Since the inception of ESG, research has explored how costs, revenues, risks, and valuations are influenced by ESG performance, often through ratings providers like MSCI and Sustainalytics. Numerous studies confirm a positive relationship between strong ESG performance and financial outperformance. For example, an EY–EBS University (2023) study found that funds with better ESG profiles achieved internal rates of return up to 7.8 percentage points higher than competitors with poor ESG profiles. While measuring the relationship between ESG performance and financial outcomes is a good start, we are entering a new era. The next generation of ESG integration must move from ratings-based assessments to bottom-up, company-level financial modeling.
Our approach
Our approach focuses on quantifying how sustainability decisions affect core financial drivers – cost, revenue, and risk. This approach requires examining three steps of financial implications: inaction, action, and outcomes. Each of these can have positive and/or negative financial implications, and understanding these dynamics is essential for managers and portfolio companies seeking to embed sustainability into value creation strategies.
Financial implications of inaction
Failing to act on material ESG issues directly erodes value. Companies with weak carbon management increasingly lose out in supplier selection; suffer from weak employee engagement and attrition; and exhibit inadequate cybersecurity measures resulting in financial losses and regulatory fines. Quantifying these dynamics allows management teams to treat ESG not as a disclosure exercise but as a profit-and-loss consideration.
Let’s take an example. Consider a mid-market UK company bidding for a National Health Service (“NHS”) contract that could increase revenue by 20%. At present, its carbon footprint management is reactive. It operates with inefficient energy systems, has limited visibility over value-chain emissions, and lacks a carbon reduction plan. Under current NHS procurement standards, its lack of a credible carbon reduction plan could disqualify it from winning the tender – a clear revenue risk. Meanwhile, let’s say the same company also has inefficient heating infrastructure that increases both emissions and operating costs. A traditional ESG assessment would highlight the environmental impact of the company’s inefficient heating infrastructure but miss the substantial financial implications of missing out on an NHS tender.
Financial implications of actions
Once gaps are identified and the financial cost of inaction has been evaluated, companies can undertake targeted actions to strengthen ESG performance and resilience. Electrifying a vehicle fleet, implementing employee retention programmes, or certifying cybersecurity practices are all actions that require investment, and modeling these clarifies decision order and payback periods.
Looking at our UK company example, creating an emissions reduction pathway to achieve net zero by 2045 would help this company meet NHS requirements. To achieve this, the company would incur administrative costs associated with the creation of an emissions reduction pathway and capital expenditure associated with retrofitting – including vehicle electrification, solar panels, and insulation.
Financial implications of outcomes
The implementation of ESG actions over time can lead to payback on company expenditure and the achievement of value creation. It is at this point that management teams should look to assess the impact of these ESG actions on cost, revenue, and risk.
Returning to our example, the implementation of the actions outlined previously would have a payback time and in turn reduce operating expenditure from improved energy efficiency. These actions would also mitigate risks associated with fossil fuel price volatility and prepare the company for future regulatory changes. Alongside this, the company would derive commercial benefits from capturing additional revenues from meeting the NHS net zero supplier requirements. The outcome for the company is a stronger balance sheet, competitive positioning, and an improved valuation multiple.
Final reflection
Ultimately, viewing ESG through the lens of inaction, action, and outcomes transforms it from a passive overlay into a strategic driver. Our conviction is clear: sustainable value creation is not external to financial analysis; it is financial analysis. Investors who understand and quantify the financial implications of sustainability factors will be best positioned to capture upside.
