The Operating System of Sustainable Finance
I signed the book contract for “The Operating System of Sustainable Finance” with Palgrave a few days before Donald Trump won the US election in 2024. In the weeks that followed, the discussions around anti-ESG and anti-DEI were annoying (what does it even mean to be anti-ESG?) and I needed a break until Christmas to start writing.
However, it helped me to have a better understanding of the topic and what the real substance is.
Let us start with some context. The global financial system is running on a very efficient model of capital allocations: optimize risk-adjusted returns. While it made markets efficient at generating profit, it created a system which did not include environmental or social criteria – and more importantly – largely ignored the non-financial preferences of capital owners.
The long chain of intermediaries with banks, asset managers, funds and funds of funds is shown in figure below. Each institution specializes in its segment and shares only the financial data needed for the next link in the chain. The result is that capital owners historically had limited insights where their money actually ended up, let alone whether it was aligned with sustainability goals (consider bank deposits or investment funds). Sustainable finance is the promise of transparency across the entire value chain.
Key Ideas
The book is built around two central concepts that define the future of capital allocation:
Value vs. Values: It is necessary to distinguish between investors using ESG data for financial risk-management (Value) and those driven by ethical imperatives (Values).
The Multi-Layer Operating System: It is a conceptual framework (Regulation, Disclosure, Data and Instruments) that explains how information and capital flow through the sustainable finance value chain.
Value vs. Values
We have two different approaches:
The Value Lens: Investors use ESG data to identify risks and opportunities for better risk-adjusted returns, such as climate litigation, supply chain disruptions or stranded assets. This is the dominant approach today by assets under management (AUM) that integrate some form of sustainable investment criteria. It also makes intuitive sense: When you have two identical companies from a financial perspective, you will probably prefer the company with the lower carbon footprint and the better labor relations.
The Values Lens: There are also investors that seek real-world impact alongside profit sometimes even accepting lower financial returns to achieve social or environmental goals. This is a smaller part of the sustainable finance universe but still substantial.
That means that we have two different types of investors. As a side note, the operating system also needs to incorporate all kinds of financial instruments.
Operating System
The second main idea is that there is a operating system which helps to direct the flow of capital towards sustainable goals. I have used four integrated layers as a general framework.
Layer 1: The Rulebook (Regulation). Whether it is the prescriptive, rules-based approach of the European Union or the market-led, norms-based model of the United States, regulation sets the boundaries and incentives. Through carbon pricing and subsidies, it changes the unit economics of sustainability. Through disclosure regulation, it is re-directing capital flows. Check out the book for a detailed analysis of the different regulatory approaches.
Layer 2: The Common Language (Disclosure). An operating system needs a language to process commands. In finance, this is disclosure. A central debate here is between “financial materiality” (does climate change affect the company?) and “double materiality” (does the company affect the planet?). This materiality question impacts disclosure standards which are necessary to compare results and avoid greenwashing.
Layer 3: Data and Information. This is the information backbone. We are currently seeing a lot of unstructured data, estimated metrics and divergent ESG ratings that create a “Tower of Babel” in ESG information. Technology, from AI to satellite imagery, can be expected to act as an error-correction mechanism. The book also looks at the different approaches and a comparison between Lufthansa and Ryanair is quite informative to understand the limits of the current ratings.
Layer 4: Financial Instruments (Applications). Finally, we have the “apps” that users actually interact with. The book covers climate mitigation instruments (green bonds for renewable energy, carbon credits, climate VC), climate adaptation instruments (catastrophe bonds, resilience bonds, adaptation-focused blended finance), social impact instruments, (social bonds, impact funds, microfinance solutions), biodiversity & natural capital instruments (blue bonds, sustainable forestry funds, biodiversity offsets) and multi-objective instruments (sustainability bonds, SDG-linked instruments).
Check out the book if you are interested in the details.
