Financialise ESG to save it

ESG can be interpreted in widely different ways in investment circles and, often, the pursuit of compliance overshadows the pursuit of meaningful change. Rodrigo Tavares writes that the best way to save the environmental, social and governance framework from irrelevance is to strip it from all elements that don’t impact a financial asset. This way, ESG can become a textbook requirement for investment and banking professionals.

There’s only one way to prevent environmental, social and governance practices (ESG) from becoming a mere feel-good exercise or a reputational fluff: to financialise them. That is not synonymous with monetisation. To financialise ESG means to strip it from all elements, data and concepts that don’t impact the profitability, liquidity, solvency, efficiency or valuation of a financial asset. This entails separating data from aspiration, and relying only on the ESG factors that are mathematically relevant for investment decisions, risk management or financial modelling.

ESG can be interpreted and put into practice in countless ways for many reasons, including its unclear conceptual boundaries, political polarisation in the US, excessive regulation in Europe, reliance on unverified self-assessments, voluntary market action and opaque rating agencies. These factors could lead to a spectrum of outcomes, ranging from significant positive impact to complete financial irrelevance. It may be fair to say that never such an imprecise and mystified idea gained so much space in investment and banking practices. As highlighted in Pitchbook’s Sustainable Investment Survey 2024 released last month, the most discerning challenge for ESG investors is the framework’s wide range of interpretations within the investment community. It is also self-evident that in jurisdictions where ESG is heavily regulated, the pursuit of compliance often overshadows the pursuit of meaningful change, reducing it to a mere tick-box or parroting exercise.

For twenty years, golden-hearted activists, environmentalists, ideologists and young millionaires have been the driving force behind ESG. But its future should be enhanced by financiers and mathematicians, who must now shape its trajectory. The financial world should take ownership and shape the practices it has been urged to adopt.

The first step to effectively financialise ESG is to generate high-quality and reliable data for money managers to use. Significant progress is actually being made in this area. The new reporting standards released in 2023 (ISSB S1/S2 and the European Sustainability Reporting Standards) are gradually standardising the ESG data companies must disclose. We are also making progress in legally ensuring that this data is independently verified. The era of inconsistent ESG data and unchecked sustainability claims is drawing to a close.

By leveraging artificial intelligence, natural language processing and sentiment analysis, we can tap into a vast reservoir of additional data, ranging from news articles in hundreds of languages to Satellite Earth Observation (EO) data and company filings. Several data companies are showing their muscles on this front.

The next crucial step is to sift through the vast sea of ESG data, discarding the irrelevant and retaining only what has financial significance. Existing materiality frameworks (for instance SASB/IFRS and MSCI’s materiality maps) help us identify the sustainability issues most relevant to financial performance in a large set of industries. But this is merely the prologue. The holy grail of ESG would lay in the convergence of financiers, startup entrepreneurs and AI pioneers working together to forge algorithms that decipher the financial significance of ESG data for individual assets, not large pools of them.

While universal ESG principles may emerge, their application must be finely tuned to the idiosyncrasies of each asset, encompassing its industry and geographic footprint. The heart-pounding effects of climate change, for example, might hold financial relevance for, say, a Japanese multinational or be inconsequential from a business perspective, depending on the nuanced intricacies of its subsidiaries.

In this context, the future of the one-hundred-or-so ESG rating agencies hangs in the balance. Their survival depends on transparency. If their methodologies remain opaque, they risk irrelevance. It is unclear what their precise focus is: corporate sustainability, ESG risk or the socioenvironmental impact of companies’ products and services? Those focused on ESG risk are likely to be bought out by the dominant credit rating agencies.

The final step is to integrate the ESG data that is financially material into investment decisions, risk management and financial modelling. Unfortunately, existing trading platforms, valuation software companies and AI algorithms often fall short in providing guidance, leaving money managers with a dearth of tools to measure the impact of ESG data effectively. Financially material ESG data needs to be weaved into traditional models and variables such as company’s revenues, operating profit margin, balance sheet, capital expenditure, credit ratings, or in its discounted cash flow (DCF), a method used to estimate the value of an investment by projecting its future cash flows and discounting them back to their present value.

Yet, most finance professionals are still ill-equipped to harness the full power of ESG data due to technical limitations or resource constraints.

Scholarly research confirms that certain ESG factors are inextricably linked to financial risk. Peer-reviewed articles also reveal a significant relationship between ESG and financial performance, both at the individual portfolio and company valuation levels. Several well-known meta-studies, published in 2008, 2015 or 2021, which combine and analyse the findings of thousands of studies, found positive correlations between diligent sustainability business practices and economic performance. In an article forthcoming in 2025, my colleagues Catalina Stefanescu-Cuntze, Catarina Sá and I were also able to establish significant positive correlations even in regions where sustainability is often overlooked, such as the Gulf region.

The impact of certain ESG factors on financial performance seems easy to grasp. Strikes, labour unrest and poor working conditions can disrupt operations, damage a company’s reputation and lead to increased costs. Extreme climate change-related events such as hurricanes, floods and wildfires can cause physical damage to assets, disrupt operations, and lead to increased insurance premiums. Depletion of natural resources can lead to increased costs and supply chain disruptions.

It is clear that banks and investment houses that fail to consider financially material ESG factors are acting irresponsibly because they are limiting their potential for financial gain, overexposing themselves to unnecessary risks or falling into crowd-pleasing ephemeral practices. The history of money management is full of successful and unsuccessful attempts to maximise value by deepening our understanding of market and asset dynamics. Just as behavioural finance, factor investing or fundamental analysis have transformed the industry, ESG, if reduced to its financially relevant core nature, will be an indispensable tool and a textbook requirement for investment and banking professionals.

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• This blog post represents the views of the author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
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