Why assessing externalities quantifies the sustainability of your investments in a way ESG ratings can’t

Climate change, social inequality and other global challenges are putting pressure on businesses to meet costs which were previously externalised. This only increases the investment risk associated with unsustainable business models.

Clouds over container shipping port


Ben Corris, CFA, PhD
Head of ESG models and Data

The measurement of externalities offers a powerful tool to understand sustainability outcomes and manage investment risks. Whereas conventional ESG ratings typically provide a subjective assessment of sustainability performance, SustainEx applies a quantitative, comprehensive view of a company or sovereign issuer’s externalities and resulting risk profile, taking into account positive and negative effects. This can lead to more informed investment decisions in relation to sustainability.

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Introduction: the need to measure sustainability

As sustainable investing has moved into the mainstream1, the importance of being able to measure and demonstrate a security or a portfolio’s sustainability has grown. This has increased both the use – and criticism – of third party ESG ratings.

Here we set out the benefits of an approach rooted in the analysis of sustainability risks associated with the internalisation of previously externalised costs. We also discuss the limitations of ESG ratings.

Schroders’ approach to sustainable investment quantifies the positive and negative externalities that organisations impose on wider society in monetary terms. Viewing those costs and benefits through a hard economic lens provides an objective measure of their credit or deficit with society, which becomes more important as they crystallise into financial costs or benefits.

The challenges of following ESG ratings

As sustainable investing has grown in popularity and complexity, so has the demand for reliable and consistent tools to measure the sustainability performance of securities and portfolios. While ESG ratings are one of the most widely used tools for this purpose, they have drawn criticism [2],[3],[4].

A common observation is that there is a lack of consistency in approach and divergence in outcomes: in stark contrast to credit ratings, for example, there is significant variation and disagreement among ESG ratings in their assessment of individual companies or sovereign issuers. A 2022 study found the correlation between the ESG ratings of six major providers was only 0.54 on average[2], indicating a lack of consensus around how to assess sustainability. Rather than providing an antidote to different conclusions, disagreement increases in line with levels of disclosure[3],[4]. This is important as it suggests that we should not expect convergence in ratings as a result of increased mandatory sustainability reporting requirements.

We do not consider disagreement among rating providers problematic. Research analysts regularly reach different recommendations on individual companies and, insofar as we consider sustainability factors an important component of investment decisions, a similar picture is expected.

One explanation for ESG ratings diverging may be the overlapping but distinct view on what they are attempting to measure. Without a clear definition of the problem statement, what ESG ratings are aiming to capture can result in a muddled approach.

Moreover, ESG ratings usually impose a view on which are the most material issues for a sector or even an issuer. This judgment on the relevance of different factors causes much of the variation between ratings agencies. By assessing the monetary value of externalities produced by an organisation, the relative importance of different factors is determined by the analysis, rather than being imposed onto it. This results in a conclusion expressed in dollar terms that can be assessed in the context of financial statements.

Sustainability through the lens of externalities

Externalities are the costs or benefits that a third-party experiences as a result of an economic activity, but that are not reflected in the market price of that activity[6]. For example, companies in many sectors and countries emit damaging greenhouse gases for which they are not “charged”.

It can be helpful to map out the various stakeholders that support a given entity’s success and consider which externalities are significant and which stakeholder relationship is under the most strain.

Companies and their relationships

Negative environmental externalities, such as pollution or resource depletion, are often the most visible. These can lead to widespread environmental degradation, affecting air and water quality, biodiversity loss, and contributing to climate change. The cost of these impacts is often borne by society or governments, either through health consequences, or through the expense of mitigation and adaptation.

However, the impact of externalities isn't confined to the environment. They can also have significant social implications. For instance, if a company pays wages below the living wage, the cost of supporting its employees is pushed onto society. Similarly, poor working conditions can lead to health and social issues that are absorbed by the wider community.

Large externalities can attract regulatory attention, leading to potential legal and financial risks for the company, making business models reliant on externalising costs inherently more vulnerable than those whose profitability is grounded in delivering clear social benefits. As regulators and societies increasingly focus on ensuring that companies bear the full cost of their operations, this can lead to fines, sanctions, or changes in consumer behaviour which lead to previously externalised costs becoming internalised financial penalties.

Externalities may also be positive. For example, a company that invests in renewable energy or innovative new products creates a positive externality for society, which benefits from lower emissions or improved living standards.

As we discuss below, there is a broad range of mechanisms that can disrupt an organisation’s ability to continue to impose costs on wider society[9],[10],[11],[12],[13],[15].

By understanding both a firm’s exposure to specific externalities and the wider context of its net position, we start to build a rich and insightful picture of potential future risks and the sustainability of its growth trajectory.

Externalities explained

Externalities are important for sustainable investing because they represent a source of risk and opportunity for investors. When externalities are not yet internalised there is a potential for market inefficiencies and mispricing. This can lead to over-investment in activities that generate negative externalities and underinvestment in activities that generate positive externalities, resulting in suboptimal outcomes for both the economy and society.

Mechanisms for internalisation

Large externalities can often present a store of future problems for a company; an unrecognised liability that hangs over future profitability. The stakeholders bearing these costs often have an incentive to renegotiate the terms of their relationship with the company. Additionally, the possibility of regulatory intervention increases as authorities aim to protect stakeholders and maintain a balanced business ecosystem. These factors can result in significant investment risks, which are not captured in traditional risk models.

Over the last 20 years, large businesses have become bigger and more powerful. Their shares of employment, business revenue, exports or economic output have risen significantly around the world[21],[22],[23],[24]. This is not a narrow theme dominated by any particular sector; it is a broad phenomenon and we have seen increased concentration across a range of industries[20],[26]. The multinationals listed in the Fortune Global 500 now generate revenues close to 40% of the value of global GDP[24],[25].

The expanding role of large companies is in tandem with intensifying social and environmental challenges. This has been exacerbated by larger, wealthier, consumption-hungry populations putting further pressure on finite global resources and ecosystems (Fig 3).

Climate change is perhaps the highest profile outcome: close to 90% of the world’s population is now connected to an electricity grid, where 64% of the electricity comes from fossil fuel combustion2. Around one-third of this power is generated by listed utilities3, tracing a direct link from economic expansion and corporate growth to environmental damage.


On the other hand, the public sector has become less and less able to absorb those social and environmental challenges. The World Inequality Lab calculates the capital controlled by each sector of major economies, net of debt, showing that the public wealth of developed economies has sunk into the red while their private sectors have thrived. Social and environmental costs cannot continue to be absorbed by societies and governments.

The blame cannot be laid solely at the door of big business. However, as their impacts have grown, and governments have become more focused on intervention, the threat companies face has risen. Businesses whose models create the most damage will come under increasing pressure to shrink or compensate for the costs they impose.

Spurred by changes in social attitudes following the global financial crisis, governments have begun to move costs they have borne back to the private sector.

A broad range of internalisation mechanisms allow regulators and other stakeholders to reduce the cost of the externality that is placed on society. Depending on the mechanism employed, this can result in either reduced demand for problematic products and services or increased operating costs associated with less sustainable business models. Mechanisms that can act to regulate previously unchecked cost externalisation include, but are not limited to:

  • Targeted taxation[9],[10]
  • Litigation[12]
  • Industrial action[15]
  • Restrictions on business practices and advertising[16]
  • International sanctions [17]
Climate litigation

This exposure to regulatory, reputational, legal, or operational risks, arising as governments, consumers, or civil society may demand or enforce actions to correct the externalities, drives the investment relevance of our analysis.

There is also a range of mechanisms such as subsidies, grants and patent protections that exist to support the ongoing production of public goods. We believe that firms that are perceived as positive actors (for example through their status as good employers, innovators, working in partnership with their local communities, or providers of solutions to the climate crisis) have a protected social licence to operate and have strengthened brands[17].   

It is essential for investors to be able to identify, measure, and manage the externalities associated with their investments, and to incorporate them into their investment process and decision making. By doing so, investors can not only align their portfolios with their sustainability objectives and concerns, but also enhance their risk-adjusted returns and generate long-term value for themselves and society.

Why understanding externalities goes beyond following ratings

Quantifying externalities can provide a more objective and consistent measure of the environmental and social impact of companies, as well as the risks and opportunities they face. By monetising externalities, investors can compare the performance of companies across sectors and regions and adjust their valuations accordingly. Moreover, quantifying externalities can help align the incentives of companies and investors with the broader goals of society and the planet and foster more responsible and sustainable business practices.

Moreover, by providing externality-by-externality data to our investment teams, we help them to form a well-rounded, holistic view of the risks associated with their investments. This level of granularity and transparency goes beyond what can be achieved using off-the-shelf ESG ratings. It allows investors to make more informed decisions, tailored to their individual risk tolerance and investment goals. 

Moving from theory to practice – the launch of Schroders’ SustainEx

In 2018 the launch of SustainEx[14] made the analysis of externalities the corner stone of sustainability research at Schroders.

The starting point of SustainEx is to identify material externalities (both positive and negative) that companies and countries have on society. We use our stakeholder model as a framework, focusing on the constituencies with which companies and countries interact: consumers, communities, employees, governments and the environment.

The measures we select are:

  • Quantifiable so that costs and benefits can be measured and compared objectively.
  • Attributable to ensure impacts can be sensibly allocated between companies and/or countries.
  • Disclosed widely enough that comparison between global companies or countries is possible.
  • Transparent so that users can understand their meaning.

When we launched the tool back in 2018, we initially hoped to draw on existing work in this area – but there were few analyses mapping or measuring corporate externalities and we found none providing comprehensive views. We reviewed public reports such as The Economics of Ecosystems and Biodiversity analysis of natural capital and the costs of its damage4, consultants’5 frameworks to assess companies’ social and environmental impacts (though none had systematic analysis across companies using public data), and companies’ case studies summarised by the World Business Council for Sustainable Development (WBCSD)6.

The externalities we have identified for use in SustainEx are based on our own analysis, drawing as far as possible on the existing frameworks, including the UN Sustainable Development Goals and The Economics of Ecosystems and Biodiversity initiative mentioned above. The full list of impacts we have included in our analysis are presented below (Fig 5).

Tabler of externalities

Our goal with this analysis is to be comprehensive rather than to pre-judge the most important externalities: by putting economic costs against them, the most important externalities will automatically assume more importance.

Our fundamental analysis and other proprietary tools help us understand the materiality of the risk for investments, how companies and countries manage those, and their transition path to a more sustainable model where relevant.

Externalities total costs

Chart source: Schroders, March 2024

The SustainEx model initially covered companies only. In 2020, we expanded it to countries, with 29 externalities attributed to sovereigns. We focused on areas where countries contribute more or less to global, rather than domestic, challenges or benefits. Some externalities overlap with companies (such as carbon emissions) while others are unique to countries (such as education spending or piracy).

By treating both companies and governments within a constant framework, we allow for a true cross-asset integrated and comprehensive analysis that encompasses multiple asset classes including Equity, REITs, corporate and sovereign debt. Figure 7 demonstrates the comparability of our approach between a corporate and sovereign issuer of debt.

Externalities example by holding

Chart source: Schroders, March 2024

Figure 7 shows the key positive and negative impacts of Veolia and France. The overall impact on stakeholders from externalities is determined starting from a baseline of zero, to which positive contributions are added and negative impacts deducted, to reach a net value measure, shown here as a percentage of sales or GDP.

As well as our externality analysis providing a view of an issuer’s net position as having a positive or negative effect from its externalities, it can be important to contextualise the analysis with a relevant peer group. This is important as the sustainability profile of the peer group can vary greatly by industry and by geography. A peer group analysis based on, for example, a company’s sector, a country’s regional grouping, or between developed and emerging economies on a consistent basis, can help identify sources of potential risk within sectors, regions or at portfolio level.

SustainEx aims to provide a comprehensive and objective assessment that a wide range of investors across asset classes can draw from to build insights into forward looking sustainability risks. A more complete overview of our methodology is available for further reading[19].


As the world faces unprecedented challenges such as climate change, social inequality, and public health crises, pressure grows to deploy mechanisms to internalise previously externalised costs. This only increases the investment risk associated with unsustainable business models.

By thoughtfully quantifying externalities ourselves, we can gain several advantages over an approach relying solely on third party ESG ratings. We are able to:

  1. Account for the different materiality and relevance of externalities for different stakeholders at a company rather than sector level and avoid bias or subjectivity in the selection and weighting of ESG indicators.
  2. Generate insights into the key themes driving the results of the analysis and trace those insights back to the underlying hard data points.
  3. Link the externalities directly to our expectations of financial performance and the risks associated with a specific security, and incorporate them into our valuation and portfolio construction processes.
  4. Provide more insight and transparency into the drivers and sources of the externalities, and identify the key areas of improvement or opportunity for a company.
  5. Trace the externalities back to the raw data points that underpin them. This allows us to verify the accuracy and reliability of our analysis.

In summary, the measurement of externalities offers a powerful tool for understanding and managing investment risks. By quantifying externalities, we go beyond what can be achieved with ESG ratings and can achieve a more nuanced, objective, and comprehensive view of a company’s or country’s risk profile, ultimately leading to more sustainable and informed investment decisions.


  1. According to the Global Sustainable Investment Alliance[1], global sustainable investment assets reached $30.3 trillion in 2022, with non-US markets seeing an increase of Assets Under management of 20% since 2020. The growth of sustainable investing has been driven by a range of factors, such as increased awareness of global challenges, changing investor preferences, regulatory developments, and improved data availability.
  2. Data from the International Energy Agency’s (IEA) 2017 Energy Technology Perspectives model shows 69% of global electricity generation is from fossil fuel sources. Our world in Data
  3. Based on World Bank analysis.
  4. See TEEB website
  5. KPMG’s True Value framework is framed as a tool to connect corporate and societal value creation. PWC’s Total Impact Measurement framework is designed to help companies understand how their activities contribute to the economy, environment and society.
  6. See Measuring and valuing social capital: Insights into employment, skills and safety.


[1] Global Sustainable Investment Review 2022

[2] Florian Berg, Julian F Kölbel, Roberto Rigobon. “Aggregate Confusion: The Divergence of ESG Ratings”. Review of Finance (2022)

[3] Christensen, Dane M., George Serafeim, and Anywhere Sikochi. "Why is corporate virtue in the eye of the beholder? The case of ESG ratings." The Accounting Review (2022)

[4] Liu M. “Quantitative ESG disclosure and divergence of ESG ratings”. Front. Psychol. (2022)

[5] Chatterji, Aaron K., et al. "Do ratings of firms converge? Implications for managers, investors and strategy researchers." Strategic Management Journal  (2016)

[6] Pigou, Arthur. “The Economics of Welfare”. Macmillan (1920)

[7] Helbling, Thomas. “Externalities: Prices Do Not Capture All Costs”, International Monetary Fund  Externalities: Prices Do Not Capture All Costs (

[8] Helbling, Thomas. What are Externalities? What happens when prices do not fully capture costs, International Monetary Fund (2010) Back to Basics - What Are Externalities? - Finance & Development - December 2010 - Thomas Helbling (

[9] World Bank, Record high revenues from global carbon pricing near $100 billion.

[10] World Health Organization, Tobacco control can save billions of dollars and millions of lives, 2017

[11] UK Government, High Stakes: Gambling Reform for the Digital Age, 2023

[12] Global Climate Litigation Report: 2023 Status Review, 2023

[13] Scottish Government, Policy: Alcohol and drugs, minimum unit pricing

[14] Schroders, SustainEx, 2019, SustainEx-short.pdf (

[15] Barry, Michael, and Rebecca Loudoun. "Industrial relations, occupational safety and health, and union organising in Australia: lessons and opportunities." Policy and Practice in Health and Safety 4.1 (2006): 31-44.

[16] Williams, Robert J., Beverly L. West, and Robert I. Simpson. "Prevention of problem gambling: A comprehensive review of the evidence and identified best practices." (2012).

[17] Agus Harjoto, Maretno, and Jim Salas. "Strategic and institutional sustainability: Corporate social responsibility, brand value, and Interbrand listing." Journal of Product & Brand Management 26.6 (2017): 545-558.

[18] UN,  United Nations Security Council Sanctions Regimes, 2023

[19] [SustainEx methodology summary, 2024][CB1] 

[20] Gábor Koltay, Szabolcs Lorincz. “Competition Policy Brief” European Commission (2021) Industry concentration and competition policy (

[21] US Census, “Statistics of U.S. Businesses Historical Data”, (1988 – 2021), SUSB Historical Data (

[22] Theo Francis. “Why You Probably Work for a Giant Company" Wall Street Journal (2017) Why Americans Are More Likely to Work for a Large Employer, in 20 Charts (

[23] “Is big business really getting too big?” The Economist (2023) Is big business really getting too big? (

[24] “69 of the richest 100 entities on the planet are corporations” Global Justice Now (2018)  69 of the richest 100 entities on the planet are corporations, not governments, figures show - Global Justice Now Global Justice Now

[24] Fortune Global 500, (2022) Fortune Global 500 – The largest companies in the world by revenue | Fortune,

[25] Global GDP - Statistics & Facts | Statista

[26] Ryan Decker and Jacob Williams, “A note on industry concentration measurement”, Federal Reserve (2023) The Fed - A note on industry concentration measurement (

[27]; Chancel, L., Moshrif, R., Piketty, T., Xuereb, S., (2023), "Historical Inequality Series on - Updates", World - WID - World Inequality Database

[28] Andrew, R. M., & Peters, G. P. (2023). The Global Carbon Project's fossil CO2 emissions dataset (2023v36), CO₂ emissions dataset: our sources and methods - Our World in Data

[29] Marcos Poplawski-Ribeiro, Jiae Yoo, Victoria Haver, Youssouf Kiendrebeogo, Roberto Perrelli, Zhonghao Wei, Chenlu Zhang, Meron Haile,  “2023 Global Debt Monitor” International Monetary Fund. 2023-09-2023-global-debt-monitor (5).pdf

[30] World Wildlife Fund (WWF) and Zoological Society of London “Living Planet Report 2022” 2022


Ben Corris, CFA, PhD
Head of ESG models and Data


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