As in other emerging markets, environmental, social, and governance (ESG) risks are not yet a central topic for investors in Russian corporates. We expect this to change, however, and we believe it is inevitable that companies will have to address ESG-related questions from the investor community in order to maintain access to the global capital markets. Companies that deal or plan to deal with international debt and equity investors therefore have to take special care of how they manage ESG risks and how they report on them. Many will benefit from having a relatively good starting point compared to their emerging market peers, but they will need to do more.
The vast majority of Russian companies that we rate in the energy and commodity sectors publish sustainability reports, some of them having done so for more than 10 years. Still, the disclosure varies significantly between companies and is not always comparable to global peers. Based on our assessment of how companies approach ESG, environmental risks are usually their main area of focus. Social risks are primarily considered in relation to safety of operations, as other social factors retain low risk. Still, companies are gradually introducing ESG factors as key performance indicators (KPIs) for management and in some cases they are linked to pay. We expect ESG to become central to the strategy of companies in the next several years. But how are Russian companies positioned from an ESG perspective today compared to their peers?
Tackling The Growing Impact Of Climate Change Will Require State-Stimulated Investment
Although we generally assess the risk of environmental disasters as relatively low for Russia, the country has begun to feel the impact of climate change on its economy. According to Bloomberg, Russia is losing $2.3 billion every year because of the melting of its permafrost area, where Russia sources 15% of its oil and 80% of its gas. Gas producers such as Novatek or Gazprom have already had to freeze the soil to support the continuity of operations. Several miners operating in the North, notably Norilsk Nickel, will be exposed to those risks.
Climate change is having a positive economic impact for Russia as well. Global warming should now allow for all-year use of the North Sea route, which is of crucial importance for the development of oil and gas projects and could also significantly shorten the transportation route between Europe and Asia. Climate change has also aided agricultural producers in some regions. The federal government has made the importance of the environmental agenda clear, launching a national "Ecology" project (one of 13 state projects the federal government plans to implement over 2019-2024) aiming to build an efficient waste treatment and recycling industry as well as reduce air and water pollution.
Russia has meaningful potential to reduce emissions
Russia has one of the most CO2 intensive economies. It has the fourth-highest absolute level of CO2 emissions in the world (after China, the U.S., and India), but is outside the top 10 in terms of GDP. The relatively low GDP compared with absolute emission levels partly reflects the strong orientation of the economy toward exports of commodities such as oil, gas, and metals, whose production increases emissions but that are consumed outside of the country. It also reflects the weak development of industries with lower emissions, notably services.
Russia's energy mix suggests there is a significant potential to reduce emissions. Unlike China and India, where coal still dominates the electricity generation structure, Russia has meaningful low-carbon hydro and nuclear generation and sources almost 50% of its energy from lower-emitting natural gas. Given the availability of cheap gas and competitive cost of construction of nuclear power units in the country, the government has set a modest target of building 5.5 gigawatts (GW) of solar, wind, and small hydro capacity by 2024 via capacity-supply agreements, the mechanism used by the Russian government to support other forms of electricity generation as well (such as thermal, nuclear, and hydro). We think that without specific government focus to promote renewables, the current energy balance structure in Russia is likely to remain generally unchanged in the next 10-15 years.
The large capacity of Russia's power reserves (up to 20%-30% of the system total) boosts the stability of the energy supply and reduces the risk of outages but contributes to higher carbon emissions. The reliability of electricity is a key pillar of Russia's long-term energy strategy, and Russia ranks favorably in this regard in a global comparison. The World Bank has awarded Russia the highest available score for the reliability of supply and transparency of tariff index, together with France, Germany, Sweden, and the U.K. On the other hand, having this extra power reserve means higher carbon emissions, because Russia still operates a high percentage of forced generation and many of those units have not yet been upgraded. Large industrial customers can mitigate the carbon impact by constructing captive electricity generation (currently with a capacity of 10-15 GW, projected to increase), which might reduce the need to keep such a large reserve and also constrain emissions as the new units usually have better than average efficiency. Overall, we believe the path to reduce emissions in Russia lies through further economic growth on the basis of existing power generation, better capacity utilization, and higher energy efficiency.
Also supportive of emissions reduction is the profile of the Russian transportation sector. Unlike the U.S. or Brazil, where transport is a more meaningful contributor to overall emissions (36% and 47% respectively), in Russia it accounts for only 16%. This is primarily because Russia has massive railroad infrastructure and, despite long distances, trains are naturally cost-competitive for cargos and competitive for passenger transportation because of subsidies. Also, Russia has suffered from underinvestment in airport infrastructure, which until recently has dampened passenger traffic. Russia can build on this advantage and will not have to turn to measures to stimulate the use of rail, which some EU countries are considering or have already implemented through additional taxation of air transportation. The migration to cleaner fuels for car transportation should also become a driver of lower emissions.
The existing environmental framework does not force companies to invest in environmental activities
In September 2019, Russia ratified the UN Paris Agreement on climate change. However, the exact implementation mechanisms are far from complete: the guidance on CO2 emissions monitoring, reporting, and payments (if quotas are exceeded) by corporates is yet to be developed. It is not clear at this stage which industries might be affected nor the quotas and payments themselves. We view it as unlikely that Russia would implement strict quotas or high payments as many corporates would likely have to scale down production to comply, which would run against a number of other important government objectives such as increasing exports, employment and, notably, economic growth. Consequently, given the early stages of quota discussions in Russia, we consider it unlikely they will be incorporated in full in the next five years, meaning any rating impact will be limited.
Russia's existing environmental regulation is quite stringent and is primarily focused on prevention of direct environmental impact, such as spills, land and water pollution, and toxic waste utilization. Still, there are two significant issues with enforcement. First, some companies apply for temporary permits to violate certain norms on a regular basis, and the regulator might issue such waivers for years. Examples include the largest water utilities in the country, Mosvodokanal and VKSPB, which failed to comply with several maximum permissible limits in sewage treatments. It will take many years for the companies to achieve a sustainable improvement in this area. Second, the penalties for noncompliance with imposed ecological standards are very low, and many companies treat those as a routine part of operating expenses, as investments to comply would be significantly higher. The Moscow airports, for example, have been dumping some chemical waste into the nearby rivers for years while not investing in a long-term solution. We understand discussions to meaningfully raise the fines are ongoing, but it is unclear whether the outcome will stimulate a meaningful reduction in environmental impact.
The environmental regulatory framework has been developing in Russia to mitigate these issues. In 2015, the federal law on environmental protection was updated to reflect the transition of the largest industries to higher ecological standards on the basis of the best available technologies. It requires a selected 300 corporates to obtain "complex ecological permission" (CEP) by the end of 2022 that details and limits all the monitored wastes and polluting agents. A further 7,000 firms will need a CEP by 2025. If an entity is found noncompliant with those limits, it will have to develop a relevant modernization program to reach compliance within seven years (or 14 years for monotown enterprises and strategic entities). The regulator might issues waivers allowing the limits to be exceeded while the modernization programs are undertaken, which could be significant because the timescale for the changes (including equipment upgrades) is long term, and the positive environmental impact could be delayed until closer to 2030. Companies' usage of the best available technology principle is pivotal, but we think it has already been implemented by many corporates in oil and gas, metals and mining, utilities, and the chemicals and fertilizers industry in their pursuit of raising efficiency.
As such, corporates' eco-targeted investments are currently largely their own initiatives rather than being externally imposed. Many companies are interested in improving living conditions in the main areas of operation to follow the eco-agenda and also attract and retain workforce. For example, Norilsk Nickel has shut down its oldest nickel plant in the center of Norilsk to significantly reduce the material sulphur dioxide emissions; Severstal implemented a complex program to deal with the pollution in Cherepovets (where the company produces about 12 million tons of steel); and NLMK aims to complete a new captive power station by 2023 that will use converter waste gas to produce energy.
Russian oil and gas companies' emissions compare well with peers in the upstream segment, but are much weaker in downstream
Russia's largest oil and gas companies are well-positioned in terms of emissions in upstream compared with their global peers (see chart 2). This is because Russian oil and gas production is conventional, with solid pipeline infrastructure, which generally supports low emissions. Greenhouse gas (GHG) emissions per unit are in line with leading European players and significantly better than the U.S. peers. Companies' emissions levels benefit from their scale, as large oilfields generally support lower per-unit emissions, and from their generation of their own electricity based on gas, unlike many peers. Potential differences in reporting may also contribute to Russian companies' lower reported emissions.
In addition, thanks to pipeline infrastructure, gas flaring (the combustion of excess gas through pressure-relief valves) is also less of an issue for the majority of Russian companies, especially compared to the U.S., where gas flaring is very meaningful (see chart 3). Gazprom, Lukoil, and Novatek are not far behind industry leader Equinor, which committed to reduce flaring to zero by 2030. The relatively high flaring of Gazprom Neft is explained by its Novy port and Messoyakha fields that were launched a couple of years ago, when the associated petroleum gas (APG) utilization infrastructure was not ready. Sibur has been an active player in helping the oil producers to process APG. It processes about 22 billion cubic meters of APG annually, preventing extra emissions of 72 million tons of CO2.
Russian oil players are also well positioned in terms of spills, primarily due to the quality of the Russian pipeline infrastructure (see chart 4). Rosneft has relatively high spills compared to other Russian players because of its higher share of legacy brownfields, such as Samotlor or Neftyugansk. We note that the overall volume of spills for the oil majors is usually negatively skewed by operations in emerging markets, especially in Africa, where infrastructure is weaker and also because stolen oil is reported as spills.
The midstream and downstream segments of the integrated Russian oil and gas companies compare less favorably with global peers. Many Russian refineries require upgrades and are less complex, resulting in higher emissions. Russian companies also do not invest meaningfully in renewables and new energies, as they believe that oil demand will stay robust over the next 10 years with peak oil demand beyond 2040. Unlike global oil and gas majors, none of the Russian companies have public numeric targets to reduce emissions.
Metals companies' pursuit of better technology is driving more efficient energy usage
The emissions levels of metals companies depends on their production costs, and energy-saving initiatives are often the direct consequence of attempts to improve operating efficiency. Environmental exposure is significant for the metals and mining industry as a whole, as shown for example by steel and aluminum production restrictions in China, recent incidents at Norsk Hydro's Brazilian assets with bauxite deposit spillover investigation, and the Vale dam collapse in Brazil.
In Russia, steelmakers faced significant needs to upgrade outdated equipment in the early 2000s. A period of sizable modernization programs was largely completed by national champions (Severstal, NLMK, MMK, and to some extent Evraz) by 2008. This has brought tangible benefits for the companies' efficiency, which, coupled with marked ruble devaluation, has given the Russian steelmaker an evident cost advantage, locating them in the first quartile of the global cost curve. The quest for efficiency and related investments has continued since then, and the usage of best available technologies has brought the side benefits of reducing pollution and emissions. In addition, the big steelmakers have generally been pioneers in Russia in ESG disclosures, targets, and related KPIs.
Generally, Russian steelmakers are adequately placed in terms of GHG emissions compared with global peers (see chart 5). Evraz's higher emissions levels are explained by sizable in-house coal assets. This brings the benefits of vertical integration and self-sufficiency for the group (and also additional cash flows from external sales, especially in the times when coking coal price is rocketing), but results in increased average GHG emissions.
Russian metals companies have just started implementing international standards of reporting, and we expect it will take some time to adopt those consistently. In Russia, steelmakers are reporting total atmospheric emissions (see chart 6), which provides peer comparison among them, but is incomparable with internationally reported CO2 equivalent emissions in terms of greenhouse gases, Scope 1 (direct emissions), and Scope 2 (indirect emissions). We can still pinpoint elevated emissions at Severstal because, like Evraz, Severstal owns large coking coal mining operations. However, these data also have limitations since they do not fully account for the complexity of the production chain: the more value-added products you produce, the greater your total emissions.
There is potentially a risk of new trade barriers--in steel, for instance--if the EU adopts a carbon border tax. We think this risk is to some extent mitigated by the low cost position of Russian steelmakers, the even weaker environmental position of Chinese steelmakers, and Severstal's and Evraz's direct control over mining assets, which allows them to fine-tune the technological process and reduce carbon emissions.
The positioning of Russian gold producers varies meaningfully. Compared to its direct global peers, Polyus stands out in its higher level of GHG emissions, despite being the lowest cost gold producer globally. This is attributable to a sizable share of coal and diesel in its primary energy consumption structure, but also to the active ramp-up of a relatively large greenfield (Natalka) in 2017-2018. That said, the company is reducing emissions, and we believe they will ultimately even out with peers in line with the company's target to reduce them to an industry-average level.
Social Risks For Russian Companies Are Low Compared With Emerging Market Peers
We see social risks as low in Russia, which is a striking difference compared to many emerging and even developed economies. Large, even private, Russian companies always have a social mandate, which includes responsibility over the nearby infrastructure as well as creating and maintaining jobs. In return, private companies receive ongoing support from the government, creating a mutually beneficial relationship. Since the Soviet era, the main facilities of many of the biggest companies have been located in mono-cities, where the company is the only large employer. The amounts these companies spend on social activities are higher than peers in other countries, but are manageable and included in the economics of the projects. Major examples of mono-cities among rated companies include Norilsk (where the main employer is Norilsk Nickel), Magnitogorsk (MMK), Cherepovets (Severstal), and Novolipetsk (NLMK). The most recent example of a successful private-government cooperation is Novatek, which, with the help of the government, built a new city of Sabetta in the North of Russia for its Yamal LNG project.
Professional unions in Russia are not very powerful or independent and rarely push for actions such as strikes. At the same time, labor law is quite protective, especially for women. The law allows for people to be fired in certain cases, but in practice companies very rarely go for massive cuts, as they could break the social agreement with the government. Headcount has therefore been quite stable for the biggest companies, which do not actively push for new technologies to replace staff with automated processes. Instead of massive staff cuts, Russian companies usually prefer to divest noncore activities and subsequently outsource related services (for example, repairs or industrial construction), often based on long-term contracts, to manage social risks in their regions and vis-à-vis local and even federal government. The decline in headcount for Russian Railways of more than 200,000 people over a 10-year period is largely due to the outsourcing of some noncore activities. The only big employer that has seen meaningful staff reductions is former telecoms incumbent Rostelecom, where the reduction was related to inevitable improvement of technology.
The safety of operations is generally in line with global averages
Russian companies are generally in line with peers in terms of safety of operations, with only a few outliers. The main reason why some companies have higher rates of accidents is that procedures are not always followed. Russian firms generally take this issue quite seriously and in some cases safety outcomes are linked to management KPIs. Accidents at mines happened regularly in the 1990s, but since then there have been only a few major accidents with multiple casualties, which we see as an improvement. Currently the amount of accidents is lower than in comparable emerging economies. There are differences between companies, however. In mining, Severstal and NLMK have a better safety record than Evraz and MMK, which reflects their more modern assets as well as lower share of coal. The Russian oil and gas sector is dominated by conventional production, which is less complex and therefore involves less risk of injuries. This largely explains why Russian oil and gas majors report a strong lost time injury frequency rate (LTIFR) compared to international peers, which have higher percentage of higher-risk offshore production (see charts 9 and 10).
The Soviet legacy supports gender equality
Russia is a leading country in terms of gender equality in the corporate sector. Independent research indicates that Russia is among the top five countries with regards to the percentage of women in management positions (estimated at around 40% compared to a global average of 29%). This is also true for workers, where we see comparably higher percentages of women. This is a legacy of the Soviet Union, as figures are similar in the majority of former USSR countries, well above the majority of developed countries. We observe similar trends among corporates that we rate, as the largest Russian energy and commodity companies on average employ more women than their peers.
Russian labor law is generally supportive for women. For example, women that go on maternity leave are legally entitled to keep their role for up to three years, which sets Russia apart from other countries. That said, according to independent research, the discrepancy in pay between men and women in Russia is somewhat higher than in developed markets, with the pay gap estimated at 25% in Russia compared with 15% in Europe and the U.S. in 2016. Many research participants have noticed improvements in the last two-to-three years, however.
The biggest gap in gender equality in the workplace is probably the representation of women on boards of directors. Boards have historically been dominated by men, with women only gradually being added. This is not too different from the majority of the emerging markets, but Russia is still behind Brazil or South Africa and well below developed countries. Our analysis of the 30 largest companies that we rate in Russia indicates that only 8% of board members are female, which is consistent with the broader data research recently conducted by Ernst & Young. We also note that comparable companies in emerging markets have achieved more progress in this area. Russian GREs are particularly slow to improve. We think it will take time for Russian companies to achieve gender equality in board representation.
Governance Is Improving, But Remains An Important Credit Factor
Governance has historically been an important rating driver for Russian corporates, in some cases leading to defaults. The situation has somewhat improved overall, notably for the largest companies that we rate. Our overall assessment of high governance risks for Russia recognizes the risks for all companies operating in Russia, such as corruption or selective contract enforcement, which are greater for smaller companies. The overall assessment should therefore not be seen as inconsistent with the fact that we assess only one Russian company we rate as having weak management and governance (see chart 14). There are no cases where we assess this factor as strong.
The Russian economy continues to be dominated by large government-related entities, which operate in key sectors of the economy. Although the largest GREs continue to make improvements to their governance practices, overall, the risks are higher than for the largest private companies. The key risks for these companies are the following:
- Transparency and timeliness of decision-making. The government has a key role in approving major strategic moves for the GREs, but it usually takes time for various ministries in Russia to take a decision on certain initiatives and projects. For some projects, the political angle becomes at least as important as economic considerations, which might have a negative bearing on their credit quality.
- Counterparty selection and corruption. Russia's largest GREs are responsible for construction and management of national projects with huge budgets, which are difficult to control. The likes of Gazprom, Transneft, and Russian Railways are frequently accused of non-transparent tender procedures and overspending on projects--and some of those cases have been brought to court.
- Weaker reporting, both in terms of quality and frequency. In some instances, reports come later than for private companies and the disclosure is more limited.
- Lower-quality financial management. There have been several cases of government-owned entities (like Transneft and Novorossiysk Sea Port) that have lost cash in defaulted banks, sometimes leading to corruption allegations. Overall, we believe GREs have a less diversified lender base and less sophisticated financial management, although this is not the case for Gazprom, for example.
Many privately owned companies have made very meaningful improvements to their governance using global best practices. Many private Russian companies are traded in London and New York (although their overall number has decreased in the last several years), and fully comply with respective disclosure standards. Most companies in the economy-leading commodities and energy sectors have published sustainability reports for several years. For the companies we rate, we highlight generally high-quality management, robust strategic planning, and solid reporting, which could have supported a strong assessment. Russia's largest metals companies particularly stand out in this respect. Their business success stories are to a large extent a confirmation of management's strong expertise and adequate strategies.
The main governance risk for private Russian companies relates to their shareholding. Large private Russian companies are usually owned by rich Russian individuals (oligarchs), who dominate the decision-making processes. It is not common for these individuals to give up their majority on the board to independent directors. The owners usually have a final word on all strategic decisions, which creates a risk. There have been several examples in previous years of a majority shareholder single-handedly approving a one-off dividend or buyback that had a direct negative impact on credit quality. For example, we lowered the rating on Uralkali to 'BB-' from 'BBB-' after the owners announced a massive share buyback in 2015. We also lowered the rating on MegaFon to 'BB+' from 'BBB-' after the company took a decision to delist from all exchanges and buy back shares. Aggressive financial policy, resulting from shareholding and governance, is a constraining factor for several ratings in Russia. That being said, there were some cases where governance protected the company from external intervention. The most recent is Rusal, where the independent board of directors navigated the company through the imposition of U.S. sanctions and allowed the sanctions to be lifted.
For GREs, the share of independent directors generally matches the share of free float (see chart 15). In some cases, however, the independent directors are nominal and are former or existing government officials. In our assessment, it is very rare for independent directors on Russian GREs to vote against the government representatives.
For private companies, the share of independent directors meaningfully exceeds the free float (see chart 16). We take a positive view of the fact that the number of companies where independent directors have more than 50% representation in the board has increased in the past few years. We believe that the owners are now more comfortable with giving a majority to independent directors. This might have positive credit implications in some cases.
- ESG Industry Report Card: Metals And Mining, June 3, 2019
- ESG Industry Report Card: Transportation Infrastructure, June 3, 2019
- ESG Industry Report Card: Oil And Gas, June 3, 2019
- ESG Industry Report Card: Regulated Utilities Networks, May 13, 2019
- Environmental, Social and Governance: How We Apply Our ESG Evaluation Analytical Approach, April 10, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||Alexander Griaznov, Moscow (7) 495-783-4109;|
|Sergei Gorin, Moscow (7) 495-783-4132;|
|Secondary Contact:||Elena Anankina, CFA, Moscow (7) 495-783-4130;|
|Research Contributors:||Ilya Tafintsev, Moscow;|
|Igor Golubnichy, Moscow;|
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