Commentary: 6 steps to evaluating investors' consideration of systemic risks

Regulators are increasingly calling on investors to consider systemic issues.

Most recently, the U.S. Securities and Exchange Commission proposed updates to its regulations for advisers of hedge funds and private equity funds, calling on them to assess systemic financial risk in their reporting on the funds. Similarly, the U.K.'s Financial Reporting Council updated its Stewardship Code in 2020 to direct investors to "identify and respond to market-wide and systemic risks to promote a well-functioning financial system."

These regulatory changes recognize that systemic challenges have profound effects on market returns. Climate change poses an existential threat to the reliable functioning of markets — to say nothing of the other systems we rely on for our health and well-being. Accelerating income inequality is further destabilizing the foundations of our society as the chasm between rich and poor widens, leading to political strife and uncertainty. The social constructs of race and identity, including gender, sexuality, ability and neurodiversity remain key markers for health and economic outcomes. Taken together, these trends point to a potentially bleak future: one of greater market disruption and more instability for asset owners and managers.

Fortunately, a growing number of "system-level" investors are responding to the call for greater management of systemic risk. These investors go beyond traditional environmental, social and governance approaches, managing systemic risk by incorporating aspects of system-level investing. These investors, which include the $476.9 billion California Public Employees' Retirement System, Sacramento; NZ$60 billion ($41.7 billion) New Zealand Superannuation Fund, Auckland; and The Church Commissioners for England, London, which manages the Church of England's £9.2 billion ($12.1 billion) endowment, believe a primary responsibility of investors in the 21st century is to ensure that their investments intentionally support the health and resilience of crucial systems, reduce systemic risks and promote opportunities for all.

Integrating systemic risk considerations can also support fiduciary responsibility as it helps investors manage intergenerational risk and return effects that issues like climate change pose to portfolios and that can degrade future returns.

Yet, there is a fundamental concern as this nascent investing movement rises to the challenge to tackle these global issues. We are staring down a potential greenwashing crisis just as system-level investing comes into its own.

At issue: While some investors can say they are doing system-level investing, there is no established methodology to measure and assess their performance.

There are several ESG measurement frameworks, such as the International Finance Corp.'s Impact Principles, the Global Impact Investing Network's COMPASS methodology for comparing and assessing impact, the World Economic Forum's metrics for assessing stakeholder capitalism, and the Institutional Limited Partners Association's ESG Data Convergence Project. These are all critical, valuable contributions to the field and help investors understand the portfolio-level impact of their investments. But, we need to move beyond ESG measurement and reporting to embrace a bigger vision and broader tool set if we want to tackle the major, material systemic social and environmental risks we face as a global community.

The Investment Integration Project, or TIIP, developed a measurement framework for asset owners when evaluating the systemic performance of its asset managers. Based on TIIP's work evaluating over 100 asset owners and managers, the framework identifies six ways of measuring how managers deal with varieties of systemic risk:

1. The clarity and credibility of their beliefs or principles about systemic challenges. Without clearly stated beliefs or principles, it is difficult to know if managers will act consistently over the long term when addressing systemic challenges.
2. Their justification for focusing on certain social or environmental issues. A manager could defend their focus on a systemic challenge such as climate change citing a reasonable global consensus as to its broad importance; its impact across all asset classes; and their ability to exercise influence on systemic outcomes in ways that reduce related uncertainties.
3. The appropriateness of the tools they are using to confront identified challenges. To address climate change, for example, a manager can employ tools that go beyond security selection, such as coordination among their peers around the transition to a low-carbon economy.
4. The effectiveness of the application of the tools at key leverage points. In addition to security selection, a manager might, for example, focus on increasing the availability and usability of climate-related data; or, if more ambitious, on working explicitly to shift society's underlying paradigm from one of dependence on fossil fuels to one based on a mix of renewable energies.
5. Their efforts to align the interests of key stakeholders. A manager can help assure such alignment by actively persuading peers and other stakeholders to adopt common system-level goals and invest in the means of reaching those goals that are in the interests of all.
6. Their progress toward achieving systemic goals and generating system-level influence. Unless progress is made toward systemic goals, a manager's efforts will be in vain. For example, efforts to promote renewable energy will be of little help if greenhouse gas concentrations in the atmosphere are still rapidly increasing.

Grounding investment decisions in a robust framework can help ensure that investment decisions are achieving the system-level results promised. Asset owners can include these dimensions in their RFPs, for example, to help them vet and decide on managers and advisers that are committed to system-level approaches. A statement of investment beliefs, targeted investment programs and shareholder engagement activities are also opportunities for investors to put a system-level focus into practice.

We are beginning to see a community of practice coalesce around system-level investing as well as the development of plug-and-play solutions for driving implementation. But we need to get more serious about the tools and tactics that we use to achieve our goals. Regulators in the U.S. and U.K. are signaling more and more that greenwashed approaches will no longer be tolerated. The stakes are too high, the time to act is yesterday.

William Burckart is president of The Investment Integration Project, an applied research and consulting services firm. He is based in New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.