Emilio Barucci, Professor of Financial Mathematics at Politecnico di Milano, says more advanced and sophisticated climate risk models are needed to support ESG investing.

ESG investing focuses on investment processes and products that take into account the ESG features of stocks, bonds and mutual funds. The growth of ESG investing, in terms of assets under management, is driven both by investors, whose activities are affected by factors not limited to economic performance, and therefore to the risk-return trade-off, and by regulation aiming to promote sustainable investment and financial products as part of the green transition.

The relationship between ESG and economic performance

The three pillars of ESG look quite different along two dimensions at least. First of all, the indicators capturing ESG features are different in nature. While it is difficult to measure a company’s ethical performance or corporate governance, which is coming under increased scrutiny, the extent to which an organisation meets its environmental targets can be quantified considering Scope 1, 2 and 3 emissions, the amount of green energy used and other metrics. The quality of data and their evaluation is a crucial issue, which, at QFinLab – the Quantitative Finance Lab of the Department of Mathematics at Politecnico di Milano – we are addressing through our ESG Corporate Data, which focuses on companies listed in the Italian stock exchange. The initiative aims to provide a repository of ESG data for the Italian market with reliable information and an annual report exploring key trends in the ESG transition.

The connection between the three dimensions of ESG and economic performance, moreover, is not well-established. This point is crucial, as a simple approach to ESG investing based, for instance, on the exclusion of certain sectors from the investment process – an approach very popular a few years ago – is no longer viable, in that it is in contrast with the mandatory duty of asset managers. A more suitable approach, which requires investors to estimate how the ESG profile of a company impacts its future economic performance, should aim to integrate ESG factors into the asset management process. Organisations, in other words, are grappling with the issue of double counting, in the sense of economic and ESG performance, which is not an easy challenge to address.

The multiple facets of climate risk

From an investment perspective, climate risk deserves special attention. It comes in two different forms: physical and