ESG and finance: Why sustainability now drives financial strategy

In recent years, Environmental, Social and Governance (ESG) has become a top concern for finance. ESG sits at the heart of investment decisions, company strategy and new rules. This is more than a trend – it’s changing how we measure business success and financial health.

What is ESG and why does it matter?

ESG stands for Environmental, Social, and Governance – three key pillars used to measure the sustainability and ethical impact of a company’s operations. ESG criteria are widely used by investors to assess potential investments and by companies to guide responsible business practices. By considering ESG factors, financial leaders gain a fuller understanding of long-term risks and opportunities beyond traditional financial metrics.

• Environmental: How a company treats the planet. This covers energy use, waste, pollution and climate action.

• Social: How a company treats people. This means workers, customers, suppliers and the local community.

• Governance: How a company is run. This includes leadership, fair pay, diversity, ethics and clear reporting.

ESG is not just about ticking boxes. It helps spot risks and chances that standard financial checks might miss.

The evolution of ESG in finance

ESG has roots in socially responsible investing from the 1960s, when funds avoided industries like tobacco or weapons. Now, ESG is much more than exclusion – it involves evaluating a company’s practices and performance across a wide range of environmental, social, and governance criteria.

Why the change? There’s more proof that ESG affects profits. People care more about climate and fairness. Better data tools help, and new rules require more transparent reporting. Today, ESG factors into almost every financial decision, from single investments to global strategies.

The business case for ESG

Some argue ESG is about ethics, not economics. But evidence increasingly shows that companies with robust ESG practices can outperform their peers over the long term. They typically:

• Get cheaper loans and lower costs

• Face fewer fines and scandals

• Operate more efficiently

• Attract and retain talented staff

• Show greater resilience during tough times

A major review by NYU Stern in 2021 examined over 1,000 studies. Most showed a positive link between strong ESG and improved financial results. Only a small number found the opposite.

ESG investment strategies

Investors have developed various approaches to incorporate ESG considerations into their portfolios:

• ESG integration involves systematically including ESG factors alongside traditional financial metrics when making investment decisions. This approach doesn't necessarily exclude any industries but weights investments based on relative ESG performance.

• Negative screening excludes companies or sectors that don't meet specific ESG criteria, such as fossil fuel producers, weapons manufacturers, or companies with poor human rights records.

• Positive screening (or best-in-class) selects companies with stronger ESG performance relative to industry peers.

• Thematic investing focuses on specific ESG themes like clean energy, water scarcity, or gender diversity.

• Impact investing aims to generate measurable social or environmental benefits alongside financial returns, often through direct investments in projects or companies with explicit sustainability goals.

• Active ownership involves using shareholder rights to influence company behaviour through voting and engagement.

The rise of ESG data and ratings

ESG growth has led to the rise of many data providers and ESG rating agencies, such as MSCI, Sustainalytics and S&P. They rate companies across hundreds of ESG criteria, though methodologies and results can vary significantly.

But there are problems:

• No single ESG standard: Each ratings agency uses its own method.

• Some data is missing: Especially for smaller firms or new markets

• Risk of greenwashing: When companies make themselves look greener than they are

Groups like the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI) work on better, clearer standards.

Regulatory developments in ESG

Regulatory requirements for ESG disclosure and integration are evolving quickly in the UK, EU and worldwide.

• EU: New rules require funds to explain how they use ESG in decisions

• UK: Companies must report climate risks and follow green standards by 2025

• US: Plans for more climate-related reporting and investment rules

• Global: The International Sustainability Standards Board (ISSB) is setting new worldwide standards

These changes mean ESG is now part of the financial system, not just a nice extra.

Climate finance and the net zero transition

Climate change presents one of the biggest ESG challenges for the financial sector. Achieving net zero emissions by 2050 is expected to require trillions of dollars in global investment.

Banks and investors are responding with more green loans, climate-friendly products and green bonds. Groups like the Glasgow Financial Alliance for Net Zero (GFANZ) unite hundreds of banks and funds aiming for net zero by 2050.

Social factors gaining prominence

While climate issues have dominated the ESG agenda in recent years, social factors are receiving increased attention, particularly following the COVID-19 pandemic and heightened awareness of social inequality.

Key social considerations for investors include:

• Workforce practices (wages, benefits, health and safety)

• Diversity, equity, and inclusion initiatives

• Supply chain management and human rights

• Product safety and data privacy

• Community relations and social impact

Companies with strong social performance tend to benefit from enhanced brand reputation, greater customer loyalty, and improved ability to attract and retain employees – all factors that can contribute to long-term financial success.

Governance: The foundation of ESG

Effective governance provides the foundation for addressing environmental and social challenges.

Governance considerations include:

• Board composition, diversity, and independence

• Executive compensation structures

• Shareholder rights and engagement

• Business ethics and anti-corruption measures

• Tax transparency and responsibility

• Risk management frameworks

Good governance practices help ensure that companies are well-positioned to address ESG risks and opportunities while aligning management incentives with long-term value creation.

ESG challenges and criticisms

Despite its growing prominence, ESG investing faces several challenges and criticisms:

• Measurement difficulties: ESG factors can be difficult to quantify consistently, leading to divergent ratings and assessments.

• Materiality questions: Different ESG issues may be more or less financially material depending on the industry and company.

• Short-termism: Financial markets' focus on quarterly results can conflict with the long-term nature of many ESG considerations.

• Greenwashing concerns: Companies may exaggerate their ESG credentials to attract investment without making substantive changes.

• Politicisation: In some markets, particularly the US, ESG has become entangled in broader political debates about the role of corporations in society.

• Performance debates: While evidence generally supports the financial case for ESG, some studies have found mixed or negative relationships between ESG factors and returns.

Addressing these challenges requires continued refinement of ESG methodologies, greater transparency, and clearer connections between specific ESG factors and financial outcomes.

The future of ESG and finance

Looking ahead, several trends are likely to shape the evolution of ESG in finance:

• Standardisation and regulation: Continued movement toward standardised ESG reporting frameworks and increased regulatory requirements.

• Technology integration: Advanced data analytics, artificial intelligence, and blockchain applications will improve ESG data collection, verification, and analysis.

• Biodiversity focus: Growing attention to biodiversity loss and nature-related financial risks, similar to the evolution of climate risk awareness.

• Just transition emphasis: Increased focus on ensuring that the shift to a low-carbon economy is socially inclusive and doesn't exacerbate inequality.

• Outcome-based measurement: Moving beyond process-focused ESG assessments toward measuring actual environmental and social outcomes.

• Integration with financial analysis: Further embedding of ESG considerations into mainstream financial analysis rather than treating them as separate factors.

Practical steps for financial professionals

For financial professionals looking to enhance their ESG capabilities, several practical steps can help:

1. Develop ESG expertise: Invest in training and education to understand ESG issues and their financial implications.

2. Enhance data capabilities: Improve systems for collecting, analysing, and integrating ESG data into investment processes.

3. Clarify ESG philosophy: Articulate a clear approach to ESG that aligns with your organisation's values and client expectations.

4. Engage with companies: Use shareholder rights to encourage improved ESG practices at portfolio companies.

5. Collaborate with peers: Participate in industry initiatives to share best practices and advocate for improved standards.

6. Communicate transparently: Provide clear reporting on ESG activities and outcomes to avoid greenwashing allegations.

7. Focus on materiality: Prioritise ESG factors that are most likely to impact financial performance in specific sectors.

Final thoughts

The integration of ESG considerations into finance represents one of the most significant shifts in investment practice in generations. Far from being a passing trend, ESG has become a fundamental aspect of how financial risks and opportunities are evaluated in the 21st century.

While challenges remain in terms of measurement, standardisation, and implementation, the direction of travel is clear: financial systems are increasingly recognising that environmental, social, and governance factors are not external considerations but central components of financial value creation.

For investors, companies, and financial professionals, developing robust ESG capabilities is no longer optional but essential for navigating a complex and rapidly changing economic landscape. Those who successfully integrate ESG considerations into their strategies will likely be better positioned to identify risks, capture opportunities, and deliver sustainable long-term returns.

As we face unprecedented global challenges – from climate change to social inequality to technological disruption – the financial sector has a crucial role to play in allocating capital toward solutions. By embracing ESG principles, finance can help build a future that is not only more sustainable, but also more resilient and inclusive.