Week 13: So now weapons are acceptable ESG investments?

In this issue: ▸ Weapons, a new ESG investment? ▸ Defence sector corruption ▸ The failed audit ▸ ESG funds prefer Russian oil and gas ▸ Fast fossil fashion ▸ We need alternative data

Dear all, 

The days go by, weeks, months, sometimes years. People die and fight to survive.

When you sit there underground, beneath some building which you hope will resist at least the first lighter shelling, you think about how it was before. How you strolled along the river and talked to a friend. How you went off track with a girl you liked and lay in the summer grass watching the stars, smoking cigarettes, talking about nothing and everything.

Those moments become a mental sanctuary, a place to go when the different calibres of artillery (which you know by heart) start raining down above you.

Weapons, a new ESG investment?

Last week someone asked me if weapons or rather defensive weapons (as if there’s a difference…) should become a fully acceptable part of the ESG investment fabric.

I find the idea appalling. The reasoning behind was that since the geopolitical situation has changed due to the Russian invasion of Ukraine, we must now by all means necessary arm ourselves. And not only that, we should see it as an act of sustainable responsibility and as such regard the weapons industry as a fully acceptable ESG investment.

I went for a walk, a long one. And I kept asking myself if we’re losing our minds.

First of all, the same weapons and weapons systems in the hands of any army can be both offensive and defensive. It is the use, not the weapon itself that defines what it is.

Second, the military industry has never had any problems financing themselves. Most of the development as well as the contracts are long-term deals with governments.

Third, the military industry is one of the most corrupted and non-transparent industries in the world. 

Defence sector corruption

Nearly three quarters of the world’s largest defence companies show little to no commitment to tackling corruption. That’s the conclusion in a recent DCI analysis which assessed 134 of the world’s leading arms companies, ranking their policies and approach to fighting corruption from A to F.

The statistic is deeply concerning, if not altogether surprising to those familiar with the defence industry.

Reducing corruption in the defence sector is imperative to guarantee safety and security. Yet, a veil of secrecy, invoked ostensibly in the interests of national security, shrouds the defence sector’s activities. The widespread use of middlemen, whose identities and activities are kept secret, further limits oversight.

The impact of corruption in the arms trade is particularly pernicious. The high value of defence contracts means that huge amounts of public money may be wasted, instead of being spent on essential public services.

Corruption can encourage the excessive accumulation of arms, increase the circumvention of arms controls and facilitate the diversion of arms consignments to unauthorized recipients, perpetuating conflict and costing lives and undermining democracy.

According to the Stockholm International Peace Research Institute, of the world’s 10 largest importers of major arms between 2015-2019, eight countries – Saudi Arabia, Egypt, Algeria, Iraq and Qatar, UAE, China and India – are at high, very high or critical risk of corruption in the defence sector as measured by the Government Defence Integrity Index, the DCI’s sister index.

Critical risk of defence sector corruption means major arms are sold to countries where they are likely to further fuel corruption, and where appropriate oversight and accountability of defence institutions is virtually non-existent.

The findings of the DCI add to this worrying picture. Nearly two thirds (61%) of the companies assessed show no clear evidence of policies or processes to assess and manage risk in the markets they operate in.

In addition, only 10% of the companies actively disclose full details of countries in which they and their subsidiaries operate, leaving a major gap in transparency and oversight of corporate activity.

The failed audit of the Defence Department

When the Pentagon launched its first-ever independent financial audit back in 2017, backers of accountability in government welcomed it as a major step for a department with a track record of financial boondoggles. But the Defence Department failed that audit – and the next two as well.

“The Pentagon and the military industrial complex have been plagued by a massive amount of waste, fraud and financial mismanagement for decades. That is absolutely unacceptable,” said Sen. Bernie Sanders.

Despite having trillions of dollars in assets and receiving hundreds of billions in federal dollars annually, the department has never detailed its assets and liabilities in a given year. For the past three financial years, the Defense Department’s audit has resulted in a “Disclaimer of Opinion,” meaning the auditor didn’t get enough accounting records to form an assessment.

Let’s be firm on this one. Weapons and ESG don’t mix. It has nothing to do with morals, or it has everything to do with morals.

I would like to invite any financial manager in the world who deems weapons to be part of ESG to spend a couple of week shelled and shot at, just to get acquainted with the investments he/she is making.

It is a rather deeply moving experience, I can promise you that. 

ESG funds prefer Russian oil and gas

Citing a new report by CIBC Capital Markets, Yahoo Finance has reported that many of the ten largest energy holdings among ESG funds have reduced or discontinued investments in Canada’s oil sands while half have remained invested in Russia.

CIBC discovered that ESG funds owned twice as much Russian oil and gas as Canadian oil and gas at the end of 2021.

“Perhaps most shockingly, the ratio of dollars held in Gazprom was six times that of Suncor,” a CIBC analysts wrote in research published last week.

The four main Russian energy companies, NK Lukoil, Novatek, Gazprom, and NK Rosneft, accounted for around 0.2% of worldwide ESG holdings, according to the study. This is more than double the amount invested in TC Energy, Suncor Energy, and Canadian Natural Resources in Canada, according to the bank.

Fast fashion using fossil tactics

The topic of fast fossil fashion has been addressed earlier in these letters, and new reports sort of keep coming in. The latest one is this from Changing Markets.

The report found that brands are using “vague and misleading environmental claims.” Ill-defined targets are used to “to reach sustainable, preferred or sustainably sourced / made” leading to greenwashing.

The world champion of greenwashing in the fast-fashion industry is – surprise, surprise – H&M with 98% of its claims not living up to reality!

What’s even more upsetting is that brands are hiding behind “delay and distract” tactics on microplastic pollution and have for years been claiming that “more research” is needed.

The tactics previously used by the fossil industry are nowadays being used in other industries – and they still seem to work. 

We need alternative data – and we need it now

Given the current historical blunder by existing ESG data and rating providers in relation to Russia, there is significant need to further develop ESG data and sources of information to be used for decision making.

We simply need alternatives, and alternative data is big business. Globally, buy-side firms spent $1.71 billion on it during 2020, over half of all hedge funds used it to make investment decisions, and it is increasingly used to validate the sustainability claims of prospective ESG investments. 

Alternative data is not easy to define. It is not information from official or corporate sources, like account filings, financial reports or market data.  Typically, it is a form of big data from which a company’s financial health or activity can be assessed. For instance, satellite imagery could reveal the number of cars parked outside a supermarket and monitor rising or declining customer numbers to predict fluctuating revenues. 

Other examples may include mobile phone data, credit card transactions, website traffic, online browsing activity, product reviews, app store analytics, and social media content.

Used with more traditional data sources, alternative data give investors a fuller picture of a prospective investment. However, typically, the data alone is not enough.  The raw data needs to be processed and analysed, a process which increasingly is performed by AI technologies. 

As these technologies improve in sophistication and power, a wider base of data sets could be processed and manipulated to produce more meaningful, valuable and timely insights into businesses.

Social media provides a good example. Whilst it provides an enormous amount of information on the lives and attitudes of consumers, extracting reliable insights is no mean feat. As well as applying natural language processing techniques, it is also necessary to weed out the junk and any fake information. Its utility as a data set will be compromised unless one can readily and efficiently filter the credible from the noise.

However, little imagination is required to appreciate how valuable alternative data can be if harnessed effectively.

Another good example of how alternative data can be used concerns supply chains. Large public companies may have complex and international supply chains. The use of alternative data can allow investment houses to identify potential trends or future challenges to elements of supply chains. Having an insight into any single individual supply chain may not present any material advantage, but where one can attain visibility across the whole or significant parts of a company’s supply chain could allow for a significant edge.

In part, the utility of alternative data to verify a company’s ESG credentials is borne from a lack of consistent global standards around ESG reporting and concerns around the reliance of ESG scoring.

Companies own ESG performance reports can vary widely in terms of consistency, accuracy and how up to date they are.

To that extent, the use of alternative data may align with regulators’ focus on ensuring transparency and accuracy in the ESG investment market, and therefore enhance the protection against greenwashing.

Big (alternative) data coupled with sophisticated processing are increasingly seen as a means to dig deeper into companies’ actual ESG practices and outputs.

That’s all for this week. 

Kind regards,
Sasja