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A Gazprom Neft oil refinery in Omsk, Russia, on Feb 10, 2020.ALEXEY MALGAVKO/Reuters

Prior to Russia’s invasion of Ukraine, funds that embrace environmental, social and governance principles favoured Russian energy stocks over Canadian energy stocks by a wide margin, highlighting a key challenge for ethical investing.

According to a report from Ian de Verteuil and Shaz Merwat, analysts at CIBC World Markets, ESG mutual funds and exchange-traded funds at the end of 2021 held just US$300-million in shares of the four largest Canadian energy companies: Enbridge Inc., Canadian Natural Resources Ltd., TC Energy Corp. and Suncor Energy Inc.

The relatively skinny exposure suggests that most professional ESG investors shunned the Canadian energy sector because of its deep roots in carbon-intensive oil sands.

Yet, at the end of 2021, ESG funds held a combined US$603-million in shares of the four largest Russian oil and gas companies – Gazprom, Rosneft, Novatek and Lukoil – or twice the size of their holdings in Canadian energy stocks.

In one particularly glaring example, ESG funds were six times more exposed to Gazprom than Suncor, as the environmental profile of a Russian natural gas producer looked far more attractive to principled investors than a Canadian oil sands operator.

“ESG has been reduced to a single metric: carbon. That’s very disappointing,” Mr. de Verteuil said in an interview.

What’s more, the most popular energy stock among ESG funds – France’s TotalEnergies SE – has remained committed to its natural gas operations in Russia, even as a number of Western energy firms, such as Exxon Mobil Corp., BP PLC and Shell PLC, have left the country.

Is the focus on environmental principles, at the expense of social and governance attributes, steering investors into the wrong holdings?

Certainly, the tilt toward Russian energy over Canadian energy has likely dragged down ESG fund performance.

Western sanctions against Russian exports have derailed the country’s economy, leading to a collapse of its capital markets. The biggest four Russian energy stocks have plummeted by an average of 85 per cent this year, before the suspension of stock trading weeks ago, according to CIBC.

However, the Canadian energy sector has gained about 35 per cent since the start of the year, bolstered by soaring oil and gas prices and renewed interest in domestic energy sources.

“If you stop owning an oil producer, the greenhouse-gas emissions are not going to go away,” said Saurabh Suryavanshi, the Vancouver-based portfolio manager at Dixon Mitchell Investment Counsel.

He has invested in Canadian energy companies that look attractive from an ESG perspective because they have reduced their carbon intensities and have linked executive compensation to better ESG scores.

Russia’s invasion of Ukraine, Mr. Suryavanshi said, does not change the profiles of Canadian energy companies – but prospective returns have improved.

That could weigh on the popularity of ESG funds.

The CIBC research note pointed out that money flowing into ESG funds, after accounting for outflows, was already slowing substantially prior to the war in Ukraine. Net inflows in January and February were down by 56 per cent compared with the same months last year.

While ESG funds captured an amazing 45 per cent of global net equity fund flows over the past three years, this share has since slipped to just 20 per cent.

Part of the reason is that outflows have been picking up across different investment strategies as markets turn volatile, and ESG funds are not immune to the trend.

But performance might also be playing a role here.

Since most ESG funds tend to shy away from energy stocks, they are underweight a sector that has been performing very well in 2022 – leaving them potentially lagging diversified benchmarks like the S&P/TSX Composite Index.

“So as much as investors claim to be focused on ESG, you give them two years of bad performance and they’ll review the ESG concept,” Mr. de Verteuil said.

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