Sometime in your investing journey, you’ve probably encountered the term ESG. It celebrates its 20-year anniversary this year, and it stands for environmental, social and governance analysis of companies and investing. It evolved from an early approach called “socially responsible investing.” Sometimes, the term ESG is confused with the broader term “sustainable investing,” which includes a wide array of approaches, including ESG analysis. (You can learn more about the prehistory of ESG here.)
As the planet warms, and as younger consumers and investors make sustainability a priority, ESG has never been more financially relevant. But while it’s been roundly criticized in recent years, it’s here for good. We asked Morningstar analysts and other sustainable-investing experts how it came about, and what the next 20 years may hold.
ESG Turns 20 this year. How did it start?
ESG evolved from values-based investing as people sought more systematic ways to describe risks that weren’t strictly financial. In 2004, the UN Global Compact published “Who Cares Wins,” which discussed the concept of “environmental, social and governance” factors to describe these nonfinancial issues. It provided a systematic way of accounting for nonfinancial risks—the changing climate, say, or human rights violations―and rejected the view that investment should happen from a purely financial perspective. “In many cases, for example, responsible investors are compensating for a lack of effective public policy,” says Thomas Kuh, head of ESG Strategy for Morningstar Indexes.
Next, the law firm Freshfields Bruckhaus Deringer showed that ESG issues are relevant for financial valuation and consistent with fiduciary duty. That laid the groundwork for using ESG analysis. Its report was commissioned by the United Nations Environment Program Finance Initiative, the first of a number of studies showing that fiduciaries needed to consider ESG issues, when they were material.
The same UN body launched the Principles for Responsible Investment in 2006, creating a framework for institutional investors to incorporate ESG into their investment processes.
The Freshfields report “was a turning point. It said that not only are investment funds allowed to include nonfinancial factors, but that they arguably must, because the time horizon for what’s material to financial returns is long and nonfinancial factors present all sorts of risk and opportunities for investors,” says Lisa Cooper, founder, Figure 8 Investing Strategies. “Soon you had big European pension plans asking banks and asset managers to figure it out.”