History of ESG Investing
Hi All,
The ESG investing market has gone mainstream, with an increasing number of institutions incorporating ESG considerations into their investment decisions and ownership activity. ESG investing has become a major force in global financial markets and commands a significant share of professionally managed assets in all regions.
In this post, I wanted to explore the evolution of ESG investing from its roots in the 16th century to its current interpretation and implementation, which continues to evolve rapidly. We will cover key statistics about the size and scope of the ESG market in the future post.
The growth in ESG assets is driven by both intrinsic and extrinsic factors. The growing demand from institutional asset owners and retail investors provides commercial incentives for asset managers to engage. In addition, government policies and regulations across various regions, as well as information from NGOs and civil society, have also contributed to the growth of the ESG market.
I. A Brief History of ESG Investing/Sustainability
In 1983, the United Nations (UN) General Assembly formed the World Commission on Environment and Development (WCED), an international group of environmental experts, politicians, and civil servants in response to growing concerns about environmental issues such as ozone depletion and global warming, which were attributed to improving the living standards of the world's population. The WCED, also known as the Brundtland Commission, was tasked with providing sustainable development solutions. The Brundtland Report, also called ‘Our Common Future’, was published in 1987 and introduced the concept of sustainable development, defined as “meeting the present needs without compromising future generations' ability to meet their own needs.” It talked about how sustainable development could be achieved.
The Brundtland Report was instrumental in the 1992 Rio de Janeiro Earth Summit, also known as the Rio Summit or the UN Conference on Environment and Development (UNCED). The summit led to the creation of the UN Commission on Sustainable Development later that year. The summit emphasized the role of businesses in promoting sustainable development, stating in the Rio Declaration on Environment and Development that businesses have a responsibility to ensure their activities do not harm the environment as they gain legitimacy by meeting society's needs.
ESG investing is in fact not new, as responsible investing can be traced back to the inception of investing itself. The Quakers and Methodists in the 17th and 18th centuries had already established guidelines on investment activities for their followers. The early form of socially responsible investment (SRI), also known as ethical investing, was negative screening, which deliberately avoided investing in companies or industries that did not align with their values. SRI began as an ethical issue, with environmental issues taking center stage at a later stage. This led to the use of the term SRI rather than ESG investing.
One of the first ethical mutual funds that utilized screens based on religious traditions was the Pioneer Fund, launched in 1928. Modern institutionalization of ethical exclusions began in 1971 during the Vietnam War with the establishment of the Pax World Fund, now IMPAX Asset Management, as an alternative investment for those opposed to the production of nuclear and military arms.
In the late 1970s, the divestment movement grew through a global divestment campaign against South Africa’s apartheid system. The Sullivan Principles required investee companies to treat all employees equally regardless of race as a condition for investment. This value-based or exclusionary SRI primarily considered ethical behavior and is credited by some with pressuring the South African government to negotiate and ultimately end apartheid.
Following the 1992 Rio Summit, mainstream support for sustainable development gained further momentum.
II. Rise of Sustainable Responsible Investing (SRI)
The evolution of SRI has accelerated in recent times and is marked by significant changes. Three key developments that contributed to this evolution are:
(1) the increase in shareholder activism,
(2) the widespread consideration of environmental factors, and
(3) the introduction of positive-screening investing ⇒ seeks to maximize financial return within a socially aligned investment strategy.
The integration of ESG factors into the traditional investing framework, which was previously focused only on profit and risk-adjusted return, paved the way for responsible investment. This investment approach values companies based on both financial and ESG factors, and it has become increasingly relevant over the years.
The early 2000s saw a renewed interest in SRI, including corporate governance, after widespread fraud at Enron Corporation and other companies. In response, regulations such as the Sarbanes-Oxley Act of 2002 in the United States emphasized the importance of good corporate governance.
In 2004, a call to action from UN Secretary-General Kofi Annan led to the integration of ESG factors into capital markets. The initiative produced a report, "Who Cares Wins - Connecting Financial Markets to a Changing World," which coined the term "ESG." The report demonstrated the business case for embedding ESG factors in capital markets. Also, the UN Environment Programme Finance Initiative (UNEP FI) produced the Freshfields Report, which showed that ESG issues are relevant for financial valuation and, thus, fiduciary duty. The two reports ‘Who Cares Wins’ and ‘Freshfields Report’ led to the launch of the Principles for Responsible Investment (PRI) in 2006 and the Sustainable Stock Exchange Initiative (SSEI) the following year.
Climate change has gained particular attention in the investment industry, with the Stern Review on the Economics of Climate Change being a significant influence. Published in 2006, the report concluded that climate change is the greatest and widest-ranging market failure ever seen and that early action is crucial.
The background story is - in 2006, economist Sir Nicholas Stern was commissioned by the UK government to conduct a comprehensive review of the economic impact of climate change and how to address it. The resulting report deemed climate change to be the most extensive market failure in history, posing a unique challenge for the field of economics. It stressed the importance of taking early action, as the costs of inaction would far exceed those of taking action. The report estimated that failing to take action would result in a loss of at least 5% of global GDP each year, with the potential to increase to 20% or more if a wider range of risks and impacts were taken into account. While not the first economic report on the topic, the report had a significant impact on how investors perceive the issue of climate change, both in the UK and worldwide.
Recent events such as the Global Financial Crisis of 2008, the COVID-19 pandemic, and increased geopolitical tensions have reminded institutional investors of the risks and opportunities presented by a company's extra-financial performance. Large asset owners, perceived as "universal owners," are increasingly tied to the performance of markets and economics as a whole, making responsible investment an essential approach.
III. Conclusion
In conclusion, ESG investing has become a major force in global financial markets and commands a significant share of professionally managed assets in all regions. The growth in ESG assets is driven by both intrinsic and extrinsic factors. The intrinsic factors include a growing demand from institutional asset owners and retail investors, while extrinsic factors include government policies and regulations across various regions, as well as information from NGOs and civil society.
ESG investing is not new, as responsible investing can be traced back to the inception of investing itself. The evolution of ESG investing has accelerated in recent times and is marked by significant changes such as the increase in shareholder activism, the widespread consideration of environmental factors, and the introduction of positive-screening investing. The integration of ESG factors into the traditional investing framework paved the way for responsible investment, which values companies based on both financial and ESG factors.
Climate change has gained particular attention in the investment industry, and the Stern Review on the Economics of Climate Change has been a significant influence. The report deemed climate change to be the most extensive market failure in history, and early action is crucial. Finally, the launch of the Principles for Responsible Investment (PRI) in 2006 and the Sustainable Stock Exchange Initiative (SSEI) the following year were critical in furthering the growth of ESG investing. Overall, ESG investing continues to evolve rapidly, and it will be exciting to see where this trend leads in the coming years.
