Here's why we must not lose sight of the importance of ESG, despite the recent backlash

The consideration of environmental, social and governance (ESG) factors when making investment decisions has never faced such a profound period of negative scrutiny.

After years of increasing attention and capital allocated to ESG investments, which have made substantial strides forwards in terms of technical substance and implementation expertise, 2022 proved to be a point of reflection.

There are several drivers behind this wave of criticism. The combination of the impact of Russia's invasion of Ukraine, inflation and pockets of populism emerging in different parts of the world is shifting the macroeconomic and geopolitical context, which in turn impacts investors’ thinking.

Outdated interpretations of what is materially important in relation to an investment manager’s fiduciary duty have further obscured the purpose of ESG.

The abundance of ESG-related terminology – green investments, socially-responsible investing (SRI) and sustainable portfolios to name a few – and its meaning leads to confusion about what these different types of products should and should not invest in to be true to label.

Too many people now attach heavy baggage to their expectations of the ESG acronym, blurring its practical function in business and investment. And in the US, heated ideological debate over mandatory climate risk reporting and fossil fuels divestment, has added fuel to the criticism.

In this complex environment, we seem to have forgotten what ESG actually is.

If we take a step back, understanding ESG in a capitalist context is simple. It is the consideration of extra-financial information to enable better decisions that, if done properly, should lead to sustainable economic growth.

From an investment perspective, incorporating ESG analysis alongside traditional financial factors adds to our holistic understanding of risk and opportunities and long-term value outcomes.

As a result, for most business leaders, ESG has become a top priority. This is not because of a deep-rooted ethical or moral stance as some critics of ESG like to claim, although this should always be an important consideration.

Rather, it is because ESG risks are now one of the largest threats facing businesses, and they could have a significant impact on their long-term performance and profitability, including their ability to raise new capital.

Moreover, as regulation emerges and fines are issued, which is increasingly the case, at a very basic level organizations must comply with these.

Businesses should be focusing on all stakeholders, rather than solely shareholders, and the long-, rather than the short-, term. Global capital flows should run in step with this logic. Doing this not only benefits the environment and society, but it also makes commercial sense.

Even the most opportunistic shareholders know that it is in their general interest to care about motivated employees; a positive corporate culture; reliable and legally compliant supply chains and business partners; and having a productive dialogue with regulators.

That’s just good management of materiality risks and makes sound business sense. It’s also about sustainability.

Arguments against incorporating ESG into investment decisions because it does not align with fiduciary duty are misinformed. Asset managers have a responsibility to address all material risk factors that will affect long-term investment performance.

So short-term investment behaviours, like remaining a high carbon emitter, can have profound negative consequences on future performance and indeed even affect the viability of a business.

This leads us to another argument made by some detractors of ESG claim. They claim that this approach must implicitly mean sacrificing some performance upside. That is not necessarily true; the data is mixed.

There is certainly lots of research showing the companies that do focus on all stakeholders, and take a more serious approach to ESG, outperform in the long-term.

For example, if we look at emerging markets, companies exposed to controversies such as polluting, poor governance or labour failures, underperform over the long-term. Listed equities are particularly exposed to this.

The list of examples goes on but, ultimately, trying to understand performance of an investor that does take ESG seriously versus one that doesn’t is too binary. And it is particularly hard to judge today because we do not yet have an investment level playing field.

If you consider the energy majors – some of the biggest polluters – they are still largely financed by global banks and even central banks, which are also some of the largest sources of investment capital.

As such, there is incentive to continue supporting these fossil fuel companies, and again the flow of all capital – public and private – towards the low carbon transition, remains far too slow as a result.

The war in Ukraine proved this, with oil majors and defence stocks, which are generally unpopular with ESG focused investors, being some of 2022’s top performers.

But this dynamic may well change for the better soon. The disruption caused to energy markets by Russia's invasion of Ukraine is forcing banks and governments to speed up the movement of capital to lower carbon sources.

This shift in capital and investment may be uncomfortable in the near term, especially as populations struggle with the cost of living, but the backdrop for these sorts of decisions has put an indirect price on carbon – something fundamentally important that the world has not yet been able to officially agree on.

Further to this, the International Energy Agency estimates that, as a result of the recent energy crisis, the world is "set to add as much renewable power in the next five years as it did in the past 20". That is cause for optimism, and it should help accelerate the evolution towards a green, net zero and sustainable future.

The key role and added value of truly sustainable investing in supporting this transition, while offering investors exposure to new long-term growth opportunities, should be the best defence against the current criticism of ESG.