I recently worked with Morningstar on their survey “Voice of the Asset Owner”, which asked 500 individuals working across a wide range of AO organizations about several key trends, with particular emphasis on how ESG considerations are re-shaping the global market ecosystem.

Among the headline findings is confirmation of the materiality of ESG for these organizations, although – perhaps a little more surprising – implementation is progressing fairly slowly. Meanwhile ESG ratings, data and tools have seen a marked improvement over the past five years, but a lot of room for further improvement remains.

In this post, I shall expand on one finding from the survey which I think is worth a closer look. This is the observation in the survey report that “The ongoing maturation of the ESG field is co-evolutionary, with developments in regulation, data, reporting, analytical tools and investment processes all shaping – and being shaped by – one another.”

Co-evolution is a richer concept than simply evolution, because it takes a whole system viewpoint, emphasizing the interdependence between each part. Drawing an example from the natural world: bees evolved synchronously with flowers, flowers with bees, and neither process can be understood in isolation. They only make sense in conjunction. Hence co-evolution.

This is a useful way to look at current developments in ESG investing. Consider, for example, the position of the asset owner such as a large pension fund, endowment or sovereign wealth fund. The policies and attitudes of asset owners are currently going through a period of change, which is a response to the environment within which they operate:

• A change in the regulatory environment. The UNPRI regulation database now lists 868 policy tools and guidance, ranging from the UK’s TCFD reporting rules to the EU’s SFDR disclosures to the US Department of Labor’s various efforts to produce coherent and credible guidance in a politically-charged environment (the latest being a rule published last week removing barriers to the consideration of ESG factors by ERISA fiduciaries.) Of that list of 868, 850 date from within the past 25 years.
• A change in norms and expectations. Stakeholders – such as a pension plan’s members and sponsor, an endowment’s donors and beneficiaries, a sovereign’s citizens, an insurance company’s policyholders – increasingly regard investment as interconnected with the environment and community, with responsibility for its impacts. Peer group effects come into play here, too.
• A change in the choices available to them. More and better data, more and better analytical tools, wider product choice. Policies that previously would have been impractical are, as a result, now becoming viable.

Yet, at the same time as these changes are shaping the policies and attitudes of asset owners, those policies and attitudes are themselves key factors in the evolution of other parts of the system. When asset owners ask for something, asset managers jump to provide it, creating implications in turn for the reporting that is demanded from corporations. So the whole supporting infrastructure of data provision, index construction, analytical tools, and so on takes its cue from the asset owners. As with the bees and the flowers, each process is better understood in conjunction than in isolation. That’s co-evolution.

Co-evolution is a process, not a steady state

One result of shifting to a perspective of co-evolution is a greater focus on the journey and less on the destination. Complex co-evolutionary processes are so dynamic that it makes little sense to think in terms of a stable future state toward which we are moving: the ongoing dance of change and response is not just a transitional phase of little interest, but rather it is the main story.

The distinction between journey and destination is relevant to how we describe any complex system. Herb Simon described it well: “Pictures, blueprints, most diagrams, chemical structural formulae are state descriptions. Recipes, differential equations, equations for chemical reactions are process descriptions.”

As an aside, the simplicity and ease of working with a state description rather than a process description is a large part of why traditional economics has been built around stable equilibrium models (the efficient market hypothesis, CAPM, etc), and as a result from time to time completely misses the point.

A state description is usually easier to grasp: a cake rather than the recipe, a value of x rather than the differential equation. If the state description tells you what you need to know, then you’d rather work with that. So shifting from a simpler model (steady states and simple evolution) to a less simple one (complex adaptive processes and co-evolution) is not always a good idea; it’s only justified when there is meaningful additional insight generated. But the process description is sometimes necessary to truly understand what is happening and, critically, to discern the right actions to take. I believe that’s the case as we try to make sense of the current state of ESG investing and how it might develop from here.

This view of the development of ESG, dynamic and driven by web of interconnections, is a different way of thinking. Consider, for example, what it means for economic activity to be sustainable. A state description might lead us to ask how much economic activity the earth can support, or how many people. A process description considers how it all plays out: what happens – what breaks down – when the physical limits are approached? What are the implications of extreme weather events or biodiversity crises? What pressure is put onto social infrastructure, what might be the fallout – such as conflict or migration – from political disruption?

In many areas of ESG, how the processes play out is key. Co-evolution can be an invaluable concept in helping to make sense of it all.