First off, let me say that I’m only an occasional reader of Epsilon Theory (ET), a website launched almost 10 years ago by investment manager Ben Hunt. ET provides newsletters with commentaries on finance, markets, politics, and popular culture. In their writings, Hunt and his colleagues refer frequently to the concept of the “Widening Gyre”. The term is derived from a line in the poem “The Second Coming” by W.B. Yeats:
“Turning and turning in the widening gyre, The falcon cannot hear the falconer, Things fall apart; the centre cannot hold;”.
Hunt uses the term to describe the current polarized state of politics and culture both in the United States and globally, in which social, economic, and political divisions are deepening, and trust in institutions is eroding. These divisions and the erosion of trust in our institutions are the result of forces created by competing narratives that are being driven by political parties, corporations, and the media.
The Widening Gyre can affect a broad spectrum of ideas and messages—many of which merit greater universal acceptance. The ET references to the Widening Gyre got me thinking about the reasons behind the increasing politicization of ESG, and how to “rescue” it (or at least make the principles underlying it more attractive to more people and institutions).
Why is ESG being consumed by the Widening Gyre?
The simple answer is that ESG is firmly embedded in the larger culture war, similar to other prominent societal topics. The detailed reasons, though, are worth exploring further in the hopes of finding ways to help investors adopt the principles, if not the label, of ESG.
Progress on environmental and social issues will require a coordinated effort between the private sector, civil society, and government, with each playing a complementary role in driving change. As such, it is a legitimate question to ask where the role of the capital markets stops and where the role of democracy and the political process starts – a core issue inherent in the widening divergence on ESG.
The role of capital markets in influencing public policy, particularly on issues like climate change, is a complex topic. Investors that integrate ESG considerations into their investment decision-making process can use their influence as shareholders to pressure companies to improve their environmental and social practices, which can lead to an increase in financial value. This influence can include engaging with management to advocate for more sustainable practices and voting on shareholder resolutions. In this way, the capital markets can play a significant role in driving corporate behavior and contributing to progress on environmental and social issues.
“As such, it is a legitimate question to ask where the role of the capital markets stops and where the role of democracy and the political process starts – a core issue inherent in the widening divergence on ESG.”
On the other hand, there are limits to what the capital markets can achieve on their own. The role of the political process and democracy in shaping public policy remains critical. While investors can use their influence to encourage companies to adopt more sustainable practices, many ultimately feel constrained by the need to generate returns. The orthodoxy on the right suggests that the role of the capital markets in shaping policy should be limited, and much of the fiduciary and trust law in the United States supports this view. Pressure is building on asset managers to toe the line on this topic, exemplified by institutions like Vanguard who recently announced their decision to leave the Net Zero Asset Manager (NZAM) initiative.
The increase in ESG investing activity and the commitments to align with net zero are due in no small part to the work of NGOs and non-profits like the UN Principles for Responsible Investment (UNPRI), the Net Zero Asset Owners Initiative (NZAO), and the previously mentioned NZAM. These organizations provide useful resources and frameworks that can help guide decision making and facilitate the sharing of best practices for adopting sustainable, climate-focused investment strategies. Many of these organizations request that asset owners and managers become signatories to various frameworks and guidelines. These frameworks and guidelines are rightly ambitious given the collective society’s need to act on climate. While the content produced and networking connections are instrumental to increasing adoption of ESG, the growing memberships have resulted in somewhat of an advocacy-led culture around the topic. For our purposes, let’s refer to this group of loyalists as simply “Us”.
For ESG detractors, the “E” and “S” have come to represent the advancement of a liberal agenda promoted by left-leaning NGOs and non-profits. As an increasing number of investors and fund managers have announced their commitments to ESG investing, a backlash has resulted, manifested in the increasing number of legislative efforts to curb or eliminate such practices. While most, if not all, of these proposed bills run counter to free market principles, they are gaining support in so far as the detractors have painted a narrative of ESG as an ideal that seeks to change social constructs, and one that expands the role of capital markets to solve problems that should be left to the democratic process and elected officials. Let’s call this group of loyalists “Them”. As with many topics that fall prey to polarization, we are witnessing the backlash to the backlash, a back and forth between Us and Them that shows no signs of relenting.
This public back and forth risks stifling investors’ incorporation of the principles that underly ESG investing. Namely that the risks represented by environmental, social and governance factors, especially those related to climate change, are becoming more evident and can have a significant impact on businesses across all sectors of the economy. Indeed, companies are already reacting to investor pressure to better disclose and manage such risks. The adoption and incorporation of these principles can have positive impacts on the long-term financial performance of investment portfolios, with the ancillary benefit of having a positive impact on society at large.
Truths in ESG Labeling
Many investors feel the need to, or are being pressured by stakeholders to act, especially as it relates to climate change, but are confused by the term ESG and deterred by the polarization. These investors may be concerned that taking steps (albeit small) will lead to tribal characterizations that are inconsistent with their institutional philosophies.
ESG is difficult to define and there are no generally accepted definitions that could help to clarify what it entails. The utilization of ESG factors for assessing financial risks is frequently referred to as “ESG Integration”. But the term ESG is often used to refer to other investing approaches, namely “values-based investing” and “impact investing” that are related to (and many times overlapping in practice), but different than ESG integration. Values-based strategies focus on excluding companies that are involved in certain industries, such as fossil fuels, tobacco or weapons, while impact investing focuses on creating positive environmental and social outcomes while still generating market-based returns.
The commingling of values-based, impact and ESG Integration approaches as “ESG investing” has led to confusion on what it is and also contributed to the polarization. Creating and communicating better high-level definitions of the various sustainable investing approaches can produce clarity of purpose, and help to free investors to focus on principles rather than labels.
As such, the ideal position for the investment industry is to coalesce around using the term ESG Integration to refer solely to the practice of assessing the impact of non-financial factors on financial performance. Values-based investing and Impact Investing should become separate categorizations, and not conflated with the term ESG. The three related but different concepts then can be adopted individually, collectively or not at all. We at FFI make this distinction in our business and urge other providers and NGO’s to follow the same course.
“Creating and communicating better high-level definitions of the various sustainable investing approaches can produce clarity of purpose, and help to free investors to focus on principles rather than labels.”
Freeing ESG for the Center
The bottom line is that investors, particularly those “in the center” need a space to make pragmatic decisions that are not unduly influenced by labelsarratives and tribal pressures. We suggest starting from a basic question:
Do you believe that undertaking activities that reduce waste, lower exposure to energy transition risks, and improve relationships with customers, employees and communities can help companies maintain or improve their long-term profitability?
If the answer is yes, then investors should take the actions that best fit their unique investment philosophy and operating structure. If that means making a public commitment, or joining an organization that promotes sustainable investing, great. For some institutions, it will make sense to make public commitments and declarations. For others, not so much.
The transition to a low-carbon economy is happening, and investors should be preparing accordingly. That could mean divestment from fossil fuels. It could mean taking a more nuanced look at the transition plans of fossil fuel companies. It could also mean engaging investment managers and companies directly to extract changes in ESG activities that can unlock value.
Some investors are in need of advice to navigate the complexities of ESG and climate change. Effective advice not only respects investor stewardship, but also recognizes the often-unspoken challenges underlying our broader society — challenges that are embodied by the Widening Gyre. To be impactful in this ecosystem, we at FFI will have to be purposeful (you should do something) but also pragmatic (do what you can). Doing nothing is not the answer. Doing everything (and shouting from the rooftops that you are) is an answer for many. For the rest, ignore the narratives, and do what you can.
Chris Ito
CEO
FFI Holdings