The Next Phase of ESG: Divestment or Engagement?

The debate over how to handle companies with poor Environmental, Social, and Governance (ESG) performance divides investors. Should investors divest—selling stakes in firms failing ESG standards—or engage, using influence to drive improvements? This question, central to responsible investing, remains difficult to resolve. But there is increasing evidence that leaning towards engagement, or focusing on those companies that show meaningful improvement in ESG performance can be a strategy that delivers both financial returns and promotes change.

Unintended Consequences

Divestment involves selling stakes in companies with poor ESG records to reduce risk and signal ethical priorities. However, it can lead to unintended consequences, such as firms delisting from public markets or obscuring ESG data, reducing transparency.

As an example, private equity ESG disclosure at both a firm and company level are often lower than increasingly comprehensive public market requirements¹, creating a transparency gap as companies migrate away from public scrutiny. Divestment also limits investor influence, given they lose a seat at the table, leaving systemic issues unaddressed.

Engagement involves staying invested and using shareholder activism, proxy voting, or dialogue to push for ESG improvements. This approach recognises that many firms with poor ESG records can improve, especially under market pressure. Engagement fosters transparency, as companies are incentivised to disclose progress to attract ESG-focused capital.

The Financial Case for ESG Improvement

Empirical evidence appears to increasingly support ESG improvement over exclusion. While admittedly, academic studies vary in quality, the logic is sound. Companies that evolve business operations are likely to capture new market opportunities by shifting from legacy industries to emerging growth sectors, may use resources more efficiently which lowers operational costs, and/or subsequently benefit from a market re-rating as investors recognise reduced business risks and lower cost of capital.

Traditional Industries May Be Crucial Enablers

Climate change and other large-scale environmental and social problems are also too large for any single government, company, or investor to solve alone. As an example, the energy transition will require massive investment—with estimates ranging widely but consistently reaching ten-to-hundreds of trillions of dollars through 2050. This scale necessitates bringing along all industries, not just green leaders. It is important to acknowledge traditional energy firms possess critical assets and capabilities, such as existing pipeline networks suitable for alternative fuel transport, offshore platforms that may be repurposed for wind development, or the drilling expertise necessary for geothermal projects. The concept of ‘just transition’—ensuring fair treatment and retraining of workers in declining industries —should also not be forgotten. Rather than abandoning entire sectors, engagement can drive workforce development programs while accelerating the shift to sustainable alternatives.

ESG is Here to Evolve

Focusing on ESG improvement presents both opportunities and challenges. While financially attractive, it shouldn’t be an excuse to enable delay. Companies must demonstrate clear objectives with specific timelines, backed by committed capital expenditure and operational changes. Without these concrete commitments, ‘improvement’ rhetoric becomes meaningless green (or rainbow) washing. When done correctly—with rigorous due diligence, measurable targets, and ongoing accountability—a focus on improving companies can drive meaningful change while generating returns. The approach won’t always be perfect, but it may be more effective than walking away.

Notes:
¹ Pascal, Hendrikse, and Joos. “ESG Transparency of Private Equity and Debt Firms.” (2022) – Review of 3,765 PE firms globally using Preqin data.