The term ESG first came to prominence in a 2004 report titled "Who Cares Wins", a joint initiative of financial institutions at the invitation of the United Nations (UN). By 2023, the ESG movement had grown from a UN corporate social responsibility initiative into a global phenomenon representing more than US$30 trillion in assets under management. Investment decisions are predominantly based on the potential for financial returns for a given level of risk. However, other criteria for deciding where to place money have always existed.
In the 1970s, the worldwide abhorrence of the apartheid regime in South Africa led to selective disinvestment along ethical lines. The Reverend Leon Sullivan, a board member of General Motors in the United States, drew up a Code of Conduct in 1977 for practising business with South Africa, which became known as the Sullivan Principles. This led to mass disinvestment by the US from many South African companies, adding weight to the impetus for the system of apartheid to be abandoned.
In the 1960s and 1970s, economist Milton Friedman argued that social responsibility adversely affects a firm's financial performance. His contention that a company's valuation should be predicated almost exclusively on the financial bottom line was prevalent for most of the 20th century. Towards the end of the 20th century, a contrary theory began to gain ground. In 1988, James S. Coleman introduced the concept of social capital into the measurement of value.
At the turn of the 21st century, a response from the supply-side of the investment market began to develop, typically referred to as ethical or socially responsible investment. In 1981, Freer Spreckley introduced the idea of internal criteria for social enterprises, including financial viability, social wealth creation, organizational governance, and environmental responsibility, known as social accounting and auditing. Later, in 1998, John Elkington coined the phrase "triple bottom line", referring to financial, environmental, and social factors in a company's value. In 2002, Chris Yates-Smith established one of the first environmental finance research groups in the City of London, known as The Virtuous Circle.
In the early years of the new millennium, the investment market still largely accepted that ethically directed investments would hinder financial returns. However, these assumptions began to be challenged. In 1998, Robert Levering and Milton Moskowitz brought out the "Fortune 100 Best Companies to Work For" list, which highlighted the financial performance of companies with strong corporate social responsibility. Moskowitz's analysis showed that improving corporate governance procedures maximized productivity and corporate efficiency. In 2011, Alex Edmans published a paper showing that the "100 Best Companies to Work For" outperformed their peers in stock returns.
In 2005, the United Nations Environment Programme Finance Initiative commissioned the Freshfields report, which concluded that integrating ESG issues into investment analysis was permissible and arguably part of fiduciary duty. In 2014, the Law Commission (England and Wales) confirmed that pension trustees could consider ESG factors. In 2006, Michael Barnett and Robert Salomon published a study suggesting a complementary relationship between social responsibility and financial performance.
ESG has been adopted throughout the United States financial industry to describe and measure the sustainability and societal influence of a company or business. MSCI, a global ESG rating agency, defines ESG investing as the consideration of environmental, social, and governance factors alongside financial factors in the investment decision-making process. Similarly, S&P highlights the consideration of how environmental, social, and governance risks and opportunities can materially affect companies' performance.
The environmental aspect of ESG involves data reported on climate change, greenhouse gas emissions, biodiversity loss, deforestation/reforestation, pollution mitigation, energy efficiency, and water management. Investors are increasingly factoring sustainability issues into their investment choices for better risk-adjusted returns. The Stern Review in 2006, commissioned by the British government, concluded that considerations of climate change and environmental issues should be included in all financial calculations. The main framework used globally is the Taskforce on Climate-Related Financial Disclosures (TCFD).
The social dimension of ESG focuses on how companies affect employees and communities, including workplace well-being, equity, and human rights in the supply chain. Social initiatives can improve employee satisfaction and contribute to long-term organizational resilience. Researchers find that businesses with effective ESG social practices often gain better trust from investors and improved financial outcomes. This includes considerations of diversity, human rights, consumer protection, and animal welfare.
Corporate governance refers to the structures and processes that direct and control companies. Good governance ensures companies are more accountable, resilient, and transparent to investors. Corporate governance in ESG includes issues from the Board of Director's view, such as business ethics, anti-competitive practices, corruption, tax, and accounting transparency. MSCI includes corporate behavior practices, board diversity, executive pay, ownership, control, and accounting that the board oversees on behalf of stakeholders.
The three domains of environmental, social, and corporate governance are linked to the concept of responsible investment (RI). RI began as a niche investment area but has become a much larger proportion of the investment market. By the end of 2020, flows into U.S. sustainable funds surpassed $51 billion, and globally, sustainable funds held $1.65 trillion in assets.
RI seeks to control the placing of its investments via several methods: positive selection, activism, engagement, a consulting role, exclusion, and integration. However, these methods can introduce additional risks, such as concentration risk and a lack of effectiveness in removing some industries.
Institutional investors have become key owners of stock, with a long-term investment strategy. Insurance companies, mutual funds, and pension funds are more interested in the long-term sustainability of their investments. Responsible investment is rapidly becoming a mainstream concern within the institutional industry. By late 2016, over a third of institutional investors in Europe and Asia-Pacific considered ESG in refusing to commit to a private equity fund. Networks of institutional investors committed to curbing climate change have emerged, such as the Institutional Investors Group on Climate Change.
The Principles for Responsible Investment Initiative (PRI) was established in 2005 by the United Nations Environment Programme Finance Initiative and the UN Global Compact as a framework for improving the analysis of ESG issues in the investment process. As of April 2019, there are over 2,350 PRI Signatories.
The Equator Principles is a risk management framework, adopted by financial institutions, for determining, assessing, and managing environmental and social risk in project finance. It provides a minimum standard for due diligence to support responsible risk decision-making. As of October 2019, 97 adopting financial institutions in 37 countries had officially adopted the Equator Principles. These principles were based on existing environmental and social policy frameworks established by the International Finance Corporation.
ESG rating agencies are the main infomediaries of ESG investing. Sustainalytics estimated over 600 ESG-rating companies in the ecosystem in 2018. The market is experiencing increasing concentration, with companies like Morningstar acquiring stakes in Sustainalytics, and Moody's acquiring Vigeo Eiris. Small groups of big index providers, like MSCI, play a pivotal role in setting standards for sustainable finance. ESG rating agencies can be categorized as ESG risk rating agencies, which measure exposure to ESG risks, and ESG effectiveness rating agencies, which measure commitment, integration, and results of ESG factors.
The first ten years of the 21st century saw growth in the ESG defined investment market. One major issue in the ESG area is disclosure, as ESG data is qualitative and not readily quantifiable. The lack of clear standards and transparent monitoring has led to fears of greenwashing. One solution is the provision of universally accepted standards for the measurement of ESG factors, such as those from the ISO (International Organization for Standardization). The corporate governance side has received more regulation, with the Combined Code on Corporate Governance widely accepted as a benchmark for good governance practices.
European regulators have introduced concrete rules to deal with greenwashing, including legislative measures from the European Commission's Action Plan on Sustainable Finance. In March 2021, the U.S. Securities and Exchange Commission (SEC) announced that examination of regulatory compliance related to disclosures for ESG would be a focus. In November 2022, the Employee Benefits Security Administration (EBSA) announced a final rule removing the Trump administration's pecuniary interest only requirement for fiduciaries in proxy voting under ERISA when considering ESG investments for 401(k)s.
Under ESG reporting, organizations are required to present data from financial and non-financial sources that show they are meeting the standards of agencies such as the Sustainability Accounting Standards Board, the Global Reporting Initiative, and the Task Force on Climate-related Financial Disclosures. ESG reporting is usually done on a voluntary basis, but in some places like India, it is mandatory for specific types of companies.
The Kentucky Bankers Association is suing Kentucky Attorney General Daniel Cameron over his investigations into banks' ESG practices. In March 2021, the SEC announced the creation of a task force to pursue enforcement cases against investment fund managers and public companies for deceptive marketing for ESG investment funds. In June 2022, the SEC was reportedly investigating the ESG investment funds of Goldman Sachs for potential greenwashing, and in November 2022, Goldman Sachs agreed to pay $4 million to settle the investigation.
According to a 2021 study by the NYU Stern Center for Sustainable Business, studies use different scores for different companies by different data providers. Research shows that intangible assets comprise an increasing percentage of future enterprise value. A study by the European Securities and Markets Authority found that ESG generally improves returns and cuts client costs over time. A Rasmussen opinion poll in the U.S. in January 2023 reported that 9% of Americans considered the promotion of "causes like diversity and environmentalism" to be the most important aim for companies.
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