12 things to know about ESG and sustainable investing, and a look at the next 20 years.
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 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.”
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.”
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.”
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 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.”
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.
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).
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.
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.”
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.
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.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
Leslie Norton is editorial director for sustainability at Morningstar.
Norton joined Morningstar in 2021 after a long career at Barron’s Magazine and Barrons.com, where she managed the magazine’s well-known Q&A feature and launched its sustainable investing coverage. Before that, she was Barron’s Asia editor and mutual funds editor. While at Barron’s, she won a SABEW "Best in Business" award for a series of stories investigating fraudulent Chinese equities, which protected the savings of investors and pensioners by warning about deceptive stocks before they crashed.
She holds a bachelor’s degree from Yale College, where she majored in English, and a master’s degree in journalism from Columbia University.
Charity Blue is a senior product manager and reporting program manager on Morningstar’s Enterprise Sustainability Team.
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