ESG Turns 20: A Brief History, and Why It’s Not Going Away

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.”

Two landmark events catalyzed the growth of ESG. Developments in society also helped it along.

In 2015, the Paris Climate Accord and the Sustainable Development Goals were signed. The Paris Agreement, now ratified by 180-plus countries, sets goals for curbing global warming.

The UN also established Sustainable Development Goals, calling for nations to address challenges related to poverty, inequality, climate change, and peace by 2030. The SDGs embrace actions that corporations and others can take to achieve the goals. This sets a framework by which business leaders and investors could speak the same language and work toward shared targets.

Soon after, “Corporate Sustainability: First Evidence on Materiality” was published, which showed that focusing on financially relevant ESG factors had a positive effect on shareholder value. For example, “If climate change matters for investors’ decisions, then climate risk is material even if the company is not inclined to state that in regulatory documents,” says Kuh.

Issues that weren’t on investors’ radar were now financially relevant. The 2008 global financial crisis showed how unchecked financial system weaknesses could erode value. Investors began framing the climate crisis as a market failure, providing momentum for the Paris Agreement, says Jackie Cook, who leads the proxy-voting advisory service for Morningstar Sustainalytics.

As they adopted ESG analysis, investors found new risks. Consider factory farming, where ESG analysis underscored risks such as food contamination and labor issues. The coronavirus pandemic disproportionately affected vulnerable communities and thrust companies in the public glare. “Remember workers in slaughterhouses continuing to work during covid? Suddenly, people realized ‘Oh, we’re looking at ESG issues,’” says Maria Lettini, executive director of US SIF, the trade organization for sustainable investing. “Covid highlighted how food system risk affects economies and commodities and access to food.”

Companies also saw ESG as increasingly relevant.

To help address the challenges of achieving the Paris Agreement goals, the G20 and Financial Stability Board created the Taskforce on Climate-Related Financial Disclosures, to help people understand “carbon-related assets in the financial sectors.” TCFD would become a regulated reporting requirement across many global regions. By 2022, 61% of G250 companies disclosed information in line with at least one of the framework’s pillars.

In 2018, BlackRock CEO Larry Fink urged fellow CEOs to position for long-term profitability by focusing on the role of the corporation in society. Companies focused on minimizing negative environmental and social impacts and accentuating positive ones would be rewarded by customers, protect their brands, and attract top talent, enabling them to better navigate the transition to an increasingly low-carbon and digital economy, Fink wrote.

Previously, the economist Milton Friedman’s doctrine of shareholder primacy held sway. By 2019, the powerful Business Roundtable also reversed its stance on shareholder primacy, saying that other stakeholders—customers, employees, suppliers, communities—are also important.

“The shift toward a stakeholder view of the firm and how it should be governed was already happening well before the COVID pandemic—fueled by a post-financial crisis awakening to the systemic vulnerabilities introduced by short-termism, as well as a growing urgency for global action to halt climate change,” says Cook of Sustainalytics. “However, [the pandemic] brought to the fore fundamental flaws in shareholder primacy-style governance. The economic and political fallout ignited a collective awareness of the overlapping interests of stakeholder groups in securing resilience across systems.”

ESG goes mainstream.

In 2016, Morningstar introduced the Sustainability Rating for funds and ETFs and established its sustainability indexes. Jon Hale, a prominent sustainable-investing commentator and former Morningstar head of sustainability research, helped create the rating. Hale recalls: “I couldn’t believe how complex and sophisticated the frameworks had gotten. I asked Joe [Mansueto, Morningstar’s founder], ‘Can we do this?’ He said, ‘Sure.’ And once he said that, then people said, OK, we’ll shake loose some resources. When we launched the rating, it focused attention on sustainable investing. Academic papers were written. Morningstar had given its stamp of approval on this idea of sustainable investing. It got a lot of heads nodding.”

More big investors began to use ESG analysis. “In 2014, we noticed in our trends reporting that the biggest jump was in the use of the ESG integration strategy,” says Bryan McGannon, managing director of US SIF, the trade group for the sustainable-investing industry. “It began to permeate mainstream finance.”

As the value proposition grew clear, consolidation took place throughout the sustainable-investing ecosystem. Eaton Vance bought Calvert Research & Management in 2016, followed by Impax purchasing Pax World Management, both prominent sustainable-investing boutiques. In 2017, Morningstar took a stake in data and analytics provider Sustainalytics, which provided the data for its fund sustainability ratings, and bought the rest of the firm in 2020.

Morningstar’s own development, like that of many financial-services companies, is intertwined with ESG’s evolution.

Morningstar analysts covered socially responsible funds PAX World Fund, Dreyfus Third Century, and the Calvert funds, starting in the 1980s. Sustainalytics established global ESG research and ratings offerings in 2010 and expanded its offering to include governance research and carbon solutions in 2015. Morningstar’s approach to its own corporate sustainability drew on its approach to research, centering on independence, materiality, and transparency. “We’re founded on the idea that investors deserve transparency into what’s in their portfolios and the tools to make better decisions,” said Gabriel Presler, global head of enterprise sustainability for Morningstar. “Stakeholders, meaning our employees, shareholders, and clients, deserve that same transparency. Environmental, social, and governance information provides stakeholders with a more complete view of an issuer or investment or an organization―not only its value in the market and the risk it presents, but also the externalities, good and bad, it is creating.”

Europe takes the lead.

In 2017, the European Commission presented its sustainable finance action plan to refocus capital on a low-carbon economy. The plan included proposals for regulation of disclosures on sustainable investment and sustainability risks. The European Green Deal came in 2019, followed by a separate plan to help companies and investors identify economic activities that are environmentally sustainable, as well as an anti-greenwashing rule that makes fund managers and others communicate the environmental and social impact of their transactions. Such moves accelerated the adoption of ESG. By 2023, Morningstar’s coverage of ESG funds was worth $2.8 trillion dollars, with Europe representing more than 80% of these global ESG fund assets.

Transparency and comparability grow more robust.

It was a big year in 2023: The EU’s Corporate Sustainability Reporting Directive became law, new sustainability reporting standards were finalized, and California enacted two broad-based climate-related reporting laws. In 2024, the SEC finally adopted a sweeping rule to make companies listed in the US report climate-related risks and their plans to adapt to them. Today, according to the SEC, some 90% of companies in the Russell 1000 Index already disclose this kind of sustainability data. Other jurisdictions go further than the SEC: For example, companies that do business in Europe or California are preparing to make more detailed disclosures than what the SEC requires. (For more on sustainability reporting requirements around the globe, download Morningstar’s “Sustainability Reporting Requirements” white paper).

But … the nomenclature grows confusing.

Increasingly, people use the term ESG investing for a vast array of approaches, whether investing according to their values, such as screening out stocks or finding companies that have an impact, or pursuing values based on nonfinancial factors, or some combination of approaches. ESG as a tool becomes conflated with the broader notion of sustainable investing.

Properly understood, ESG is an analytical framework that uses ESG factors to approach an investment, says Morningstar’s Kuh. “It’s is a useful tool for informing investment decisions.” There is no such thing as an “ESG company,” for example.

The ESG reckoning begins.

Russia’s invasion of Ukraine in 2021, highlighted contradictions, inconsistencies, and conflicts between the E, the S, and the G, points out Hortense Bioy, head of sustainable investing research for Morningstar Sustainalytics. For example, in Europe, governments reneged on their environmental goals by turning to fossil fuels to reduce dependence on Russian gas. The war also boosted oil and gas shares, making fossil-fuel-light ESG funds underperform by comparison. It highlighted the need for a strong defense industry, “something that doesn’t align with the values of investors focused on sustainability,” says Bioy.

Meanwhile, as fund managers chased after new clients, greenwashing charges grew—just as critiques of sustainable investing were on the rise. In 2023, DWS, an investment firm controlled by Deutsche Bank, settled with the SEC over misstatements regarding its ESG investing. Separately, critics slammed ESG on grounds that it overpromises on performance or reduces motivation by governments to solve climate change. Others said it violates fiduciary duty because it ventures outside the economic interest, narrowly defined, of investors. Says Kuh: “Greenwashing can be seen as primarily overreach on the part of fund managers but also unrealistic expectations on the part of investors.”

ESG becomes politicized.

In 2021, Texas prohibited government contracts with companies it thought were punishing the fossil fuel and firearms industries and banned public pension funds from using ESG principles in investing. Republican opponents also slammed companies for venturing into social issues, dubbing ESG “woke capitalism.” This year, Florida effectively bans the term “climate change” from its state laws.

Today, dozens of states have passed either pro- or anti-ESG bills related to financial institutions and other large companies. The decisions have financial consequences: Wharton says decisions to ban certain banks as municipal bond underwriters in Texas means cities will pay an additional $303 million to $532 million in interest on $32 billion in bonds. As the term “ESG” became a political football, companies and investors shied away: BlackRock CEO Fink said he’d stop using it because it’s become weaponized on both sides, the right and the left, and it’s become too polarizing.

Should the term ESG be retired?

• Some people think so. Originally a specific term, “it’s often used to refer to both value- and values-based investing approaches which has fueled an opportunistic political attack on investing choice based on a deliberately narrow interpretation of ‘fiduciary duty,’” says Cook. Adds Leslie Samuelrich, President of Green Century Funds: “The term should be retired because it’s misused. There’s no such thing as ESG investing. There’s using ESG data to assess risk and reward. But too often it becomes synonymous with investments that are making an impact in the real world instead of companies that are just addressing their risks.”
• ESG is necessary. Most things that aren’t purely financial or economic have an ESG angle to them. “It’s that breadth that has sometimes left proponents of ESG integration in investing open to the charge that they are taking their eye off the ball when it comes to fiduciary duty,” says Lindsey Stewart, director of stewardship research and policy for Morningstar Sustainalytics. But considering ESG information is essential for getting a 360-degree view of the risks and opportunities a business is facing.
• ESG data and frameworks allow investors and companies to understand the actual costs of corporate behavior. “With negative externalities, it becomes the public’s responsibility to bear the cost. ESG data demonstrates the true cost of company behavior. It’s transparency in the hands of people who have not had this power before,” says Presler of Morningstar.

Says Andy Behar, CEO of shareholder advocate As You Sow: “ESG is about the relationship between shareholders and companies they own. Companies need to disclose [ESG information] honestly and in a standardized format for shareholders to make a good decision,” much as the SEC required standardized financial disclosures decades ago.

• And it’s too late to go back. Any factors that are material to investment returns will find their way back into the investment process. Most financial system participants, including central banks, regulators, large institutional investors, believe that nonfinancial investing factors are financially relevant. Consumers have increasingly voiced support for their own sustainability goals. “Couldn’t we just drop ESG altogether and get back to investing as we used to know it? It’s not that simple: ESG issues are already embedded into our lives,” says Adam Fleck, director of research, ratings, and ESG at Morningstar Sustainalytics.

The next 20 years. Remember that the year 2030—a target for many climate pledges—looms large.

• Expect regulations and standards globally for companies to measure and disclose climate risk management, says Stewart, “like the birth of generally accepted accounting principles half a century ago, but for sustainability. Today, it’s almost incomprehensible that there would be no standardized method for companies to disclose their revenues and profits, or assets and liabilities. Before long, we’ll feel exactly the same way about ESG disclosures like GHG emissions or workforce metrics.”
• Expect more impact-oriented investing and other data. “Impact is a new form of values-oriented investment,” says Bioy. New EU regulations require companies to report on risks to their business and their impact on the world around them. These regulations “will facilitate the new trend.”
• Expect funds to be more targeted. For example, about two thirds of sustainable funds have energy sector exposure, as they engage with companies. “It’s time to reconsider that view,” says Hale. “Sustainable funds that currently invest in fossil fuels should say they are going to spend no more than the next five years engaging—and after that, they are going to wind down their exposure to fossil fuels. There is no more time to wait.”
• Expect “S” factors to remain a political hot button. “Investors’ efforts to advance S-related policies, practices and investing approaches will continue, but will be increasingly referred to in general terms like human capital management and supply chain resilience,” says Cook.
• Artificial intelligence will transform how we gather and analyze sustainability issues in a world inundated with data. Sustainability research will complement company-reported information with data about companies from external sources, such as geospatial data on methane emissions. “Sustainable investing should not be expected to ‘solve’ complex, often global, problems, but it can be a force for change,” says Kuh.