ESG is suffering some serious criticism. As the dominant concept shaping corporate governance today, proponents could expect ESG to come under close scrutiny. But recent attacks have been vehement and even argued the invasion of Ukraine highlights the hollow nature of the ESG movement. Is the criticism justified?

The answer to that may depend on your point of view and how you expect ESG (environmental, social and governance) concerns to affect the running of companies.

The most recent criticism focused on the effect of ESG considerations on the provision of key essentials; in the context of the Ukraine–Russia war that is arms and fossil fuels. An article in The Times by Oliver Shah claimed a “monomaniacal focus” on ESG of some investors had seen them turn away from arms and fossil fuel companies and take decisions that should otherwise be reserved for a democratically elected government. Weapons are currently required in vast quantities and fuel is needed to drive Ukraine’s war effort.

“It is time to dismantle this inflexible dogma and replace it with something nimbler and more nuanced,” Shah wrote, adding that he wants ESG to be replaced with “common sense, decency and pragmatism”.

“The best part? There won’t be highly paid advisers or priests [institutional investors] lecturing from the pulpit of giant fund managers. There will just be investors who engage with boards thoughtfully.”

Shah is not alone in his ESG scepticism. Earlier this year one of the City’s most high-profile fund managers, Terry Smith, turned on Unilever, the consumer goods company famous for its ESG reputation. He worried the company was preoccupied with “sustainability credentials” at the expense of “focusing on the fundamentals of business”.

He took aim at management’s treatment of a kitchen staple. “A company which feels it has to define the purpose of Hellman’s mayonnaise has in our view clearly lost the plot.”

ESG investors

There is much to unpack here. Smith seems concerned about ESG getting in the way of the best possible return for investors; Shah worries that ESG is getting in the way of a war effort because of a blind adherence to its principles. Both seem to agree ESG is a distraction.

Not everyone agrees the ESG landscape is so simple. According to Leon Kamhi, head of responsibility at fund manager Federated Hermes, investment around some industries, for example weapons is more nuanced.

“Simplistically,” says Kamhi, “there are two types of ESG investors. Firstly, the thematic investor who excludes certain activities on environmental, social or governance grounds based on their ethics. Many thematic investors have excluded defence companies for those reasons.

“The second type is the investor who credibly integrates ESG factors that are material to performance and risk in investment decision-making and engages with the company to improve their performance in relevant ESG and other performance factors.

“This type of ESG investor will not be underweight in defence companies but rather—if active—supporting the defence company to play an appropriate role in a country’s society and economy. Providing a country with a deterrence capability could well be that role.”

So, investors are still backing defence companies. Defence, particularly in the face of an invader, is easily defined as having a societal purpose and thus, an ESG candidate. Indeed, one investment adviser told Board Agenda defence investment accords with No. 16 in the UN’s Sustainable Development Goals (SDGs), which aims to ”promote peaceful and inclusive societies for sustainable development, provide access to justice for all and build effective, accountable and inclusive institutions at all levels.” The war in Ukraine serves as a brutal and tragic reminder of that fact.

Reporting and ratings

Perhaps the problem is not the ideas underlying ESG, but the way it is implemented. And that’s not just about boards making policy decisions inside their organisations. ESG standards are, in part, driven increasingly by regulators adopting or setting reporting standards, including the Task Force on Climate-related Financial Disclosures (TCFD).

ESG is also subject to a superstructure of consultants, experts and index providers pushing companies along. (There may be as many 450 ESG indexes for fund managers to use in the construction of portfolios, according to some counts.)

This is a particular concern for Shah. His article points to what he describes as the “bloated industry of advisers, experts, lobbyists and PR firms” that have grown up around ESG: A “gormless snake eating its own tail”, he calls it.

Of course, the purpose of ESG is not ESG. But, perhaps, the mission has drifted. According to James Corah, head of sustainability at fund manager CCLA, it may be time for “taking stock”.

Corah’s belief is that this isn’t the time to move away from away from ESG but to see what’s fundamentally important in the concept. And what’s important is that ESG is an issue for all companies, not a process for fund managers to pick stocks that “just do good”.

That, Corah says, has forced fund managers to focus on “portfolio construction” which misses the point that the whole economy—all companies—should be thinking ESG. He uses Australian brush fires as an analogy. A fire extinguisher is a good thing to have, congratulations all round to whoever owns the fire extinguisher. But it doesn’t change the fact the country is burning.

‘This isn’t the moment for ESG to disappear’

In the same way, an ESG portfolio may look good, but if the climate is still collapsing in on itself, well, that portfolio looks a little redundant. Or, to put it another way, it look a little like escapism.

“The idea that you can build portfolios that focus just on companies that do good things is a Panglossian fantasy,” says Corah.

“We really have to take this moment to reassess what ESG is about and remember that, actually, it should be about connecting to the real world. And connecting with the real world means that we accept the world as it is, not as we want it to be.

“We realised that the whole purpose of ESG in the starting place was to make things better; to use the power of finance to improve the environment and the lives of our communities.

“When you begin to get back to that, this isn’t the moment for ESG to disappear. It’s actually the moment for ESG to step up and focus back on what makes the world a better place.”

And that’s where many investment advisers find themselves: using ESG, or responsible investment, as a means of pursuing long-term financial performance by allocating capital in a way that fits with evolving political, social and legal expectations. As one adviser told Board Agenda: “In the final analysis, responsible investment—with its E, S and G pillars—may be a fancy name for good business sense that is focused on the long-term, measures its externalities and is transparent about its impacts on all stakeholders, not just shareholders.”

ESG need not exclude investment in defence industries. Nor should it exclude investment in traditional energy companies if those companies are on a road to transition from fossil fuels to more sustainable forms.

If the cost of saving the planet, and improving the lives of the disadvantaged, is a “bloated” industry of advisers, or reflection on the purpose of a condiment, then that seems a small price to pay for shifting mindsets wholesale. We might be doing ourselves a disservice if we confuse content with form.