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, applying pressure to the South African regime.
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.
What began to develop at the turn of the 21st century was a response from the supply-side of the investment market, typically referred to as ethical or socially responsible investment. In 1981, Freer Spreckley published "Social Audit — A Management Tool for Co-operative Working", introducing internal criteria for social enterprises: financial viability, social wealth creation, organizational governance, and environmental responsibility. Later, in 1998, John Elkington coined the phrase "triple bottom line", referring to financial, environmental, and social factors in a company's value calculation. 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 accepted the assumption that ethically directed investments would hinder financial returns. However, these assumptions were challenged. In 1998, Robert Levering and Milton Moskowitz brought out the "Fortune 100 Best Companies to Work For", which highlighted companies with good corporate social responsibility and their financial performance. Moskowitz's analysis concerned corporate governance, arguing that improving these procedures maximized productivity and ensured 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. The Law Commission (England and Wales) confirmed this in 2014. Michael Barnett and Robert Salomon published a study in 2006 suggesting a complementary relationship between social responsibility and financial performance.
Responsible investing through ESG has been globally driven by the COP21 or the Paris Agreement, and the UN 2030 sustainable development goals. In 2021, the ESG assets market value was over $18.4 trillion, with a projected growth of 12.9% until 2026. ESG saw outflows for the first time in 2023. By 2023, the EU had 84% of global assets in the sustainable funds market, and the US accounted for 11%. Amid allegations of greenwashing and stricter regulations, there is a notable decrease in funds incorporating ESG-related terms into their names in the United States, a trend not observed in Europe.
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 consideration of how environmental, social, and governance risks and opportunities can materially affect companies' performance.
Data is reported on climate change, greenhouse gas emissions, biodiversity loss, deforestation/reforestation, pollution mitigation, energy efficiency, and water management. The threat and concern over climate change have grown, leading investors to factor sustainability issues into their choices for better risk-adjusted returns. The Stern Review in 2006, commissioned by the British government, concluded that 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 dimension includes 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, Governance Lens watching over Corporate Behavior of the CEO, C-Suite, and employees at large. MSCI includes corporate behavior practices and governance of board diversity, executive pay, ownership, and control, and accounting that the board of directors has to oversee on behalf of stakeholders. Other concerns include reporting and transparency, business ethics, board oversight, CEO / board chair split, shareholder right to nominate board candidates, stock buybacks, and dark money given to influence elections.
The three domains of environmental, social, and corporate governance are intimately 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. Globally, sustainable funds held $1.65 trillion in assets at the end of 2020. ESG corporate reporting can be used by stakeholders to assess material sustainability-related risks and opportunities. RI seeks to control investments via several methods: positive selection, activism, engagement, consulting role, exclusion, and integration.
Institutional investors have become the key owners of stock, rising from 35% in 1981 to 58% in 2002 in the US and from 42% in 1963 to 84.7% in 2004 in the UK. These investors tend to work on a long-term investment strategy. Insurance companies, Mutual Funds, and Pension Funds are more interested in the long-term sustainability of their investments. By late 2016, over a third of institutional investors in Europe and Asia-Pacific said that ESG considerations played a major role 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. Equator Principles Financial Institutions (EPFIs) commit to not provide loans to projects where the borrower will not or is unable to comply with their respective social and environmental policies and procedures. The Equator Principles were formally launched in Washington DC on 4 June 2003, 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 the number of ESG-rating companies in the ecosystem at over 600 in 2018. The ESG rating providers market is experiencing an increasing trend of concentration. For instance, Morningstar took 40% of Sustainalytics stakes by 2017. Moody's acquired Vigeo Eiris in 2019, while Institutional Shareholder Services (ISS) acquired Germany's Oekom. S&P Global acquired the ESG rating business of RobecoSAM. Small groups of big index providers, like MSCI, play a pivotal role in setting the standards for sustainable finance. Each rating agency uses its own set of metrics, and there is no industry-wide set of common standards.
The first ten years of the 21st century have seen growth in the ESG defined investment market. One of the major aspects of the ESG side of the insurance market is the essentially subjective nature of the information on which investment selection can be made. ESG data is qualitative, non-financial, and not readily quantifiable in monetary terms. A lack of clear standards and transparent monitoring has led to fears that ESG avowals mainly serve purposes of greenwashing. One of the major issues in the ESG area is disclosure. The information on which an investor makes decisions on a financial level is fairly simply gathered, but with ESG considerations, companies often provide their own figures and disclosures, which are seldom externally verified. 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).
Under ESG reporting, organizations are required to present data from financial and non-financial sources that shows 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. Data must also be made available to rating agencies and shareholders. ESG reporting is usually done on a voluntary basis, but in some places like India, it is a requirement for specific types of companies. For example, India has a regulatory requirement called BRSR (Business Responsibility and Sustainability Reporting) that makes ESG reporting mandatory for the top 1000 companies based on their market value on the stock exchange.
The Kentucky Bankers Association is suing Kentucky Attorney General Daniel Cameron over his investigation into banks' ESG practices. In March 2021, the U.S. Securities and Exchange Commission (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 August 2021, the SEC and the Eastern New York U.S. Attorney's Office were reportedly investigating the DWS Group after its former chief sustainability officer leaked internal emails showing the company had overstated its ESG investment efforts. In June 2022, the SEC was reportedly investigating the ESG investment funds of Goldman Sachs for potential greenwashing. In November 2022, Goldman Sachs agreed to pay $4 million to settle the SEC investigation without admitting or denying guilt.
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