Seeing systemic risks

Disruption has become endemic. This was true before the pandemic. Of course, every generation has its sources of disruption (from the coming of the wheel, to steam, to the microchip) – and no doubt every generation feels like it is living through unprecedented disruption. The distinctive feature of our age of disruption might be that much of it relates to systemic stress.

Put another way, our collective activities have placed many of the core systems on which we rely under massive and unsustainable strain. Inequality stirs protectionist rage, upending democracies, and prompting trade wars. The productivity of arable land is sharply declining, accompanied by patterns of drought and water stress. Climate change is driving patterns of disruption that are comprehensive and existential in scope.

Facing this context, there are signs that corporations and institutional investors understand, to some degree, that these trends require a response. The rise of ESG suggests an acceptance that prior investment analysis provided an incomplete picture of the sources of value creation – and destruction. The discourse on corporate purpose suggests that corporate managers see value in charting a path toward approaches that balance outcomes across groups impacted by corporate practice.

Few of these efforts have been couched in terms of preserving systems – with a few notable exceptions. That should change and become a structured feature of corporate and investment practice. We point here to some recommendations and encouraging early signs.

Identifying and managing systemic risks

“Systemic risks” generally comprise events or trends that influence the interconnected aspects of our lives and can spike in intensity with surprising and often devastating consequences for our collective health and prosperity. They manifest in many forms. At the more obscure end, we see Lyme disease on the rise as warmer winters increase deer tick survival creating new populations with chronic health problems (just one chronic illness rising in intensity driven by climate change). At the all too well-known end, Covid-19 reminds us that urban sprawl and deforestation are among the factors behind the rise of zoonotic transmission.

Often these “systemic risks” are talked about as if they are uncontrollable acts of God; akin to bad luck, Murphy’s Law on a global scale, a bad roll of the cosmic dice. Yet research, including that conducted by The Investment Integration Project (TIIP), suggests that this framing is highly inaccurate and diminishes our ability to prepare for and cope with systemic risks. There are many ways, within reach of averagely sophisticated investors and corporate managers, to anticipate, mitigate, and even in some cases, control the existential threat of systemic risks in our lives. Fatalism leaves us unprepared and diminishes our capacity for foresight, planning and preparation.

Management of systemic risks through investments requires an evolution from a conventional approach to portfolio management. It also involves developing investment practice beyond the consideration of environmental and social factors or ESG integration. That next stage is system-level investing.

As covered in the soon to be released 21st Century Investing: Redirecting Financial Strategies to Drive Systems Change, system-level investors support and enhance the health and stability of the social, financial, and environmental systems on which they depend for long-term returns. They preserve and strengthen these fundamental systems while still generating competitive or otherwise acceptable performance.

Happily, a growing group of institutional investors are adapting to versions of system-level investing as part of portfolio management, capturing the broad implications of the systems approach in their investment policies and principles. The California State Teachers Retirement System (CalSTRS), for example, determined that climate change is a systemic threat to their members’ retirements, and developed a multi-year, multi-asset-class with an internally managed Low-Carbon Index (LCI) for passive equity management. Launched in 2017 with a $2.5 billion commitment, the LCI is made up of stocks in all industries in all markets (U.S., developed, and emerging) around the world. CalSTRS’ goal is for these holdings to have reduced carbon emissions and reserves in each market by between 61 per cent and 93 per cent in the coming years.

Consequences of narrowness and short-termism

A narrow and short-term view constrains our ability to think about systems. As a number of leading asset owners stated “if we were to focus purely on short-term returns, we would be ignoring potentially catastrophic systemic risks to our portfolios”. Systems command managers to not just think about what is “material” today but what may become material tomorrow.

There is some movement within the corporate community to focus on longer-term decision making to plan for a more sustainable future. Last year, the Business Roundtable released a statement from over 180 corporate CEOs to commit to leading businesses “for the benefits of all stakeholders–customers, employees, suppliers, communities and shareholders.” With such statements come questions about practical implications. It won’t be hard to find examples of corporations where real-world decisions appear at odds with the appealing stakeholder rhetoric. We do though see significant value in CEOs seeking to talk about a longer-term time horizon throughout their investor dialogue, including the earnings call.

In any event, corporations are key actors in the health of our systems (often by function of sheer scale of operations). We have seen countless negative outcomes of corporate practice on the systems on which we all rely. Consider: only 20 companies produce over one-third of all total greenhouse gas emissions. Partly this is enabled by the well-known structural feature of our economies that corporations externalize their negative social impacts – and have the financial heft to skew political decision-making and the marketplace for ideas in their favor.

It is worth noting that corporations are very capable of undermining the very systems that they themselves directly rely on. Stable accounting rules are a key feature of advanced market economies. Yet, corporations are often presented with opportunities that may cause them to undermine such systemically valuable features of an arm’s length financial system. As ever, there is some need to “constrain the merchant in the interests of capitalism” – better perhaps first to provide the merchant with the tools to see that they first need to save themselves.

Simple steps – to reframe behavior 

How can corporations and investors better manage systemic risks and strengthen our institutions? The how-to of system-level investing is laid out in 21st Century Investing. They can invest in solutions to systemic problems, like green energy or workforce development. The Dutch pension fund manager PGGM, for example, has allocated $17 billion to what it describes as a solutions or impact portfolio that focuses on four issues: climate change, food security, health care, and water. Of this $17 billion, $1.53 billion was invested in climate change, pollution, and emissions solutions—producing over 11.6 megawatt hours of renewable energy, or enough to power around 3.5 million homes for a year. Another $477 million was invested in water-scarcity solutions in 2018 alone—saving enough water to cover the average water consumption of 1.6 million residents in the Netherlands for a year.

They can also collaborate with each other, rather than compete, to strengthen the systems they operate in. For example, the California Public Employees Retirement System (CalPERS) has compiled academic research in a database called the Sustainable Investment Research Initiative (SIRI). SIRI facilitates scholarly reviews of system-related research, convenes researchers to discuss environmental, social, and governance (ESG) factors and related issues, and manages a public online database of 1,900 studies on sustainable investing.

Finally, instead of working around the government, they can pay their share of taxes and work with governments to try and create more resilient systems. For example, in 2017, Norges Bank Investment Management (NBIM), a unit of the Norwegian central bank, issued a position paper on taxes because of their concern that excessive short-term emphasis on allocating profits to shareholders may not be in companies’ or investors’ best interests, NBIM clarified its belief that “Managing long-term value does not require aggressive tax behavior.” NBIM also solidified that it expects corporate boards of directors will “discourage the pursuit of aggressive tax avoidance not in shareholders’ long-term interest.”

These examples can and should be a model to us all. We are not recommending corporations and investors do this out of the goodness of their hearts. Companies benefit when systems run well. As climate change worsens, income disparities grow, and we remain polarized, we expect to see more disruption in our lives – and the potential for huge and unmanaged value destruction. Focusing more on preventing these disruptions rather than reacting to them can benefit everyone – corporations, investors, governments, and workers.


William Burckart is president of the The Investment Integration Project and Brian Tomlinson is director of research at the CEO Investor Forum.

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