The ESG backlash: manage sustainability risk now or pay later

By Judy Kuszewski

Beyond the ESG backlash: The critical role ESG standards play in managing investment risk in 2024

What goes up must come down. Nothing escapes Newton’s Law of Gravity and most recently it’s the rising star of ESG investment that has been brought down to earth.

It is hard currently to fully quantify the real-world impact of the ESG backlash which describes the rise in scepticism around investors’s use of ESG criteria and came to the fore last year.

On one hand there is a trickle of reports which point to ESG fund outflows, closures and a slowdown in fund launches since 2023.

Other evidence shows the momentum of ESG investment remains formidable: take for example the 53% rise in assets under management for Blackrock since 2022 or the Morgan Stanley study which found sustainable funds outperformed traditional ones by 6.9% to 3.8% in 2023.

While the anti-ESG wave has failed to crash in the UK and Europe, firms in the US face being barred from markets in Texas and Florida, among other places. This has created friction between the fiduciary duty to operate within laws which prohibit ESG-related consideration of investments versus the risks presented by climate, nature, human rights and other sustainability themes to the value of portfolios and assets.

As a result, for investors who are considering their strategy for ESG integration and reporting in 2024 and beyond the ESG backlash prompts an important question: is now the right time to intensify efforts in this area or can firms get away with trailing rather than leading the pack?

Stepping away from the media headlines which feature more heat than light and looking at the fundamentals which have driven the adoption of sustainability themed investment – from climate risk to resource scarcity – and their future path, there is no doubt that investors must move faster and more decisively on ESG integration.

Climate transparency

The tightening of climate-themed regulation and disclosure is one reason for this.

Despite myriad pressures from certain business sectors such as agriculture to change course, the EU’s mandatory CSRD reporting deadline is now in force with large companies falling into scope 2025.

Together with the recent proposal for an economy-wide 2040 target for 90% net greenhouse cuts compared to 1990 levels, this represents a new muscular approach towards organisations and their climate obligations.

Even though the US and UK have yet to announce a full suite of climate disclosure rules for business, the direction of global travel is clearly set as wider commitments such as the requirement for financial services firms to report on financial risk relating to climate change through the TCFD framework ensure transparency by default in the business and investment ecosystem.

Nature’s emerging role

Rather than an end point for sustainability disclosure, the evolving need to report on and integrate climate risk in investment portfolios and assets now represents the path that investors will need to follow in other areas of ESG as the understanding of the systemic risks that they represent are better understood.

Chief among these is nature-based reporting against the new framework from the Taskforce on Nature-related Financial Disclosures. With more than half of the world’s economic production dependent on nature, the TNFD provides a way of singling out the physical risk from resource scarcity, and transition risk from changing environmental policies, and create actions plans to manage nature-related dependencies in their investments.

The framework may be voluntary today with around 100  investor signatories among the early adopters but if it matches the same trajectory as the TCFD, it will set the standard and expectation for disclosure, and inform future regulation to ensure investors consider nature as specific portfolio risk.

Alongside this, other urgent and emerging areas which require proactive risk management are supply chains, the focus of the embattled corporate sustainability due diligence regulation (CSDDD) proposed by the EU and the human rights reporting advocated by the UN-supported Principles for Responsible Investment for investors they recognise as a systemic sustainability issue.

Carrot and stick

It’s not just the growing web of sustainability disclosures and regulation which provide a compelling reason for accelerating ESG integration and enhanced reporting.

As 2023 gained official recognition as the hottest year on record, it wasn’t just the temperature rises in the air, sea and at the Antarctic which were notable. The volatility of the weather and its associated impact through drought, crop failure and wild fires are already damaging economies, communities and livelihoods in a whole new order of intensity and immediacy than to which we are accustomed or was predicted by climate scientists.

In other words, the sustainability risks identified by ESG reporting frameworks are best seen as risks of today rather than of the future.

We may have time to hit internationally agreed climate targets or hit sustainability standards but there is every chance that events may outrun policy, leaving investments at even greater risk today as capital flows seek resilient assets which can reliably deliver in the long term.

Robust Risk Management

There is no doubt that in some areas of the broad ESG universe – such as ESG ratings, fund labelling and evaluation of ESG activity – there is not only room for criticism of approaches and tools used but scope for improvement, as is the intention of regulators in the EU, UK and the US.

Set against this, ESG reporting and evaluation tools such as the UN’s PRI, are highly credible in helping understand and manage sustainability risk and provide comprehensive frameworks through which investors can proactively manage risk and understand the future capabilities they need to do so more effectively.

If the imperative for every investor is to manage risk and safeguard investee funds, then these tools are critical to the analysis of ESG issues associated with target investments.

The ESG backlash may continue but the case for ESG integration is stronger than ever. Firms who understand sustainability risk are not only better positioned to manage portfolio risk but to find future opportunities which may be hidden from those who have less evolved approaches to ESG integration.

A proactive approach to ESG reporting gives firms time to build the right approach, hire the right people, prioritise the right sustainability issues and stay ahead of the pressure which comes through ESG regulation.

Acknowledging and acting on material ESG risk will also represents the best way of mitigating against future green lawfare targeted at investors who were either too slow or stood aside when it came to taking action on ESG risk.