Every company’s annual report now contains a section on how it is embracing all things ESG (environmental, social and corporate governance). ESG causes permeate every facet of a business’s output, keeping shareholders, clients and consumers satisfied that the company is doing its bit to save the world. Speaking out openly against anything ESG related is akin to career suicide. ESG is a good thing and must be embraced. However, and whisper it quietly, the adoption of ESG policies can come with a downside.
Yes, by embracing ESG-compliant strategies and policies, companies can often be doing themselves harm. This doesn’t mean to say that they should abandon these actions, but by acknowledging and identifying these problems they can be worked around, and hopefully result in a healthier balance sheet and a healthier planet.
But which areas of ESG adoption can damage a company or investor?
Minimising the investment universe
Responsible investors will often exclude certain sectors from their portfolios, such as tobacco, alcohol, weapons and fossil fuels. This is mostly done for ethical or environmental reasons. It can also, however, limit an investor’s options. By excluding certain sectors from their portfolios, investors can run the risk of focusing on too narrow a group of industries, which might score well in terms of ESG credentials but lack the diversification needed to ride out tougher economic times.
Impact on financial performance
There are concerns that there are trade-offs between ESG compliance and financial performance. Some investors fear that ESG investments generate smaller returns than those that focus less on such issues. As a result, some investors worry that they are compromising on returns in favour of a better ESG performance.
A focus on ESG could come at the expense of other business concerns
Environmental issues are only going to rise in importance on a global scale. There are numerous regulations that are designed to encourage greener global habits and slow down the negative impacts of climate change.
However, the pressure to ‘go green’ in both governance and investment is easier to implement in some places than it is others. Many developing economies rely heavily on fossil fuels and do not have the resources to speed up a transition to renewable energy. If pressure is continually placed on the environmental part of ESG, particularly within developing countries, the social or governance parts could suffer.
Africa provides an example of this problem. If Western investors push too hard for a decarbonisation agenda in Africa and rule out all fossil fuel investments in the continent, then African countries could be denied the energy required for their industrialisation and it could take a lot longer to lift millions of Africans out of poverty.
Defining ESG-compliant investments can be subjective
Defining the dos and don’ts of ESG investing can be subjective. As an example, investing in the defence industry has been a no-no for ESG-conscious investors for many years. However, the Russian invasion of Ukraine has altered this narrative, pushing investors to rethink their policies when it comes to defence. Several investors are now considering investments in the defence industry because it is currently seen as a key sector for security reasons and/or in assisting Ukraine’s fight for its freedom. This shows how quickly sentiments can change towards an industry.
Accusations of greenwashing
Greenwashing is another problem that can arise through ESG investing. Due to the increasing interest in all things ESG, some companies and investors have been known to very publicly be seen to embrace such practices in order to attract more clients but fall some way short when it comes to providing any actual evidence of promoting sustainability. As a result, several companies have been called out for greenwashing, which has damaged their image and reputation.
This has been a particular issue with oil and gas companies that have stated that they are reducing their carbon emissions, while in reality they were increasing them. There have also been numerous cases of financial services companies misleading investors about the size of green assets they have under management.
ESG is still good for business, however
In spite of the issues listed above, the advantages of ESG-compliant strategies will typically outweigh the disadvantages for a business. Such an approach tends to result in a more profitable company that is better prepared for any future shock events.
Data from S&P Global Market Intelligence, for example, shows that companies with high gender diversity within their board of directors have been more profitable than those with less.
Additionally, a global survey from the IBM Institute for Business Value shows that 71% of employees and employment seekers consider environmentally sustainable companies to be more attractive employers.
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Embracing a meaningful ESG agenda (and not just seeing it as a tick-box exercise) is something that no company can sidestep. Yes, there are some difficulties and disadvantages associated with some aspects of ESG compliance, but these can be worked around. Most of these problems are of a short-term nature too. The implementation of ESG-related policies is a long-term process, and businesses approaching the topic as a sprint and not a marathon are the ones that will suffer.
Editor’s note: The original version of this piece appeared on our sister title Investment Monitor.