From ESG to Sustainable Impact Finance: Moving Past the Current Confusion

In this chapter, we argue that environmental, social, and governance (ESG)/sustainability is moving from being based primarily on ESG ratings and rankings, which has caused significant confusion, to being based on mandated disclosure and analysis of externalities. We briefly examine the basis of ESG ranking and rating confusion, concluding that the current methodologies of major providers result in neither significant change nor accurate disclosures by firms. Alternatively, we suggest that an integration of externality data will significantly modify Modern Portfolio Theory as it does not account for externality effects on “systems” (think market beta) or the interactive effects of firms’ actions on other firms in various types of portfolios, both directly and indirectly. These dynamics are qualitatively important given the growth and dominance of universal owner-type portfolios. Not accounting for externalities leads to sub-optimal economic system performance, reducing the financial return both absolutely and sometimes relatively. In turn, these dynamics redefine what financial “materiality” means. Finally, we place these concepts and developments into the context of global emerging regulatory standards and debates about them.