The full-scale invasion of Ukraine by a revanchist Russia continues to dominate headlines as the war enters its second month. While the sometimes-terrible choices facing those living in the conflict zone are unparalleled, investors around the world also have choices to make. Among those, ESG funds that are tasked with minimizing investment risks associated with environmental, social and governance issues find themselves with difficult – and sometimes contradictory – dilemmas.

Russia is among the world leaders in hydrocarbon extraction, trailing only the United States and Saudi Arabia in crude oil production in 2020.[1] Europe’s reliance on Russian natural gas seems to have bolstered the Putin administration’s belief that EU countries would not take strong, united action against Russian aggression, as European countries relied on Russia for more than 38% of their gas imports on average.[2] At the same time, the Russian economy is widely perceived to suffer from substantial levels of corruption, with Russia consistently ranking between 135 and 138 out of 180 countries surveyed (higher is worse) over the past decade.[3]

Given the Russian economy’s significant reliance on fossil fuel exports and persistent perception of corruption, ESG funds could be expected to have a low exposure to Russian assets. One survey by Bloomberg was able to confirm 300 ESG funds with $8.3 billion directly invested in Russia. Although this is a material exposure, it represented 6.25% of the 4,300 funds surveyed and less than 0.5% of their $2.3 trillion in total assets under management.[4]

Importantly, each ESG fund incorporates these principles differently, as set forth in the fund’s offering documents. This has given ESG funds wide latitude and broad discretion to implement ESG policies. Some funds forego certain industries, while others may invest in the “cleanest dirty shirt,” i.e., the company in a troubling industry that shows the greatest commitment to improvement.[5]

This discretion is now a source of friction in some instances, as ESG fund managers face calls to exit investments that directly benefit – or in some cases, are even tangentially related to – Russia’s efforts to expand its subjugation of Ukraine beyond Crimea and Donbass. Because fund managers can wield substantial power in the execution of a fund’s ESG policies, their decisions in some cases to delay divestment have been sharply highlighted.

The ESG funds’ conundrum arises from pressure to divest from Russian assets in a climate where Russia is being systematically isolated from the world economy. Historically, ESG funds have been able to rebalance portfolios in a market where counterparties were more concerned with returns than sustainability. In the current climate, however, ESG funds face significant hurdles finding buyers for Russian assets as sanctions now extend to traditionally neutral countries such as Cyprus, Sweden and Switzerland. For example, Blackrock, the world’s largest investment manager, recently disclosed that it recorded a $17.2 billion write-down of its Russia-related assets – nearly 95% of their value – and has suspended purchases of all Russian securities.[6]

Even funds that are not technically ESG funds have been grappling with how to best pare down investments in Russian operations. For example, the California Public Employees’ Retirement System has been assessing how to answer Governor Gavin Newsome’s call for California state funds to divest from Russia. One report indicated that CalPERS’ initial review showed that an abrupt disposal would require booking a near total loss.[7]

Further exacerbating ESG funds’ concerns has been China’s disappointing support for Russia’s expansionist endeavor. Despite decades of growing commercial ties between the U.S. and China, at least one leading ESG advisor is now warning that ESG funds should classify both Russia and China as “uninvestable.” As reported by Bloomberg, Paul Clements-Hunt, who led a group that coined the term ESG back in the mid-2000s, said “If you don’t factor in autocracy and a malevolent government, then you have failed in your ESG assessment.”[8]

While funds like CalPERS may have the luxury of at least a modicum of time to arrange a reasonable exit from Russian assets, ESG fund managers will need to revisit the terms set forth in their funds’ offering documents and, if need be, work closely with counsel to understand their ability to balance the legal requirements of their strategies and their goals of protecting and growing clients’ investments.