slow moving and the data is available typically only on an annual basis. The situation in Russia has identified the need to rethink the process of sovereign ESG risk analysis and develop a more dynamic approach. We have seen the reaction of the various ESG ratings agencies in the wake of the crisis, downgrading Russian assets significantly. Expect rating agencies to rethink the methodology that drives the ESG country ratings and investment managers to develop more robust processes around their own evaluation of these risks.
The conflict will have significant implications for the energy markets with countries focused on solving for two distinct problems, energy inflation and energy insecurity, with the latter potentially transforming and accelerating the energy transition. The short to medium term implication is related to energy inflation and will have countries look to solve for the increasing cost of conventional energy. This will lead to short term policy changes, which we have already seen in the EU with governments pushing to keep nuclear and coal plants online past their scheduled decommissioning dates. The EU who has struggled with the inclusion of nuclear as a transition fuel over the past several years appears to be rethinking that approach. The EU will also likely ramp up its immediate utilization of liquified natural gas, as it shifts away from Russian gas. The EU currently imports 90% of the gas it consumes. And half of that comes from Russia, who also represents 25% of oil imports and 45% of coal imports.
This places pressure on the energy insecurity part of the equation as the EU appears prepared to tackle this issue. On March 8th, the European Commission took the first steps towards implementing a plan with the Repower EU Initiative. This calls for the diversification of gas supplies, conducting faster rollout of renewable gases, hydrogen being the primary candidate and replacing gas and heating and power generation. There has also been pushes to work towards producing greater energy efficiency and plans to retrofit existing homes and infrastructure. These are long term challenges that the EU faces. However, the conflict will have reverberating and long-term implications for accelerating the energy transition in Europe. North America will not be immune to the effects on conventional energy and the oil and gas sector with the focus on ESG considerations in the oil and gas business and the push for greater energy security. Canadian oil, which has long been shunned as dirty and expensive will emerge as a more secure and socially acceptable source of oil.
Canadian firms have long been leaders in ESG relative to global oil and gas peers, many of which are committed to net zero in their own operations, have robust environmental policies in place, and strong employee rights and safety. The oil price shock will rattle the North American consumer, which will likely increase demand for renewable energy and technology. For example, in the first week of March with the price of gas spiking, the Google Search trend for electric vehicles increased by 400%. Price is the biggest motivator and with the cost curve shifting in favour of alternative sources of energy, the longer oil prices remain high, the more consumer sentiment will change. This will also shift the green premium where historically consumers have had to pay higher prices for green sources of energy. We’ve already seen through technological advances a significant reduction in this premium. And with higher oil prices, it will shift to possibly a discount.
We will see greater research and development of technology and more willingness of the average consumer to invest and transition to these emerging technologies. Where the long-term implications of climate change have been an effective motivator at forcing governments and corporations to implement net zero ambitions, the conflict has created short and medium term benefits. Governments and individuals will be motivated to control energy inflation and security, which will accelerate the global transition, making our ambition for net zero by 2050 more possible. While investors in conventional energy have benefited in the short term, this may be their last hurrah.