System-level investing is better served by action than abstraction

At PRI in Person in Amsterdam last month, there was a lot of discussion about “system-level investing”. I was excited to participate in these discussions as addressing system-level risks has been a curiosity and area of focus for me for several years.

Following this year’s conversations, I continue to believe that sustainable investors elevating our focus to the system-level is a positive development. Issues like the climate crisis cannot be diversified away from and will impact the broader economic health investors depend on for long-term value creation in portfolios.

In a rapidly changing and increasingly fractured world, effectively addressing system-level issues requires a deeper understanding of feedback loops, leverage points and herd behaviour in financial, economic, political and social structures.

However, in Amsterdam I also heard growing concern about the narratives surrounding system-level investing. This boiled down to a belief that some investors are not approaching system-level investing with a practical or actionable lens.

For example, some system-level investing advocates argue that investors should pressure companies that generate negative externalities, such as high-emitting operations, to shrink those activities, even at the cost of the company’s own returns.

The reasoning is that reducing the externality will improve the health of the broader economy and, in turn, the investor’s whole portfolio. But because this asks an investor to potentially accept a near-term loss in one holding in exchange for a diffuse, long-term benefit that no single investor can guarantee or capture, it is unlikely to gain traction among institutional investors for both practical and political reasons.

If we are going to effectively embrace the concept of system-level investing in the sustainable investment community, we can’t do it in the abstract and we can’t do it alone.

As a first step, we need to make sure the way we are defining system-level investing translates into practical and actionable programming that aligns with the broader strategic goals of our institutions.

I would offer four practices that have helped sharpen my own thinking as a practitioner:

1. Start with clarifying your institution’s approach

“Systems” can be defined in many ways: economic, environmental, financial, etc. However, the best system for any investor to understand first is that of their own institution. That understanding is best served by starting with several questions:

• Is your organisation trying to apply a system-level investing approach to benefit portfolio management, to address system-level risks in the real economy or both?
• If it is part of portfolio management, are you starting with a broader focus on your whole portfolio or narrowing in on a specific asset class?
• If seeking to address risks in the real economy, is it through tools of asset allocation, stewardship, impact investing or public policy engagement?

There is no “right” answer to these questions, and a robust understanding of your institution’s answers is fundamental to any system-level success.

2. Speak the language of your audience

When engaging people on this concept internally, I try to leave the jargon at home and frame points in a language familiar to the audience. For example, here are two different ways to make the case for addressing system-level climate risk to a chief investment officer:

• Option 1: “Climate risk is a market-wide issue that poses a threat to the financial stability that the portfolio’s returns depend upon. You should integrate consideration of this risk into investment management processes to protect the portfolio’s ability to generate strong risk-adjusted returns and to align with client/beneficiary interests.”
• Option 2: “Climate risk is a system-level issue that poses a threat to the ecological stability and social cohesion that the real economy depends upon. You should integrate consideration of this risk into ESG processes to protect the economic health the portfolio relies upon and to align with stakeholder interests.”

While ostensibly saying the same thing, Option 1 is likely to be a more productive starting point because it speaks the language of the CIO and connects the risk to outcomes that matter to their role. Even better if you can come prepared with specific and actionable examples of what that would look like in practice.

3. Lean into your institution’s strengths and alignment

It is also important to observe and study where your organisation’s internal alignment is strong on system-level issues. Is there strong consensus on certain system-level topics? Is there expertise in different asset classes or stewardship practices that could be impactfully deployed?

Effective system-level advocates often lean into where they find existing consensus and strengths within their institutions.

The Handbook of System-Level Investing by Jon Lukomnik and Bill Burckart is a great collection of case studies of leading institutions both building alignment and leaning into their strengths.

4. Challenge assumptions on theories of change

One way to bake curiosity into your process is to work closely with partners who have expertise in the areas investors are seeking to change.

For example, asset owners have every right to ask open-ended questions of asset managers about their system-level investing approach, and owners should seek both innovation and alignment in these exchanges.

However, these same asset owners should also be willing to listen to and collaborate with asset managers to identify the most impactful and practical stewardship asks to make of companies. Asset managers often have closer relationships with companies and better understanding of the dynamics their corporate leadership are navigating, including sector expertise that is highly relevant to company engagements.

Another way to engage asset managers on system-level investing is to complement individual company-focused discussions with questions about how the manager is using its expertise and resources at the sectoral level.

System-level investing interest can also often lead to discussions of policy engagement. This is a natural connection as policy engagement is an important lever to change the rules of the game that govern the economy, as written about by Patrick Peura and me in the paper Future of Investor Engagement.

Policy engagement is difficult and requires different skills than traditional stewardship. But talking to policy engagement professionals will help inform whether an institution has the appetite and resources to create a strategic and impactful theory of change for their policy work. Otherwise, any accompanying effort could easily do more harm than good.

Putting Theory into Practice

I recognise that system-level investing can be a difficult concept to ground in concrete and actionable next steps. Indeed, I have struggled with how to give recommendations in this article.

However, if there is one thing a reader should take away from this short missive, it would be encouragement not to get caught up in theoretical debate. While reading case studies and different best practices are useful, they will only bring you so far. Each institution is different and the best system-level investing approach for each will look different.

In this context, there are no short cuts beyond experimentation, listening, learning, failing and growing. In short, the best teacher is practice.