Despite a complex domestic picture, there is growing evidence that Russian energy firms, mining companies and exporters are aligning themselves with international ESG standards.
Revenues at Risk...
Around 30-40% of the Russian federal budget depends on declining hydrocarbon revenue. Over the medium-to-long term, this creates a significant structural risk for the Russian government, for domestic industries invested in fossil fuels, and for the large numbers of Russian citizens employed in related sectors.
“The peak of [fossil-fuel] consumption may have already passed [...] the risk is rising in the longer term” - Deputy Finance Minister Vladimir Kolychev, Moscow¹
These risks are partially buffered by several factors:
Demand for fossil fuels is projected to decline slowly even in the most progressive markets - at least in the immediate future. S&P Global Platts Analytics expects demand for natural gas in Europe to decrease by 0.3% per year on average over the next decade.²
Russian firms have low production costs, allowing them to remain profitable even as revenues falter. This extends their commercial longevity.
Russian firms benefit from large and stable domestic demand. Russia houses one of the world's largest domestic gas markets (accounting for over 11% of global gas consumption).³ Moreover domestic prices are at least partly government controlled in order to ensure de minimis coverage of basic operating costs. Therefore, even as international demand for fossil fuels decline, the effects on Russian industry are partially cushioned.
Employment at Risk...
The hydrocarbon economy functions as a major source of domestic employment. Coal mining in particular provides mass scale employment in regions like Kemerovo Oblast (southwestern Siberia). In addition, fossil fuel revenue has long supported affordable energy bills for citizens. There is therefore a distinct social dimension to the way Russian energy production is currently orchestrated. This makes for a complicated picture where environmental concerns and social concerns appear, at least on the surface, to pull in different directions.
Digging a little deeper however, it is clear that while intentional divestiture from fossil fuels would present social risks (especially to employment), the transition could still be managed in a controlled fashion. Arguably far greater social risks attach to the status quo which would leave employment at the mercy of declining international demand without alternative provisions in place.
Reliance on International Funding
This leads to the central point - namely, Russia's reliance on the international market. Hydrocarbon exports account for 20% of GDP and support around 60% of goods exports. Although internal ESG pressures remain low (in relative terms), Russia is exposed to growing pressure from ESG-conscious international investors and purchasers of Russian goods.
It is true that the largest Russian corporations are often government controlled and therefore less exposed to the intensity of shareholder pressure typically faced by publicly traded companies in the West. Notwithstanding, S&P Global estimates that Russia's domestic financial system is not broad enough to fully service the needs of her largest industrial borrowers.⁴ Foreign direct investment (FDI) is therefore a necessary supporting pillar of Russian industry - and evidence shows that it is growing at pace. According to research by Santander, FDI to Russia grew from just $13B in 2018 to $31B in 2019.⁵ Continued access to this pool of capital is increasingly tied to ESG criteria.
The EU 'Carbon Border'
The EU Carbon Border Adjustment Mechanism (CBAM) currently exists only at proposal stage, but aims to artificially levelise European producers with external competitors from countries with more permissive or relaxed environmental standards. Although the details have not yet been finalised, CBAM will essentially function as a form of carbon tax that incentivises non-EU competitors to abide by EU standards, or at minimum protects EU producers from being undercut by environmentally reckless peers.
In practice this could reduce the profit margins of Russian coal and metal exporters, and will incentivise voluntary coordination with EU regulatory and reporting sustainability standards.
Commercial Impacts of ESG Pressure
The impact of ESG pressures on Russian firms actually predates the formulation of ESG as an acronym and sets the context for what we observe today. In November 2009 for example, Norway's Government Pension Fund Global divested its entire holding of Russian metallurgical and mining company Norilsk Nickel, citing "severe environmental damage" The fund's Council on Ethics noted "especially high emissions of SO₂ and heavy metals from Norilsk’s activities on the Taymyr Peninsula" which served as the "direct cause of forest death" alongside serious "health problems and illnesses" afflicting the local population of 200,000 people.⁶ Although ESG didn't exist as an acronym in 2009, it is unarguable that environmental and social concerns played an influential role in the investment process even at that early time.
Fast-forward to 2021, and we now see environmental concerns being enforced not just by investors but by Russia's courts - marking a notable escalation in the importance given to ESG factors within the domestic agenda. Norilsk Nickel has been ordered to pay a fine of 146 billion ₽ ($1.95B) relating to damage caused by a large 2020 oil spill.⁷ The scale of the fine is commercially significant (rising to 27% of Norilsk's 2019 EBITDA) and highlights that ESG pressure has grown well beyond tokenistic or symbolic gestures.
On the positive end of the spectrum, energy firms have announced large scale cooperation with international peers to deliver reform on emissions. Rosneft have just committed (4 Feb 2021) to prevent 20 million MTCO₂e emissions by 2035 and are working together with BP on joint energy transition projects.⁸ This illustrates how ESG concerns are leading to greater commercial alignment and cross-border cooperation with international partners.
Steel and mining firm EVRAZ plc (operationally Russian, though headquartered in London) may opt for a more 'tactical' response to ESG pressure by segregating out their most environmentally polluting business unit (Russian coal subsidiary PAO Raspadskaya), in the hope of retaining access to pools of ESG conscious funding. As Fitch Ratings notes, although "the carbon footprint of EVRAZ's steel production through the value chain will not change as a result of the demerger [...] carbon emissions linked to excess coal volumes will be removed from [their] operational scope."⁹ The proposal may be viewed as a weak or cynical response to ESG concerns because it externalises accountability for a portion of carbon emissions while doing nothing to reduce real-world impact. Nonetheless, the demerger would potentially unfetter EVRAZ to pursue a more aggressive decarbonisation trajectory going forwards. The externalisation of the coal mining business would relieve internal stakeholder constraints and allow the firm to act more independently in pursuit of lower emission alternatives. This is certainly a more optimistic assessment, but has merit in that it presents an intelligible forward looking perspective rather than a simple snap-shot analysis.
Finally, there are also notable examples of ESG or green financing exerting real operational influence within the domestic Russian market. In September 2019, precious metals mining company Polymetal International raised a $75 million sustainability-linked loan from Société Générale in which the cost of capital is linked to 5 key environmental and social performance indicators:¹⁰
Implementation of a comprehensive climate management system.
Ensuring tailings storage safety.
Reducing fresh water use.
Maintaining occupational health and safety.
Supporting and engaging local communities.
Just over a year later (November 2020) Russia's largest state-owned bank, Sber Group, issued its own ESG loan (the first of its kind) to Russian conglomerate PJSFC Sistema. The 10 billion ₽ credit facility links interest payments to key sustainability metrics, and follows on the back of Sistema's inclusion in the FTSE4Good Index Series two years prior.¹¹
An ESG Pathway for the Future
The external ESG pressures facing Russian firms (both regulatory and financial) highlight an enormous decarbonisation opportunity for Russian corporates. This is because Russia currently generates less than 1% of its total power from renewables - leaving a vast untapped space for green investment. By growing the share of renewables within the total mix, Russian energy providers will find a ready market of domestic industries who gain a competitive advantage by decarbonising their export products. Those industries will insulate themselves from CBAM penalties while simultaneously improving their access to global pools of ESG capital.
Comments