Key takeaways

• Russia’s aggression in Ukraine and its impact on energy and agricultural commodities have caused significant global economic disruption, which is likely to continue to be felt for some time. Ultimately, there will need to be a massive reconstruction and recovery aid effort to assist Ukraine and opportunities for well-designed financial markets to amplify this support.

• In terms of social risk, Russia’s slowness to release agricultural commodities from Ukraine has contributed to widespread food scarcity, with higher food costs deepening wealth disparities and exacerbating social inequality, not only in Ukraine and nearby Eastern European nations, but also across the Middle East and North Africa.

• Ultimately, we believe these developments may compound social and geopolitical risks, leading to further political instability and an exacerbation of mass migration that could trigger second-order economic and sociopolitical dislocations in Europe.

• In the short run, the conflict is damaging the world’s progress toward carbon emissions reduction; longer term, we think it will have helped accelerate the low-carbon transition—particularly as Europe seeks to reduce its dependence on Russia’s energy exports.
  

Looking beyond the conflict to recovery

However long the conflict in Ukraine lasts, we believe its reverberations will likely be felt through global commodity markets, political regimes, and social infrastructures for years to come. Recently shattered cities have begun to tentatively return to life as they undergo emergency renovations against a fast-approaching winter. Aid from Western nations, including pledges by dozens of sovereigns to support a comprehensive reconstruction of Ukraine’s economic infrastructure, will ultimately—and hopefully swiftly—lead to a detailed road map for financing a sustainable recovery.

Of course, although Ukraine’s reconstruction costs were recently estimated at $350 billion, we can’t yet know the final figure—particularly as it’s unclear how long the war will last and how much further civilian infrastructure will be damaged. We believe that far-reaching reconstruction will take the form of long-dated loans, guarantees, and grants that will proceed from deep reservoirs of global capital backstopped by G7 nations and supranational organizations.

The imminent conference for the recovery, reconstruction, and modernization of Ukraine should offer more clarity on how this task shall be funded. The involvement of supranational organizations such as the World Bank, the European Investment Bank (EIB), and the European Bank for Reconstruction and Development (EBRD), to name a few, is also to be expected in some form. Finally, private sector involvement can provide auxiliary support in channeling necessary funding toward a better, more resilient Ukraine. This will allow fixed-income investors to direct capital allocation where it’s needed most.

Major dislocations enhance the significance and necessity of active judgment

A highly disruptive event such as the conflict in Ukraine poses challenges for credit analysis, to say the least. With its significant economic, agricultural, and energy market dislocations, the war currently escapes the systematic, data-driven facets of our sovereign environmental, social, and governance (ESG) model—until, that is, the data catches up across each indicator and until we can reassess the impact of the conflict. Nevertheless, having an appreciation for the likely direction of ESG-related data as the sociopolitical and environmental impact continues to compound, we feel confident in making two general forecasts—one for the impact of agricultural scarcity and the second for the impact of fossil fuel insecurity.

Ukraine is famously known as a breadbasket to the world; Russia, too, is a major exporter of grains. But Russia’s blockades of Ukrainian ports halted grain exports for months until Russia agreed with Ukraine this summer, under Turkey’s auspices, to slowly unblock Ukrainian agricultural exports to the rest of the world. In addition, Russia—and Belarus for that matter—hold the lion’s share of global fertilizer exports, jeopardizing future crops on top of current global disruptions.

The volatility in the supply of grains has since caused—and is likely to continue to exacerbate—food scarcity and longer-term food insecurity affecting millions, which may intensify refugee crises and other geopolitical risks. Extreme weather conditions caused by climate change will only intensify the already bleak agricultural picture.

In addition, the conflict will either accelerate or set back the adoption of low-carbon fuel alternatives that are needed to address climate change on a global scale. That’s nothing short of existentially significant, first and foremost for the tens of millions of people who may ultimately be displaced and put at extreme risk due to the war’s impact. In the face of such turmoil, it will of course also carry a quantifiable significance for sovereigns—in terms of growth outlooks amid energy insecurity, demographic trends, and the overall liquidity and investability of their debt markets.

1 Social risks from the conflict will continue to transform the geopolitical landscape

The worst migration crisis since World War II

As of early August 2022, more than 12 million people in Ukraine, nearly a third of the country’s population, had been displaced. This has prompted it to be called the worst migration crisis since World War II. More than 6 million of these refugees—predominantly women and children—swiftly fled to neighboring countries, particularly Poland, but also Latvia, Moldova, Romania, Slovakia, Hungary, Belarus, and Russia. Of course, the housing, food, and healthcare costs assumed by these nations, and by whichever countries and cities these displaced and at-risk populations eventually call home, will be substantial. By one recent estimate, these costs could exceed $30 billion in the first year alone.

Unfortunately, 12 million is likely just the beginning of the migration wave created by the crisis. The impact on export markets for grains and fertilizer from Ukraine and Russia, while felt globally, is particularly acute in the Middle East and North Africa (MENA), where the reliance on these agricultural products is high. Even with the recently brokered agreement to resume shipping of these critical commodities, tens of millions of people who were already dealing with food scarcity before Russia’s invasion of Ukraine in February are likely to experience malnourishment as a result of the war’s substantial disruptions of the agricultural supply chain.

We see food scarcity and insecurity as a potential trigger for a major increase in refugee movements within the MENA region as well as to Europe. The effects of this on the MENA region could be predominantly negative, particularly in terms of the reduction of skilled labor forces in specific countries and the human rights implications for intraregionally displaced populations. For Europe, although the short-term impact may be negative, there could be long-term positive effects of this transfer in human capital as these migrants are integrated into communities and begin contributing to labor market growth. This assumes that European immigration policy stays more focused on welcoming temporary migrants and permanent settlers than on denial of entry based on anti-immigration sentiment.

This European immigration policy assumption is at the core of our analysis, but we treat it with caution. As a case in point, the political parties of some recent European victors have neofascist roots and offer unambiguously anti-immigrant plans for border controls, which raises the risk of negative socioeconomic surprises.

History, furthermore, suggests that a continued welcoming of displaced populations, particularly following the magnitude of displacement from Ukraine, is unlikely to occur.

Instability reigns: the Arab Spring and the European refugee crisis

A useful historical example to consider is the period involving the Arab Spring, a popular uprising in North Africa against autocratic regimes that began in 2011 in Tunisia and then spread to Libya, Egypt, Syria, and Yemen. After the political crackdown that followed in most of these countries, autocracy strengthened and democracy became more constrained, while some states collapsed into outright war zones (Syria and Yemen, for example). Needless to say, investing in the region became more of a fraught enterprise; even in the case of a more solid example such as Egypt, policy and government debt management have since revealed substantial governance risks according to our research.

The political repression that greeted the Arab Spring helped prepare the foundations of the European refugee crisis of 2015, in which 1.3 million people fled to Europe. Armed conflict was a leading cause of this mass exodus. The largest share of refugees fled to Germany, which was welcoming under then Chancellor Angela Merkel, as well as to Hungary, France, Sweden, and other countries across the European Union (EU).

This prompted a political backlash within Europe that brought the region close to adopting a critical mass of protectionist leaders bent on closing borders and reshaping climate policy in a way that promised to slow the low-carbon transition already well under way in the region.

Unfortunately, we believe the risk of a similarly extreme refugee and political crisis is high in the years ahead as a direct result of the war in Ukraine. Some of the world’s most vulnerable countries amid the Russia-Ukraine wheat shortages are in North Africa. Egypt, Sudan, and the Democratic Republic of the Congo import 82%, 75%, and 69% of their wheat, respectively, from Ukraine and Russia, while Somalia and Benin each import 100% of their wheat from either or both of the warring countries. Food scarcity across the MENA region—and the type of unrest that may follow—is part of the cycle of social and governance risk that’s emerging from the Russia-Ukraine war.

And given this impact on MENA countries, home to the world’s fastest-growing populations, the world’s primary sites of global population growth could experience rapidly rising food scarcity, poverty, and social inequality. With the prevalence—and severity—of undernourishment already much worse in Africa than other regions, we believe the war may drastically compound the humanitarian crisis in this region. In our view, these conditions could make the MENA region the largest source of mass migration in the remaining years of this decade.

Vulnerabilities in Egypt, Ghana, and Kenya

To take an example from one of two groupings of emerging markets in our model, Egypt displays unique vulnerabilities. By volume, Egypt is the largest wheat importer in the world. This means that higher import prices for soft agricultural products, such as wheat and other grains, are likely to manifest as fiscal stress that the Egyptian government and general population alike will struggle to bear.

Like many other trading partners of Russia across the commodity spectrum, Egypt will seek to diversify itself away from dependence on Russia, but this won’t be achieved overnight. Egypt’s domestic harvest season, which began in mid-April, has helped with the country’s wheat reserve accumulation from local farmers, but it hasn’t been enough to forestall rising food costs. Traditionally, the cost of food in Egypt has been a taboo issue propelling public unrest—as it did in the Arab Spring and in numerous other past crises. Given sufficient turmoil, the social and governance factors we measure are likely to register deepening weakness.

Downgrades may accelerate

Ghana and Kenya are also heavy wheat consumers, as wheat accounts for a third of their respective populations’ cereal consumption, and most of it is imported. For its part, Ghana is facing certain fiscal challenges pertaining to its deficit, which propelled Moody’s to downgrade its sovereign credit rating in March from B3 to Caa1 on a stable outlook. Standard & Poor’s and Fitch then moved in August to downgrade Ghana’s debt from B–/B (S&P) and B– (Fitch) to CCC+/C and CCC, respectively, based on a downbeat assessment of the nation’s financial profile and a variety of external pressures—including the impact of the war.

From an economic and market perspective, given the prevailing uncertainty related to agricultural product availability and sociopolitical integrity, credit ratings for these and other countries in the region are at commensurately greater risk of taking or resuming a downward trajectory. This further constrains their access to debt markets and their future ability to finance everything from infrastructure, healthcare, and social programs to subsidies against elevated food prices, new agricultural programs, and climate-adaptation strategies.

2 Today’s energy dislocations may ultimately accelerate the low-carbon transition

In addition to the potential for a protracted humanitarian crisis, the Russia-Ukraine crisis has caused major energy market dislocations that have intensified today’s global inflation problem and temporarily derailed the transition away from fossil fuels to combat climate change. But while much of Europe bears the immediate brunt of Russia’s restrictions of its energy supplies and countries that oppose Russian aggression are scrambling to shore up fossil fuel reserves to ensure energy security in the near term, there are numerous plans in motion—including in Europe—that are already accelerating the world’s long-term transition from dependency on fossil fuels. In our view, the long-term solutions to both the energy and climate challenges remain aligned.

Not every country is responding in positive ways to the crisis, of course. Higher energy prices have led some governments to increase exploration. Mexico’s government, for example, has announced that its future lies with fossil fuels and is actively taking steps to support fossil fuel-powered plants at the expense of renewable energy projects. And potentially much worse, the Democratic Republic of the Congo announced this summer that it will auction off oil and gas permits across vast stretches of its rainforest and peatlands. This move in particular could unleash a greenhouse gas emissions catastrophe, as it would threaten to compromise one of the world’s most important carbon sinks and sources of biodiversity.

Nevertheless, urgency behind energy security is also pushing companies and policymakers to move faster and more boldly to reconsider energy options that weren’t given as much attention prior to the crisis.

Renewables and nuclear power: finding the right fusion for global energy security

From a low estimate of 100 TWh to a high estimate of 200 TWh, a major portion of EU natural gas-based electricity is provided by Russia. But this is a manageable charge for solar and wind to replace under current expectations. According to the International Energy Agency (IEA), the anticipated expansion of renewable energy capacity is likely to significantly reduce Europe’s dependence on Russian gas exports by 2023.

Utility-scale solar and wind capacity expansion is on a fast track for growth, and the IEA recognizes that rapid policy implementation will be the key for Europe to meet its recently announced targets in its REPowerEU plan.

But as ambitious as all of this sounds, the current menu of renewables—which would extend to hydropower, biofuels, and geothermal energy sources—likely won’t be enough to bring about a successful global transition to a net zero emissions scenario judging by the approach of European governments. Under current technological realities and baseload requirements, the redevelopment of nuclear power is also a necessary part of bringing about a successful transition to a low-carbon future.

New and existing reactor projects are receiving a much more favorable view around the world, including in the Asia-Pacific and Europe. As noted by Reuters, the United Kingdom, which hasn’t had a new nuclear project under way in decades, recently moved ahead with funding for two new nuclear projects. Similarly, in Japan, which had turned away from nuclear energy following the Fukushima disaster in 2011, the government announced its intention to restart old nuclear plants and is reportedly considering the development of next-generation reactors. The latter produce less power than traditional reactors, but their advantage resides in their small size, modularity, and relative safety.

Yet, even with the expected new nuclear energy plants, the gap for power generation in this segment is expected to be large, not least because of the decommissioning of old plants and the significant time and resources required to bring new nuclear capacity online. As reported by the IEA: “According to current trends and policy targets, nuclear capacity in 2040 will amount to 582 GW—well below the level of 730 GW required in the Net Zero Emissions by 2050 Scenario.”

We believe sovereigns need to think in terms of a total mosaic of energy sources—and the interdependencies of different commodity producers and consumers—if they’re to collectively address energy security and climate change in a sustainable way.

The full spectrum of energy generation solutions is on the table to meet the short-term need, as illustrated by the currently intense interest on the part of U.S. and European leaders to stockpile fossil fuels, revive some coal-burning power plants, and build new liquefied natural gas import capacity in Europe. Consequently, the world is turning back toward some higher emission energy sources, but we expect this will be temporary: Governments have seen clearly that reliance on fossil fuels leads to price instability and energy insecurity, and the real solution is promoting low-carbon alternatives to encourage more investment, better policy support, and continued investment in electricity infrastructure.

Our ESG model incorporates active decision-making

Our sovereign ESG model combines historical data from a wide variety of national, nongovernmental, and supranational sources. These are innovative and dynamic data sets that we think give us a strong foundation on which to build our ESG views,¹ including our views of how the conflict in Ukraine is drastically reshaping globally material risks. Our views always include an active outlook, as we seek to assess how our model’s signals have changed over time, and may continue to change, using real-time investment judgment conditioned by long experience.

We believe sovereign trajectories are the result of the stability of the government and the quality of sponsored programs and fiscal policy. In our model’s terms, this means the measures they take to reduce social risks and reduce exposure or adapt to environmental risks; it also provides insight into the propensity of governments to manage these risks and thereby gain a measure of resilience or open themselves up to, potentially, economically transformative opportunity. Social and environmental factors frequently point to systemic risks—so it’s generally not advisable to overlook or exclude them from an investment process that aims to be risk aware; we believe they’ll rise in significance over time and can do so exponentially in times of crisis.

For this reason, we temper our analysis of ESG data with real-time judgment. We, by which we mean portfolio managers, fixed-income analysts, and members of our sustainability team, conduct a collective analysis of material external and internal changes affecting a government’s stability. And this, too, is tempered by our findings from bilateral engagements with representatives of sovereign issuers. This active and multifaceted nature of our research makes our ESG assessment less dependent on historical data sets.

The model evolves with the changing landscape of geopolitics, tracing sovereign progress or retrograde motion, and staying attuned to rapidly changing conditions around sovereign ESG risks. Taken as a whole, the model provides a powerful and carefully calibrated lens that aids us in credit risk analysis, currency valuation, and sovereign debt strategy formation.

Measuring exposure and vulnerability: environmental factor analysis in our sovereign ESG model

As with social and governance factors, our model’s framework for understanding sovereign strengths and weaknesses along an environmental axis depends on data inputs from a variety of independent sources. Likewise, it relies on our structured process for combining these inputs with independent judgment—particularly when dislocations deliver a serious jolt to the model’s systematic but necessarily slower-moving approach to ESG data.

Data underlying the model captures various environmental elements within sovereign control, from water-resource management and the energy intensity of the overall economy to how well the government addresses pollution and how well it maintains natural resources and real assets such as timberland. Alongside that, our proprietary adjustments allow us to override or supplement what the data tells us—or fails to tell us when there are material data gaps. Until the data is incorporated, our investment professionals and ESG subject matter experts are tracking the situation in real time and working together to anticipate future impacts.

Our analysis focuses on measuring exposures and vulnerabilities to environmental hazards and transition risks. Does a nation strive or fail to prepare the infrastructure of its communities to handle higher expected frequencies and intensities of storms, wildfires, and droughts? Does it make efforts to transition its economy to more sustainable forms of energy consumption, or does it assume a business-as-usual approach to high-intensity emissions? The model helps us evaluate the decisions sovereigns make, the policies they adopt, and the outcomes of their efforts to become more resilient to—or to ignore—climate-related risks.

We expect our model to register stark differences between different sovereign responses to the energy crisis stemming from the Russia-Ukraine conflict. This in turn may provide more clues about sovereign readiness to navigate long-term energy security questions while adapting to climate change. As this data flows through into the model, we’ll look for the largest magnitudes of change in E, S, and G scores and map these results with sovereign spreads and credit ratings. In practice, this tends to reveal disconnects between ESG scores and traditional credit ratings, as well as outliers from the standpoint of ESG strength/undervaluation or ESG weakness/overvaluation.

ESG risks amplify each other’s impact

As the conflict in Ukraine grinds on, which countries will be most resilient and able to navigate conditions of commodity scarcity, and which will be more vulnerable in navigating the challenging backdrop? Who is dependent on global supply chains for basic commodities such as food and energy, and who’s more insulated from these economic networks?

Sustaining the long-term prices of fossil fuels may well be part of the Russian petrostate’s objectives in its war on neighboring Ukraine, but the effects of this aggression are being felt in hyperinflated energy and food prices around the world, making the goal of commodity independence all the more imperative on a global basis.

As multi-sector bond investors, we believe it’s critical to understand ESG risks actively—to anticipate their changing dynamics where gaps open up between geopolitical events or major controversies and lagging data. That’s where a flexible and active model can help assess the potential future states of rapidly changing sovereign credit risk profiles.

1 Select environmental risk inputs include the World Development Indicators (WDI) from the World Bank; data from the International Renewable Energy Agency, an intergovernmental organization that supports countries in their transition to a sustainable energy future; and the Emissions Database for Global Atmospheric Research, a comprehensive global database sponsored by the European Commission. Social risk inputs include the WDI, the Global Gender Gap Index from the World Economic Forum, and the Global Innovation Index from the World Intellectual Property Organization. Governance inputs include WDI data, as well as the Human Development Reports and data from Revenue Watch Institute, International Budget Partnership, and the United Nations Conference on Trade and Development.