Introduction

The report proposes firm-level emission futures contracts as a market-based, forward-looking measure for assessing the real environmental impact of ESG investing. The authors argue that existing backward-looking, subjective ESG ratings fail to predict future emissions reductions and may inadvertently direct capital towards more polluting firms. Evidence shows that while lower emissions are associated with higher environmental (E) ratings, higher E ratings predict higher, not lower, future emissions. The report finds that inclusion in leading ESG indices, such as FTSE USA 4Good, often precedes increased rather than decreased CO₂ emissions. Despite substantial growth in ESG investment capital, emission reductions typically occur before—not because of—increased sustainable investment.

Theory

A theoretical framework divides firm value into internal (to investors) and external (to society) components. The authors define sustainable investing as maximising a firm’s total societal value by accounting for externalities. The paper evaluates two regimes: one relying on backward-looking ESG ratings (R) and another based on forward-looking market measures (M). The forward-looking measure improves prediction accuracy, reduces misallocation of capital, and incentivises firms to genuinely reduce emissions rather than simply improving their scores.

The model suggests that current ESG ratings may lead to “cheap talk” and moral licensing, where firms signal sustainability without real change. Empirical results show that cheap talk—such as frequent use of the word “sustainability” in corporate disclosures—has increased substantially and correlates with higher ESG scores but not with lower emissions.

Introducing emission futures

The authors propose a new asset class: firm-specific or index-level emission futures. These contracts would pay out the future dollar value of a firm’s emissions, calculated by multiplying expected emissions by the carbon price. This would enable a transparent, tradable measure of expected emissions and provide forward-looking insight into firms’ environmental performance. For example, a “Shell 2026 emission future” would pay out the value of Shell’s 2026 CO₂ emissions multiplied by that year’s average carbon price.

Emission futures could be initially launched for major firms and indices covering the majority of emissions. The authors note that 58 firms account for 90% of total US emissions, suggesting early market viability.

New measure

Two new indicators are proposed. The E measure reflects a firm’s expected future carbon externality, derived from the price of its emission futures. The green impact measure reflects reductions in expected emissions, calculated as the negative dollar return on the emission future. These measures could apply to individual firms or funds, improving the precision of environmental and impact assessments.

Demand for emission futures

The authors identify three main sources of demand for emission futures: (1) hedging transition risk, (2) speculative investment opportunities, and (3) improved risk allocation. Emission futures could function similarly to credit default swaps or dividend futures, offering diversification and new tools for managing carbon-related financial exposure.

Empirical analysis

Empirical tests show that current ESG ratings have limited predictive power for emission reductions. Granger causality tests indicate that higher E scores do not lead to lower future emissions; instead, emissions reductions precede rating improvements. Firms included in social indices increase emissions after inclusion. Socially invested capital, which rose tenfold from 2007 to 2020 to exceed USD 120 trillion, shows no measurable causal relationship with emission reductions.

Cheap talk analysis finds that corporate mentions of “sustainability” have risen exponentially, reaching over 2,000 mentions per firm annually. Statistical tests confirm that such language increases ESG scores but not environmental impact.

Estimating welfare gains from emission futures

The report quantifies the welfare improvements possible from introducing emission futures. Using current ESG ratings to predict emissions yields a residual standard error of 16.5 million tonnes of CO₂ per firm, compared to 2.3 million tonnes when using firms’ current emissions—a reduction of 86%. Similar results apply to Sustainalytics ratings, showing a potential 71% improvement in capital allocation efficiency.

Conclusion

The authors conclude that emission futures offer a more objective, market-based alternative to current ESG metrics. These instruments could align investor incentives with real-world emission reductions, enhance regulatory transparency, and improve capital allocation. Beyond environmental metrics, the framework could extend to social and governance measures and be applied to other asset classes such as sustainability-linked bonds.