Because systemic risks have huge financial consequences
by Hal Hamilton
I’ll use ocean fisheries as a quick example of the scope of sustainability strategy.
Imagine that you and I each own a fleet of fishing boats. Over the past few decades, we evolved a system to regulate one another, and our competitors, to achieve a fair division of a “maximum sustainable catch,” and government agencies enforce the rules. Now, however, the context is shifting: ocean temperatures are rising, water is becoming more acidic, and reef systems are dying. All these contextual changes mean that our target fish species aren’t reproducing as was expected. Some populations are collapsing, not from overfishing but from a change in the enabling conditions for species success.
Fishing is a metaphor for the larger economy. Sustainability reporting and strategy are usually based on a “materiality assessment” of impacts and an organization’s ability to have an influence on those impacts. In the example of fisheries, a relatively discrete set of players can agree on catch limits and their enforcement. As climate change affects the oceans, however, managing systemic risks is beyond the ability of any one organization or regional structure. Sustainability strategy is now a bigger ballgame.
Scientists and NGOs have long pointed at social and environmental “externalities.” The trouble is that such observations don’t easily enter business discourse, which is logically focused on what is internal to each organization’s profit-and-loss accounts. Now, within our hyper-connected world, the external chickens have come back to roost in the form of future losses.
Large asset managers are among those in the business world who first noticed this shift, and systemic risk is shaking up the financial sector.
Modern Portfolio Theory (MPT) has been the reigning framework for investment strategy since the 1950s. The essence of MPT is managing risk by building diverse portfolios. The values of specific stocks and bonds can go up and down while the overall portfolio is less volatile.
And now the world has changed. In the 1950s, when portfolio diversification was formalized, institutions owned 8% of the US equity market. Now it’s about 80%. Very large asset management firms “are increasingly likely to be universal owners, whose concern with portfolio companies’ externalities is likely to be at least partly because they understand that such externalities will affect the environmental, social, and financial systems on which the health of their overall portfolios rely.” (Just as the temperature of ocean water affects fish populations.)