Many larger rated Russian companies are well placed to tackle immediate environmental, social, and governance (ESG) challenges. Under pressure from international investors, they are flexing their ESG muscles beyond unambitious domestic regulations and aiming to capitalize on the new opportunities that ESG presents. The Russian government and some domestic banks are also finally moving ahead with developing a national ESG regulatory framework. This evolving framework reflects the difficult balancing act between subscribing to the global ESG agenda, and dealing with the realities of a carbon-intensive local economy. As a large exporter of oil, gas, and coal (13%, 26.1% and 16.6% of global exports and 12.1%, 17.0%, and 5.4% of global production in 2019, according to BP Statistical Report), Russia is exposed to ESG trends in the following ways.

The future of Russia's vast and largely export-focused oil, gas, and coal sectors is a key uncertainty.  They account for about 20% of GDP, around one-third of general government fiscal revenues, and up to 60% of goods exports. In 2019, before COVID-19-related shocks to demand and prices, Russia's exports of oil and oil products was US$121.4 billion and US$66.9 billion, pipeline gas $41.6 billion, and coal $16.0 billion. The energy and transport sectors are responsible for more than 78.9% of GHS emissions (source: 2017 National Cadaster) followed by industry (10.8%), agriculture (5.9%), and waste (4.4%). We do not expect a significant increase in economic diversification in the next decade given global demand inertia and Russia's rigid domestic institutional framework. Whether or not a subsequent disruption is on the horizon is difficult to predict.

Russian companies are already feeling investor-led ESG pressure.  Their access to international capital markets depends on their ESG characteristics, and domestic banks are also gradually becoming more ESG-aware. Despite sanctions that constrain access to some types of funding for certain Russian issuers, large companies are feeling ESG-related pressure from investors. Although some Russian officials have argued that environmentally friendly projects and entities should be exempt from sanctions, we do not expect this to gain traction. For example, aluminium producer Rusal emits relatively low CO2 levels in its smelting process, by global standards, because it uses carbon-free hydropower. It was included in the OFAC sanctions list in 2018 because of controlling shareholder, Oleg Deripaska. The U.S. took Rusal off the list in 2019 following changes in the company's ownership and governance, and regardless of its environmental characteristics. On the other hand, lack of environmental progress can lead to divestments, like when Norwegian Pension Fund exited its holdings of Norilsk shares back in 2009.

The proposed EU carbon border adjustment presents the most tangible near-term risk.  The EU could table its proposal for the carbon border adjustment mechanism (CBAM) as early as this year. Although the EU is yet to decide the exact mechanism, some estimate that it could cost Russian exporters (especially in the metals and mining sector) €3 billion-€6 billion annually.

ESG risks are already proving costly for Russia, and globally.  Russia is no exception when it comes to ESG costs. For example, after the fuel spill in 2020, Norilsk faced a RUB148 billion environmental fine (about 27% of its 2019 EBITDA). It continues to appeal the fine, but the fine reduces the company's net income and therefore 2020 dividend, which helps to smooth the impact on its financial metrics. In 2019, Russia's average temperature was 2% above average, and about 3-4 degrees Celsius in some northern regions, compared to the about 1 degree global average. This is leading to lower heating sales in winter, plus additional costs for freezing melting permafrost or addressing logistical difficulties in areas where "winter roads" are now available for a shorter time. Longer term, the possible environmental effects include melting permafrost, intensifying wildfires and floods, decreasing biodiversity, and deteriorating health of the population.

Russia's Average ESG Standards Are Low, With Big Differences Between Companies

While ESG standards in Russia are relatively low, especially if compared to EU countries, the largest industrials and financial institutions are starting to pay more attention to ESG factors. Many are feeling pressure from international investors and are significantly exceeding national ESG requirements. Some are pioneering improvements through various forums involving government representatives and regulatory bodies.

Russia averages moderate social standards, but these can vary significantly between large companies and smaller players. Large companies often spend meaningfully on corporate responsibility, are mindful of avoiding wide scale job cuts, and score well on gender equality compared to emerging markets peers--a positive Soviet legacy. Strikes or conflicts within local populations are very rare.

We view Russia's governance standards as weak on average, again with significant variations from one company to another. Corruption and rent-seeking are perceived as comparatively high; Russia ranks 137 out of 180 on Transparency International's 2019 Corruption Perceptions Index. The enforcement of laws and contracts is selective. That said, we note that many large rated companies have strengthened their governance practices by inviting independent directors to their boards, regularly publishing detailed IFRS statements, and gradually improving sustainability disclosures.

Russia is responsible for about 5% of global GHG emissions because its economy is skewed heavily toward carbon-intensive industries. Despite lacking an ambitious climate rhetoric, Russia has managed to significantly reduce emissions in recent decades (chart 2). According to Russian government data, the country's 2017 GHG emissions were only 51% of the 1990 level if land use, land use change, and forestry (LULUCF) are included, and 68% without LULUCF, thanks to coal-to-gas switching and considerable efficiency improvements compared to the Soviet era, at a rate comparable with EU peers. Still, the national goal to reduce emissions to 70% of the 1990 level (with LULUCF) by 2030 (in line with Presidential Decree 666, Nov. 4, 2020) is anything but ambitious, effectively conserves the existing energy mix, and allows for a significant increase in emissions from current levels (see charts 1 and 3).

For the next five-to-10 years, we see most Russian companies as relatively well positioned compared to international peers thanks to currently adequate emissions metrics, generally low costs, and lower ESG pressures than European peers in particular. In our view, the key uncertainties lie further ahead. Much will depend on how Russian companies respond to global ESG pressures and whether emerging local regulations will sufficiently align with international ones.

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Low, Flexible Costs Make Russia's Fossil Fuel Producers Profitable Despite Global Demand Risks

Even if oil, gas, or coal demand peak in the coming years, demand inertia is inevitable--so the subsequent decline will not happen overnight. In 2019, fossil fuels were 84% of global energy demand and 74% in the EU (according to BP data). Although Europe is leading the global energy transition, S&P Global Platts Analytics expects Europe's gas demand will only decline by less than 1% per year in the next decade. Although coal has been hit the most by the global energy transition, and COVID-19 in 2020, Russia's seaborne coal exports were roughly flat because growing exports to Asia-Pacific (APAC) significantly offset the sizable drop in exports to Europe. Meanwhile, the International Energy Agency estimates that, in 2020, global investment in fossil fuel declined by about 30%, which will hit future supply. Long reserve lives will help Russian and Middle Eastern hydrocarbon producers to stay in the game. In January 2021, S&P Global Ratings revised its assessment of global oil and gas industry risk, triggering CreditWatch placements on several oil majors, and affirmed the ratings on Russian oil and gas companies (Gazprom, Rosneft, Lukoil, Gazprom Neft, Novatek), reflecting their relative resilience to mounting industry risk.

Most rated Russian producers of oil, gas, and coal are better positioned than their European or U.S. peers thanks to low costs, vast reserves, solid and stable domestic demand, and relatively manageable ESG-related operational pressures at home. While international oil majors are increasingly looking to diversify into renewables (for example, BP has announced plans to reduce hydrocarbon production by 40% and increase renewable production 20x by 2030), Russian companies, together with Middle Eastern producers, aim to continue supplying the declining global market. Russian companies also benefit from strong and stable domestic demand for gas, coal, and oil. With domestic gas consumption of 444 billion cubic meters in 2019 (according to BP), Russia is one of the world's largest gas markets (11.3% of global gas consumption, ranking third after the U.S. and EU and currently ahead of China). Stable regulated or quasi-regulated domestic prices that cover the gas producers' operating costs, and often capital expenditure, have had a stabilizing effect on Russia's gas producers despite global gas prices hitting lows in mid-2020.

Costs for Russian energy companies center on taxes, export duties, and government tariffs for pipeline or rail transportation. Fossil fuel sector taxes form a large part of the government's budget. For producers, this interdependency implies a degree of natural hedge because export duties and non-income taxes are linked to revenues. On the other hand, it means exposure to often-unpredictable government decision-making on tax holidays, re-adjustments of tax rates, or transportation tariffs. For example, the profitability of Russia's coal exports to APAC largely depends on rail tariffs. We understand that the transportation of coal is not very profitable for Russian Railways, triggering constant negotiations on railway tariff discounts. We believe that, at least in the coming years, the government's large reserves and the budget rule (whereby it allocates hydrocarbon revenues above a certain price level to the National Welfare Fund) will create some cushion for the oil and gas industry. Longer term, tensions over sharing declining fossil fuel revenues between the government, infrastructure providers, and the largest producers will increase.

ESG Pressure From Investors Is Still Low, But Could Ramp Up

Currently, Russian companies face less ESG pressure from investors compared to international peers, for a start because they have less access to cheap international funding. For some of the larger borrowers (Rosneft, Gazprom Neft, Novatek, among others) sanctions already restrict access to long-term debt funding abroad. Others face soft constraints and higher funding costs than international peers, reflecting investors' perception of country risk in Russia. Most large rated Russian companies have relatively manageable leverage. The largest Russian oil and gas and coal companies are government-related entities or majority controlled by local investors, and therefore less sensitive to volatility in their market capitalization than publicly held and widely traded majors.

Still, the local financial system is not large enough to fully satisfy the funding needs of the country's largest borrowers. For example, Gazprom's reported debt at Sept. 30, 2020, was RUB4.9 trillion (US$62.3 billion). We estimate--based on banks' total size of capital and before taking into account various risk adjustments--the maximum exposure to a single name the Russian banking system can undertake without breaching regulatory limits is about RUB2.6 trillion (as of Dec. 1, 2020).

To date, Russian companies' access to domestic funding has not been ESG-contingent. In stark contrast to the EU's green €1.8 trillion post-pandemic economic recovery package, the Russian government's energy-related investments focus more on infrastructure and security of supply than on renewables or emissions reduction. Russian banks and investors remain cautious about green finance. They have plenty of "brown" assets on their balance sheets that are not easy to replace quickly. Some fossil fuel producers are also large employers and taxpayers in their cities or regions, and we think banks are unlikely to limit funding to those for social and political reasons, on top of purely commercial considerations.

But this picture could change. Foreign investors are starting to more closely scrutinize the ESG profiles of their counterparty Russian banks. Some Russian banks are gradually becoming more ESG-conscious.

Large Russian banks are feeling growing ESG pressures from investors and their international counterparties, and have started moving ahead under their own steam. In its Strategy 2023, announced in December 2020, Russia's largest state-owned bank, Sber Group, emphasizes ESG. Its plans include ESG assessments of all new corporate loans, 100% ESG-compliant corporate purchases, and bringing green energy to its branches. It is unclear whether Sber Group would use a national green taxonomy, when it becomes available, or set its own standards. Sber Group's strategy also mentions the importance of joining international initiatives such as the UN's Principles for Responsible Banking and the Global Compact on sustainable development. Sber Group is government-controlled, represents 35% of Russia's banking system by assets as of Jan. 1, 2020, and has a large free float, so its lending policy will matter a lot to corporate borrowers.

Things may start moving faster if development institutions get a mandate to fund green projects, or if Russian banking regulations introduce preferences for green funding such as a lower risk weight for green projects.

Companies need access to capital if they are to undertake growth-enhancing environmentally-friendly projects. Some examples of green finance are emerging. For example, Russian Railways issued green Eurobonds in 2019, and a first domestic green bond in 2020. Last year Sber Group issued the country's first ESG loan, to Sistema. Metalloinvest, Russia's iron ore and steel producer, raised €200 million in 2020 as well as US$100 million (or euro equivalent) in syndicated loans from international banks where interest rates were linked to ESG indicators. In 2019, mining company Polymetal raised a US$75 million sustainability-linked loan from Societe Generale, in addition to the $80 million sustainability-linked loan it raised in 2018. In 2019, Rusal raised a five-year sustainability-linked $1,085 million pre-export facility.

We believe that to retain access to international capital markets and to adjust to gradual changes at home, Russian companies need to satisfy investors' ESG demands.

The Carbon Border Adjustment Is A Sensitivity, But Appears Manageable

The EU's CBAM, which it could bring in as early as 2021-2022, will reduce the profitability of Russia's traditionally export-oriented metals and mining companies. Depending on the eventual mechanism, the effect on Russian exports could be €3 billion-€6 billion per year (BCG and KPMG estimates). We believe the CBAM will be generally manageable for Russian commodity exporters because they have low operating costs and are broadly in line with international industry peers in terms of emissions (charts 4, 5, 6). This will enable them to stay competitive compared to other exporters.

Still, the CBAM is imminent and quantifiable and, as such, could bring about changes in Russia's regulations and in companies' strategies.

With the CBAM, the EU aims to avoid carbon leakage and instead to create a level playing field between European producers and companies located in countries with less strict environmental policies. The exact mechanism is yet to be determined, but should comply with WTO rules and with the EU's international commitments. For example, the CBAM could be levied on EU imports depending on carbon intensity, or exporters could participate in an emissions trading scheme. It remains to be seen whether the CBAM will be able to capture emissions through the value chain and consider competition between various materials (for example between metals that are subject to CBAM and plastics, which are unlikely to be included in the first stage). It is also unclear whether the CBAM will be based on country average or recognize each exporter's specific emission metrics. Also, exports from countries where adequate local carbon pricing mechanisms exist could be exempt from the CBAM.

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To sum up, we foresee three major risks for Russia arising from the CBAM:

• The difference in carbon footprint between Russia and Europe will increase over time if Russia decarbonizes more slowly.
• The structure of Russia's exports to Europe is generally lower value-added compared to countries like China, and therefore more sensitive to the CBAM.
• A lack of regulatory and reporting coordination between Russia and the EU may prevent the latter from recognizing Russian companies' actual efforts to cut emissions (for example if the CBAM is based on imputed rather than company-specific emissions, or if local climate projects are not factored in).

Russia's ESG Framework Is Finally Moving Ahead

Russia's ESG efforts seek to strike a tricky balance between global ESG issues and the needs of a domestic economy dominated by carbon-intensive sectors. It is important to participate in global ESG efforts so as to protect access to exports and global financial markets for the country's largest corporates. On the other hand, the country's large natural reserves are its integral competitive advantage. It is also important to manage social situations in regions such as Kuzbass, where coal mining is a big employer and contributor to the regional economy, and to protect the interests of local energy consumers through affordable electricity bills and security of energy supply. Russia has vast fossil fuel reserves but wind and solar potential in the most populated regions is relatively low, meaning renewables are more expensive than traditional thermal generation.

After signing the Paris Climate agreement in 2015 and ratifying it in 2019, Russia is finally moving ahead with a number of key ESG regulations and policies, including the November 2020 Presidential Decree 666 on climate targets, a draft decarbonization strategy, draft legislation on climate projects, a hydrogen strategy, and others. Russia's central bank has issued ESG recommendations for market participants, green bond standards, and recommendations on climate risks for insurance companies. The government has appointed VEB (the state development corporation) to develop local Green Financing Principles and a Green Taxonomy, which it could introduce imminently. The Moscow Exchange belongs to the 100-member global Sustainable Stock Exchanges initiative. Although the change in official rhetoric is very cautious, it demonstrates a shift from treating ESG as a threat to national energy security to joining international efforts to cut emissions.

Russia's energy strategy, approved by the government in 2020, aims to monetize the country's vast fossil fuel resource endowment through exports of coal, LNG, and pipeline gas to still-growing markets, notably in APAC, as well as through petrochemicals and domestic use (chart 7). This implies large infrastructure investments in projects such as the capacity expansion of the Baikal-Amur and Trans-Siberian railways, the Power of Siberia-2 gas pipeline to China, new LNG plants, and the gasification of some Russian regions. It remains to be seen whether these multibillion-ruble investments will pay off once several large consumers of Russian fossil fuel in APAC have adopted decarbonization targets (Japan, South Korea by 2050; China by 2060).

Chart 7

Russia's energy strategy, as well as its draft decarbonization strategy and draft green taxonomy, focuses on reducing emissions through higher efficiency in buildings, power generation, and transport, with only a small gain coming from renewable generation (charts 8 and 9). The expected power generation mix is broadly stable, dominated by gas with a significant share of nuclear and large hydro, while renewables are growing from a very low base--from about 1% to about 4% of total energy output. VEB's draft green taxonomy is much less demanding than its EU counterpart. For example, VEB's draft includes coal-to-gas switching and gas-fired transport, which contribute to reducing emissions but would not be compatible with EU net-zero goals. We believe many projects that could qualify for the draft domestic taxonomy will be about traditional efficiency improvements and modernization, where emissions reduction is an additional positive but not the main purpose of the project.

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The draft law on carbon tax remains highly disputed between Russian regulators and the country's large exporters. If approved, a carbon tax would demonstrate Russia's commitment to the Paris Agreement goals and create economic incentives to invest in cutting emissions. The exporters' payments will then remain in the country and could be offset against the planned CBAM. On the other hand, domestic carbon tax will increase the burden on all businesses, including those with a domestic focus, and a lack of coordination between domestic and international regulators could double the pressures on exporters.

Regulatory harmonization is the key, but is hard to achieve

The harmonization of Russia's evolving ESG regulatory framework with international, and especially EU, frameworks is essential for Russian companies to retain access to increasingly ESG-conscious international funding. Both the Russian and EU frameworks are evolving, so dialogue will be important. Such dialogue should help avoid contradictions and limit double pressures, such as carbon taxes both at home and on exports, or the need to prepare two different sets of environmental reports. Without coordinated rules, Russian companies will struggle to monetize investments in CCUS or decarbonized exports, and invest in climate projects in Russia's regions to the benefit of the local environment. Better regulatory coordination should help Russian companies cooperate with international partners in technology development and access a market large enough to make their ESG-related investments economical--for example, producing hydrogen or renewables for domestic use and for exports.

Russia's larger corporations are at the ESG forefront

The greatest ESG push in Russia is coming from corporates, especially exporters or those exposed to international investors. They are already feeling pressure from international investors and end-customers who are looking to reduce GHG emissions in their supply chains. They are also the most likely to be hit by the CBAM in the coming years. Many are ahead of the government in terms of developing their own ESG strategies.

Most large rated Russian companies have published sustainability or integrated ESG reports for several years now. Many of the largest players have joined international ESG efforts such as the global environmental disclosure system, CDP (Gazprom, Lukoil, NLMK, Norilsk, MTS, Rosseti) and the international multi-stakeholder partnership Methane Guiding Principles (Gazprom, Rosneft, Novatek). They have also adopted company-level environmental and social policies and decarbonization goals, as well as strengthened the roles of independent directors to improve governance. For example, by 2035 Rosneft aims to prevent 20 million mega tons (MT) of GHG emissions, reduce upstream emissions intensity by 30%, methane emissions intensity below 0.25%, and achieve zero routine flaring of associated petroleum gas. In many cases, efficiency improvements in the normal course of operating and capital spending can have an additional positive impact by reducing emissions (for example, lower electricity losses in networks).

In recent months, several Russian companies have announced spin-offs or sales of their most polluting segments. For example, Evraz is considering a potential spin-off of its coal mining business. This is similar to divestments performed by international peers. Although this improves the companies' reported metrics, it does not reduce overall emissions but rather shifts them outside of the consolidation perimeter.

ESG Brings Opportunities For Russian Companies

To conclude, we believe that while ESG can bring risks to Russia's traditional and most developed industries, it also offers opportunities for companies with flexible strategies.

Renewable electricity.  In 2020, Russia commissioned 1 gigawatt of wind and solar capacity. Vice prime minister Alexander Novak has mentioned a plan to increase it to about 4%, but so far it's still about 1% of total power generation, well below the global average. Renewable generation is more expensive in Russia's Electricity Price Zones 1 and 2 compared to traditional technologies such as gas-fired or nuclear generation, and most of the country's wind resources are in scarcely populated Arctic areas. This, together with excess traditional power generation capacity and stagnant electricity demand, has historically limited investments. Still, natural conditions across the country are vastly diverse. To date, most wind and solar projects are in Russia's southern regions (Krasnodar, Rostov, Ulianovsk, Samara, Orenburg) with relatively favorable climates and significant local consumption. Russia has vast opportunities for renewable development in remote areas that depend on costly fuel logistics. Examples include Rushydro's recently commissioned wind power unit in Tiksi, and geothermal power generation in Kamchatka. We believe that investments in renewables are set to increase, albeit off a low base, thanks to ongoing cost reductions, existing support schemes via capacity supply agreements, the involvement of large international and local players (such as Fortum and Rosatom), and potential interest in green electricity from exporters or other corporate customers with ESG commitments.

Green exports.  Growing interest in ESG could, at some point, support premiums for green commodity exports over "brown" production. At this stage, these niches are not big enough. But given that buyers of Russian aluminium, steel, pipeline gas, or LNG will increasingly look at the carbon footprint of their supply chain, demand for these green features stands to increase. Russian companies' ability to monetize their investments in green projects in Russia will depend on whether local and "end-destination" regulators will recognize them. For example, EN+ Group was the first Russian company to receive green certificates I-REC for its power produced at Krasnoyarsk HPP and the Abakan Solar Power Plant (December 2020), and its subsidiary Rusal claims lower carbon emissions for aluminium smelting than global peers thanks to its use of hydropower electricity.

CCUS.  Russia has vast geological opportunities for CCUS. For example, Novatek's Yamal LNG is considering CCUS for its power generation unit, using nearby geological structures. The key uncertainty is the monetization of CCUS investments, which will depend on cost and on harmonized regulations.

Hydrogen.  Russia's energy strategy aims at 2 million MT of hydrogen production by 2035, for local use and exports. Russia has excess power generation capacity, but whether this can be used profitably for hydrogen exports to Europe remains to be seen. This is because Europe prioritizes green hydrogen (hydrogen produced with renewable electricity, which Russia lacks) and only plans to accept blue or yellow hydrogen (produced from gas or with excess nuclear capacity) for a limited period. The economic attractiveness of investing in hydrogen exports from Russia to Europe will therefore depend on the time available for blue or yellow hydrogen exports, on financial incentives in Europe, and on cooperation with large industrial users of hydrogen in Europe. Although mixing hydrogen with natural gas exports is technically possible, this strategy is subject to numerous technical, regulatory, and contractual uncertainties. Hydrogen affects a pipe's technical performance; the gas pipeline from Russia crosses several countries with different regulatory regimes, and export contracts specify gas rather than a methane-hydrogen mix. Gazprom is therefore considering producing low-carbon hydrogen in Europe, in cooperation with German offtakers. RusNano and Enel are considering green hydrogen production in Murmansk using wind power, the viability of which in our view will depend on production costs, transportation solutions, and regulations. Russia is also looking at developing the domestic hydrogen market. Rosatom and Russian Railways have announced they are piloting a hydrogen train in Sakhalin. Novatek and NLMK have said they will cooperate regarding hydrogen use for decarbonizing steel manufacturing.

Technologies.  Russian companies can benefit from fast developing markets for environmentally friendly innovations, as well as from energy efficiency improvements via traditional technologies. For example, Gazprom is looking at the production of turquoise hydrogen via methane pyrolysis. Although relatively expensive, this technology does not result in carbon dioxide emissions and is therefore potentially compatible with EU decarbonization goals.

Reforestation.  We see relatively modest potential for GHG reduction through reforestation in Russia because trees in Northern climates generally absorb less carbon compared to fast-growing and leafy equatorial flora. Still, there could be opportunities related to higher efficiency of forest management and especially fighting wildfires (which consumed 9.1 million hectares in 2020, according to Russia's official statistics). Also, it is important to clarify reporting and information flows regarding the GHG absorption capacity of the country's forests.

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