How European ESG investors helped Putin fund his war on Ukraine

0:12Simoney Kyriakou: Hello and welcome to the latest episode of Margin Notes with me, Simoney Kyriakou, editor of FT Advisor. We've been talking a lot about risk the past few weeks on Margin Notes, AI risk, cyber risk, crime risk, financial modelling and corporate risk. But today, we are talking about a different kind of risk, the risk of investing into autocracies. We're familiar by now with economic sanctions, which is one of the defining features of how investors penalise authoritarian regimes for their war crimes. But we may not be so familiar with the investments we have made that may have actually helped regimes to breach human rights.

0:53Simoney Kyriakou: Conflict-driven capital has been flowing in and out of investment funds, raising financial crime risk. Many organisations and end investors are exposed without realising it. Scrutiny is intensifying across ownership structures, transactions and counterparties. But what if the people running those funds knew they were benefiting from conflict-driven capital? Well, a new research paper from the University of Buckingham has uncovered uncomfortable truths when examining European ESG funds. Hundreds of these supposedly ethical or sustainable funds were, in the run-up to February 2022, putting money into companies that helped Russia prop up its machinations of war against Ukraine.

1:42Simoney Kyriakou: This is the thesis of that paper. And there is evidence that ESG investment funds even increased their Russian exposure in January 2022 in the lead-up to the invasion amid intense media coverage. Clearly, there are huge consequences in such allocations, including the human rights implications they present. And the onus is on ESG managers to make sure that what they are investing their clients' money in matches the values of the investors putting their money with them. But how can ordinary investors and advisors know exactly what their ESG-labelled funds are investing in? And what measures should they and regulators take to make ESG funds toe the line?

2:21Simoney Kyriakou: Well, joining us to talk today through all of these things and more is Sergei Christo. He's known as the Westminster whistleblower. He's the author of the paper and PhD researcher at the University of Buckingham. Sergei, welcome to the show. Thank you so many very much for having me. Thank you. So firstly, tell us a little bit about your paper. What's it called and where can we read it? Well, the paper is called When Green Turns Red, Security Implications of Sustainable Investments in Russia. It was published as part of a security note at the Centre for Security Intelligence Research at Buckingham University.

2:57And it comprised my research, which took about a year to complete, at the Brussels School of Governance, where I did my master's on this topic. And you are absolutely right. I mean, the onus for deciding whether investment is sustainable or not is on both regulators and product providers. And there are clearly, we know that the current SFDR regime, even according to the European Commission itself, isn't fit for purpose. But mysteriously, probably some of it is due to, you know, war in Ukraine and the priorities that the European Parliament and Commission are facing at the moment. The reform has been delayed to at least 2027.

3:47But that makes this subject particularly topical because there's a policy implication of some of the findings that I've tried to highlight in my paper. And I think it's for all of us, the industry, all the stakeholders, the investors and the regulators, you know, try to push this in the right direction. I mean, obviously, most of the funds that I've highlighted, although they are rated through this European classification framework of sustainability assets, which is called SFDR, but most of those funds are registered for distribution in the UK and available to UK investors.

4:28Simoney Kyriakou: So what prompted you to look at these funds? What gave you the idea for your thesis? There is a story. I came across it in one of my previous employments. I spent about 20 years in asset management, mostly in the UK. This is an interesting story, which unfortunately, for legal reasons, is not yet to be ready to be told, but I'm working towards it. Sorry, listeners. That's all right. Hopefully, I will be able to do it at some point. And although my own experience that I've just mentioned, maybe it's probably one of the worst cases that I've seen in the industry. I mean, to be honest, you know, in my 20 years, I hadn't seen anything like it.

5:14But I wanted to establish, after I recovered, my mental state after that, I wanted to establish how widespread that practice was in the industry. And that was the objective of my research. And I found that it was, you know, about, you know, around maybe 5-10 % of all SFGR Article 8 and 9 funds had Russian exposure in the six months prior to the Russian invasion of Ukraine in February 2022.

5:46Simoney Kyriakou: I mean, this is absolutely shocking. We're talking like over 400 ESG-labeled funds? Yeah, so they're Article 8 and 9. So Article 8 are those funds that, to put it simply, they should be filtering out non-sustainable assets, entities. And Article 9 are those that are actively focusing on sustainable assets. So they should have a sustainability objective in them. And interesting, actually, the Russian exposure was higher for Article 9 funds than Article 8. Don't ask me why. I mean, obviously, this is a very top level. There are lots of questions that could have been answered with this. I only scratched the surface.

6:29There could be a lot of number crunching with this data. I'm extremely grateful to Morningstar, who, after some persuasion, actually delivered data, which proved to be robust because I checked with every data provider. I mean, a couple of them refused to comment, but most of them were. And apart from small inconsistencies, because Morningstar claimed initially that they could only provide data based on current SFGR ratings, not historic. So we had to double check. But apart from maybe two or three cases, you know, the data checked out. It was robust.

7:07Simoney Kyriakou: Of course, and fun fact sheets are there on the internet and there are archives and the internet is not a place where you can hide things easily for the person who's doing research. But before we get right into the paper and some of the findings, could you talk a little bit about the theory of interdependence? Yes, that's how I kind of frame theoretically my research. And I think it's relevant to sustainability because there's a liberal interdependence theory, which basically says that when countries, two countries invest and trade with each other, invest in each other and trade with each other, it reduces the possibility of conflict between them.

7:45And that's what the post-war European framework was actually based on, you know, European community, European Union. The problem becomes when that interdependence becomes dependency. First, it becomes asymmetric interdependence and then becomes dependence. And actually, theory proved that when that happens, conflict actually becomes more likely. So we saw that in the case of Russia. So when first Germany and then it spread across Europe historically, the continent became increasingly dependent on Russia's energy. That meant that, you know, those human rights abuses in Russia were tolerated. Europe would, you know, pretend it's not seeing it or maybe say something, but actually not do anything about it.

8:38And that allowed Russia to quietly, quietly build its military ambition. And we know from history that autocratic regimes survive by aggression. Ultimately, they have to attack someone because they maintain their power by saying to its populace that there is an enemy. And, you know, they have to make themselves separate from everyone else in order to survive. And then in the end, they do have to attack someone. So sustainability is about the future. In the way, you know, in my paper, you will see lots of most of the companies, the overwhelming number of the companies that I've looked at, they were sanctioned after the war.

9:23But if you actually read the sanctioning documents, you can see that the reasoning is mainly describing a situation before the war. something that was known publicly. It's like, for example, the bank funded a campaign by GRU, which is Russian military intelligence, to interfere in the first election of Trump. And that was in congressional documents, in investigations. Yeah, widely reported. Yeah, and part of the Mueller report. So that was before, that predated Ukrainian war. But still, sustainable funds continued to invest. when the concept of sanctions was born in the early 20th century, sanctions were meant to be preventative.

10:04Now they're mostly used after the fact.

10:07Simoney Kyriakou: Punitive. Punitive. But sustainability is in a way, it's very similar to that original concept of sanctions, I think. It's all about the future. And, you know, it's also linked to ESG, so environmental, social, and governance factors. And if you look at the companies in which sustainable funds invested in the six months prior to the six-month window I've chosen before the invasion in February 2022, you will see that most of those companies actually break the standards on all three, on environmental, social, and governance. So, for example, an oil company would be a major polluter. on social it would support you know be partially owned for example by russian government providing be a very important revenue earner for for that autocratic regime which actually related to social objectives and on governance you know had a most of these companies if not all had established a history of corruption which of course also is contrary to um to principle 10 of the um UN Global Compact.

11:18Simoney Kyriakou: Yes, of course. And investors who put their money into ESG funds usually do it not because they know about sustainable investment or the future or renewable energy, but because they have strong values and they want to invest in something that meets their values. And most of them would be horrified to know that they're investing in companies that have helped aid and abet the war machine. So I think you referenced also a steel maker that was actively involved in helping to create arms that were then used against Ukraine. Yeah, there were several of them. I mean, Seversthal, which, for example, you know, is a very well established track record of producing steel for Russian and before that Soviet weapons manufacturers, Second World War, nothing really have changed there.

12:08Simoney Kyriakou: Could investment managers have said they didn't know anything about these safeguards? You know, Does SFDR sort of contain any sort of safeguards about human rights issues that perhaps these fund managers should know about? Well, of course, the criticism is that those international frameworks on human rights, they present such a broad consensus between various parties that it's really easy to go above them, beyond them, on the left, on the right, in terms of various loopholes, because the definitions are so broad and unenforceable. However, the SFJ Article 18 includes minimum safeguards on complicity in human rights abuses through Organization for Economic Cooperation and Development guidelines for multinational enterprises and the UN Guiding Principles on Business and Human Rights, both of which prohibit complicity in human rights abuses.

13:00Right.

13:02Simoney Kyriakou: And is there then a sense in your article, in your research, could investors like me been unwittingly complicit in human rights abuses by having money in these funds? That's, I mean, for me, you know, this is the most horrifying thing because the money that funded this didn't come from some mysterious evil source from some, I don't know, evil banker somewhere. Yeah. Some James Bond villain. It came from our pensions and investments. If you ask anybody, a parent, you know, saving for their children, maybe trying to put something for their school education or, you know, help them to go to get through university or buy a new home or, you know, pension holders.

13:47if you ask them, would you like, you know, particularly those that explicitly chose a sustainable investment option, if you ask them if they expected their money to be put towards something like that, I think overwhelmingly the answer would be no. But when I questioned on this, questioned on this, the SFDI team at the European Commission prior when I was scoping my research, I realized that they haven't actually proactively gone to end investors to consult on this.

14:20Simoney Kyriakou: Right. You know, everything we've heard about lobbying at the European Commission and the engagement with fund providers and industry itself at the expense of end investors is actually absolutely true. You know, there's an NGO called European Observatory in Brussels that does very good reports on this. So, for example, when I was already researching, a few months into my research, the European Commission published on their website asking investors to give feedback if they wanted to, but they haven't really reached out proactively to them. You know, nobody went to the groups, but all the money that's being spent by fund providers through their investment associations, et cetera, various trade borders at the European Commission to engage with the SFDI team, all that is happening.

15:07So it's an asymmetric situation here when I think commission, which is funded by taxpayers, is actually representing people at the expense of taxpayers.

15:20Simoney Kyriakou: Yes, of course. And the taxpayers are not getting their voices heard. And some of these consultations are worded so complicatedly, I don't know if that's a word, that it's hard for the average person, the average investor, to be able to make a representation on their own behalf. so they do rely on fund managers and other people to be able to do that for them. So obviously if the end investor is going to be absolutely shocked and horrified, as you said, that their money in the build-up to the war in Ukraine may have actually helped Russia fund its machinations of war, could we say that this investment was just incidental?

15:56Simoney Kyriakou: Could fund managers have said, look, we only were investing on best-of-breed basis, we were actively engaging with companies? what indicated that ESG managers knew there could be problems? I noted in your report, you said some increased their Russian holdings in December 2021 as governments publicly warned of an imminent invasion. Could you talk about some of the sovereign debt investors and some of the investors actively putting money right up to the run-up of the invasion? That was quite, I mean, this is something which I looked at first. My kind of hair almost stood up. And that was one of those maybe very few moments.

16:33The rest was fairly, you know, the results I got was fairly predictable. I mean, I expected, but that was really made me kind of take it. I did a double take when I saw this. I first saw it in the fact sheet of one of the fund managers, and then the data confirmed that it was actually a trend. So on the 7th of December, the White House publicized a long video call, which President Biden had with Putin, where he explicitly warned him of the consequences should Russia invade Ukraine. Following that, sustainable funds increased their holdings in Russian sovereign debt. So just to remind people, there were sanctions in place after annexation of Crimea in 2014 on hard currency, Russian sovereign debt.

17:34But for some unbelievable reason, they left Russia denominated debt, which, you know, you would understand if some funds that are not SFDR, Article 8 or 9, you know, they wanted to, for some reason, index funds or whatever, had some exposure to that. But you had actively managed sustainable funds that maintained, both Article 9 and Article 8, maintained that exposure. In one example, I saw a fund which actually had on its fact sheet, in the fund objective, a statement that it seeks to support democracies around the world. And it had about 10 % in Russian debt.

18:17Simoney Kyriakou: 10 % of the funds holdings were in Russian debt. Yeah, which was a very actively positive compared to the benchmark. I think the benchmark was about 3 or 3 point something percent. And why was the Russian government issuing debt? To get money to fund its war on Ukraine? Yeah, but you may argue maybe it's not freshly issued debt, but if you invest, it supports the price in any case. We know how the market works. So they clearly saw an investment opportunity and meant for it, just as Ukraine was gearing up to be invaded. Yeah, for them it was a price signal. So when the price fell, they thought it was a good time to buy.

18:56Simoney Kyriakou: And this is an SDFR sustainable fund. That's absolutely shocking. Most of these companies now have been sanctioned and investors can't invest in them. UK investors can't invest in Russia directly. But are any of the non-sanctioned companies still being invested in within these ESG funds, to your knowledge? I know that some people who contact me about this research, they're looking at China, for example. And I think, you know, the implications on this interdependency thing should be really quite impactful on how we actually treat autocracies around the world. It's a very painful subject. I mean, we know that in this country, in the UK, there's a lot of criticism for the current government sort of cozying up to China.

19:51For me, I mean, I recall how the Cameron administration justified its, you know, getting closer to the Putin regime in, you know, when Cameron took a plane full of British businessmen in 2011, I think it was, to the Kremlin when Medvedev was president and Putin was prime minister. uh temporarily um and i can see the same narrative is being used now uh in relation to china you know it's too big it's it's too important to ignore we have to continue talking to it all exactly the same um narrative and at the same time we know that you know there is a risk that china might blockade or invade taiwan uh and you know what would then happen to all these investments you know there's a lot of pension fund money.

20:44Also, China keeps a lot of its currency reserves in the EU. So these are risks. In terms of the interdependence theory, China wouldn't have become such a powerful geopolitical actor if we didn't basically buy things from it.

21:01Simoney Kyriakou: Yes, of course. But there is obviously a difference between an investor wanting to take the very best investment opportunities from around the world, and an ESG investor who should theoretically be prepared to accept slightly lower returns for a slightly longer term gain in sustainable, forward-thinking, values-driven companies that match their own values and visions. But that's not what we're seeing at the moment. We're seeing ESG funds making these overtures to autocratic regimes. If you ask me, you know, what it reminds me of, if you remember what triggered the global financial crisis was structured debt, you know, bad housing debt in the US was packaged up.

21:43It reminds me a little bit because from what I saw during my time in industry was, in a particularly grievous case, was I think they were just lazy. And they knew that if they managed to include a higher yielding or, you know, an asset which has a higher prospective returns, future returns in equity. And it would have the effect of lifting the overall return of the fund a little bit. Then when sustainable investors or their advisors look through the league table on Morningstar, whatever, their fund would stand out. It would look like it's the packaging thing.

22:30Simoney Kyriakou: They don't mind investing in these things as long as they're getting some money out of it. Yeah, but we know what sustainability rules are. We know that, you know, European Commission and perhaps we all should try to push the European Commission to develop rules which are clearer and more enforceable. But failing that, there are several mechanisms for investors and their advisors to see how, you know, what they're actually investing in. because SFDR is all about disclosure. The idea is that if ordinary investors knew what they're investing in, they would then decide whether they want to invest in that fund or not.

23:12And there are several things accessible now. For example, the Human Rights Foundation in the US, which organizes the Oslo Freedom Forum each year, they've just launched earlier this year an autocracy tracker, or tyranny tracker they called. Yes, which they basically, on their website, there's a mechanism. I don't know whether it's available for all the funds in all the countries, but you can put the name of your fund and then see the exposure to tyranny. There are also things like, you know, there's an index, Freedom Index, I think it's called, in the intelligence, Economist Intelligence Unit.

23:52We know that, you know, if you want to know how a specific country, so that's more for asset managers. If they have any doubts on what country they're investing in, Freedom House in the US publishes a report. And the heat map, yeah. Yeah, exactly. So there are various resources that you can use and advisors can use. Perhaps, you know, high net worth individuals that they're really concerned about, most of them would have a financial advisor and they can actually ask them to check. So there are ways of doing it even if legislation fails.

24:27Simoney Kyriakou: Absolutely. And that whole aspect of greenwashing, I mean, we're hoping that regulation will prevent that. And the UK has been very robust recently on greenwashing. And it's just a shame that the European Commission's reforms to its sustainability framework have been pushed out to next year. But what are your hopes for, let's try and get some positive, what are your hopes for the reforms to the sustainability framework? Well, there are two things, obviously. Legislation, what each investor can do and their advisors. And on that, I mean, despite spending, you know, having worked in the industry for 20 years, I'm afraid I still have remained a hopeless idealist.

25:10I know there are lots of cynics around. but personally I'm taking my research I've taken my research to PhD and what I've decided to do as part of my PhD is to develop a research model for asset managers to help them filter out those entities that carry unacceptable risks for democratic security so my research would go into case studies of different entities deep diving into detail how that Western money helped exactly, you know, with their production, what was the result of those investments. And then trying to work out, to draw the lines, where do we draw the lines? Because, you know, if you look at the banking sector, for example, where do we draw the line?

25:54Most banks equip oppressive regimes, you know, large banks. I've formed a small group of supporters who included some of my colleagues in the industry. There are lots of stories connected to that. For example, I think about three fund managers walked out and actually retired early in protest of how the funds that their own company sold and supervised under the pretext of sustainability actually did not stick to those principles. And my secondary supervisor of my PhD is someone called Marcos Buscaglia, who now teaches Columbia Business School, but is an Argentinian economist who wrote a book, Beyond the ESG Portfolio, how Wall Street can help democracy survive.

26:42And he's actually a sovereign debt specialist. So he looked at, you know, how basically Mark is completely disregarded human rights when they invested in Chinese debt and, you know, Turkish, Russian and so on. And he's now helping me, which I feel very privileged about. And the other thing is, you know, I've just come back from Lithuania when I spoke to my friends in the parliament and government there. and Lithuania is taking over the European presidency, the presidency of the European Union next year, which is 27, you know, 2027, which is the year earmarked for this SFDR reform. So I've been trying to interest them in that as well because I think, you know, there's a clear link between what's happening in Europe and geopolitical risks we're all facing and sustainability.

27:32And I think maybe it's a chance of a lifetime to put things right.

27:35Simoney Kyriakou: Absolutely. A chance of lifetime sounds fantastic, which is a really positive note to end on. But just to remind advisors that clients can also have an impact now. They can walk. Money can walk out of these funds until fund managers do it. And when you hurt them in the pocket, that's when they start changing their ways. But Sergei, thank you so much for coming to talk to us about your paper. Thank you so much indeed for letting me speak to you. And thank you for listening. Until next time, take care. Thank you.