Behind every investment decision lie assumptions about how the world works. Those assumptions might be systematically built into a formal model, or they may just be things we explicitly or implicitly take as given. Either way, they can be characterised as a map – a representation of the landscape through which we are moving.
Good maps simplify the world. They tell us what we need to know to make better decisions but, as Alfred Korzybski’s dictum puts it: “The map is not the territory.” Every map is a compromise: although good maps should be accurate, parsimony dictates that the most useful and effective maps leave out those features that are not relevant to the task at hand. A map built to a 1-to-1 scale contains a lot of information, but it’s not useful.
The emergence of ESG as a mainstream investment consideration changes the landscape and calls for a rethink of the existing maps. Things that never used to matter now matter.
Here are seven ways the old maps might need to be reassessed, seven ways investment organizations might need to update their view of the world:
#1: money alone does not tell the whole story
Money is the modern world’s go-to unit of account, allowing us to express the value of all sorts of different things in common terms. But the problem with money is that, however hard we try, money cannot measure everything. And ESG factors, by their very nature, are things that money alone doesn’t measure particularly well or where the impact is passed on – externalized – to third parties. So ESG investing begins with financial impact, but it carries us beyond that.
More on this point here: the problem with money
#2: financial and non-financial considerations are intertwined
Following on from #1, the line between what is financial and what is non-financial is impossible to draw with certainty. Even if you choose to believe that the only part of your analysis that matters is the part that can be measured with money, it’s little more than guesswork where that part starts or ends. So firms need a clear policy on their approach not only to the financial aspects of ESG factors, but the non-financial too. Having a clear sense of purpose helps to align the whole organization behind the approach, defining a shared starting point for investment, operations, sales, client service and communications.
More on this point here: asset managers will continue to struggle with ESG until they take an honest look in the mirror
#3: nature is not just there to serve the economy
The Dasgupta Review on the Economics of Biodiversity (commissioned by the UK Treasury) observes that “Not so long ago, when the world was very different from what it is now, the economic questions that needed urgent response could be studied most productively by excluding Nature from economic models.” But the impact of economic activity on the natural world is now threatening to destroy many of the things we have taken for granted. The review concludes that: “The solution starts with understanding and accepting a simple truth: our economies are embedded within Nature, not external to it. … we must change how we think, act and measure success.”
More on this point here: biodiversity is becoming an investment issue
#4: rising temperatures take us into uncharted territory
The goal of the Paris Agreement is to limit global warming to well below 2°C, preferably to 1.5°C. Failure to meet that goal would fundamentally disrupt the world around us: extreme weather events, massive loss of biodiversity, rising sea levels, geopolitical upheaval, and a long list of other direct and indirect consequences that we can only partially anticipate. These are not variables that usually need to be considered in investment forecasting models; environmental stability and the broader social context have generally been taken for granted. So these models can’t be used to analyze not-zero scenarios; they omit the things that will matter most.
More on this point here: the implications for investors of not-zero
#5: learning to manage without reliable measurement
The dynamics of the connection between investment decisions and climate impact are tough to understand, making measurement a challenge. Biodiversity impacts, human rights and other social impact indicators are even tougher. Even though measurement will improve in time, the measures will always be imperfect. Hence we need to find ways to manage even without perfect measurement. Ultimately, better management of our impacts will come down to a governance process, not just a metric.
More on this point here: what can’t be measured well can still be managed. On climate impact, it needs to be
And here: closing the doing-impact gap: reporting ESG outcomes
#6: uncertainty not risk
Investment markets are driven by unquantifiable uncertainty (where the true odds are unknown) rather than by the well-behaved measurable risk of casino games. That’s especially true when it comes to ESG investing, where we must deal with incomplete data, with unknown and shifting relationships, with difficult-to-interpret science. But, as Frank Knight pointed out over a hundred years ago, it is uncertainty – and not quantifiable risk – that creates the opportunity for real value to be added. How we build that into our investment maps (and models) is an open question.
More on this point here: marking one hundred years of ignoring Frank Knight’s point about risk and uncertainty
#7: adapting your investment edge
No investment process pursues every financial concept; each firm has its own edge, its own way of bringing value to the table. As ESG becomes a more integral part of investment approaches, its integration should be a natural extension of the wider investment philosophy. So firms ought to update their view of where they add value, and identify exactly where ESG fits into that.
More on this point here: pillars of ESG policy #3: authentic connection to the investment proposition
That’s a lot to think about. Changing our assumptions about the world does not come naturally to most of us. We get accustomed to our familiar maps, and comfortable working with them. This makes us slow to recognize when new features need to be added or changes to the landscape need to be captured.
Some might respond to the list above by using existing maps with more care, becoming more sensitive to their limitations (the principle of parsimony still holds, after all). Others may take the opportunity to create new maps, to rebuild the whole process. For most, the best response probably lies somewhere between those two extremes.
However you choose to respond, the emergence of ESG demands a rethink of the way we see the world.