Roughly 5,000 years ago in ancient Mesopotamia, some bright spark hit on the idea of baking a record of a transaction into a clay tablet – basically, an IOU – and in doing so invented money. Ever since then, money has been used as:

1. a medium of exchange, eliminating the inefficiencies of barter;

2. a unit of account, facilitating valuation and calculation; and

3. a store of value, allowing economic transactions to be conducted over long periods as well as geographical distances.¹

In other words, money makes trade easier. And it makes trade-offs easier, too. Valuing everything with a common unit allows us to be more formal in our decision making, more explicit in why we have chosen A rather than B.

As sustainability becomes a political and economic priority, and as ESG becomes ever more firmly embedded in mainstream investment, it’s natural for the asset management community to look at environmental and social factors through a financial lens. After all, money is what this industry is about. 

By expressing ESG considerations in monetary terms, we can build a model to rationally weigh all of our competing objectives – financial, social, environmental – and find the right balance. We can optimize. We’re good at this. 

And we don’t really have a choice: the decisions we make do not only have financial implications, but environmental and social ones, too. So even if the trade-off between those objectives is not explicit, it’s still there in the background. 

But does it work?

Unfortunately, in reality, this only works up to a point. This model, like all models, is imperfect. 

Here are just four of the things missing when we convert natural and human capital into financial capital:

Irreversibility. Many trade-offs are possible in one direction only. We can develop land, but we cannot easily undevelop it. No amount of money will bring back the dodo or the western black rhinoceros.

Non-linearity. It’s one thing to sell one pint of your blood, quite another to sell nine. Likewise, there are social and environmental boundaries that we really do not want to cross. Exchanges that seem attractive at the margin may well not make sense on a larger scale.

Time value of money. Financial analysis is based on the concept of net present value (NPV). NPV discounts the future: a dollar today is valued more highly than a dollar next year. But while money may be a depreciating asset, clean air is not. When we convert non-financial assets into financial values, we inadvertently de-prioritize the world that future generations will live in.

Model error. There is no perfect measure of well-being, whether expressed in dollars or anything else. Even if we somehow were able to put a price on coral reefs, biodiversity, fresh water, community, fairness, tolerance, no matter how hard we try to put everything in, something meaningful will be left out. And then our optimizer turns into an error-maximizer, diligently – religiously, even – trading away that which we failed to put a price on.

Proceed with care

So while it’s convenient and frequently necessary to put a price on the non-financial, that doesn’t capture the full picture. The right response to this challenge is not to reject the role of finance. Finance alone cannot solve the world’s environmental and social challenges, but it can be part of the solution. Indeed, there is no good solution without it. As Mark Carney put it in his recent Reith Lecture series, “to solve the climate crisis, we must address three challenges, engineering, political, and financial.” Using strategies such as a carbon tax – which places a monetary value to each ton of carbon emissions – we can align incentives and change behaviour.

The ancient Mesopotamians were an inventive lot – credited with some of the world’s earliest forays into farming, writing and even the wheel. They played a huge part in shaping the modern world. Let’s hope we can be as inventive as we work to re-shape that world to keep prospering for another 5,000 years and beyond.

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Addendum: Thank you to Philip Jackson for pointing out another item to add to the list above (which I think is really two more):

Multifunctionality. There are lots of different aspects to the value of nature (and people): a tree, for example, might be valued for the wood it can provide, but it also produces fruit, sequesters carbon and enhances the environment in many other ways.

Interconnectedness. A thing’s value cannot be isolated from everything else around it. Crops and pollinators are worth much more together than they would be separately. Companies need customers and the rule of law. In the extreme, the value of everything falls to zero if the planet is uninhabitable. 

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¹ Niall Ferguson (2008) The Ascent of Money: A Financial History of the World. The Penguin Press, New York.