What’s the role of “universal owners” in responding to “unhedgeable” risks?

October 17, 2023
Clarisse Simonek
2 Mins Read

Clarisse A. Simonek explains why investors, in particular ‘universal owners’, must work together to tackle systemic risks and create an orderly transition in response to ‘unhedgeable risks’

In recent years, institutional investors have increasingly realised that traditional investment strategies, which focus solely on seeking alpha, are insufficient for tackling the complex challenges facing global economies. Notably, they are becoming more aware of ‘unhedgeable risks’—risks that cannot be effectively mitigated through conventional investment approaches. These risks often stem from systemic and existential threats, such as climate change, social inequality, and biodiversity loss.

Institutional investors, especially the so-called ‘universal owners’ such as large pension funds and sovereign wealth funds, with diversified portfolios representing a significant portion of the global market, have a unique role in addressing these systemic risks. In this context, systemic resilience becomes crucial as these investors aim to strengthen the broader financial system against such disruptions. Universal owners are also uniquely exposed to ‘unhedgeable risks’ at the system level.

A recent Cambridge study, to which I contributed, quantified the potential loss of diversified portfolios due to systemic shocks and assessed the extent to which these losses could be hedged. The study found that “no strategy will offer more than 50 per cent coverage” of the negative impacts of climate change.

This finding suggests that leveraging environmental, social, and governance (ESG factors) to enhance financial system stability might be a more effective strategy than merely seeking alpha.

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Universal ownership in the Anthropocene

The good news is that, due to their size and influence, universal owners usually have the ability to impact the overall stability of the financial system. Consequently, they are increasingly being called upon to move beyond the traditional framework of modern portfolio theory and consider the broader implications of their investments, particularly in relation to climate risk management.

Ellen Quigley, in her article on Universal Ownership in the Anthropocene, emphasizes that the decisions made by these institutions have far-reaching consequences for environmental, societal and financial stability. It’s a strong argument for financial institutions to align their investment strategies with sustainable development goals and prioritize investments that promote long-term resilience, resource efficiency, and social well-being.

Transitioning from climate risk to impact

Financial institutions and regulators worldwide recognise the need to transition from solely assessing climate risk to considering the actual climate impact of the financial sector. The Network for Greening the Financial System, was founded in 2019 and now has 114 central banks and supervisors on board.

But the consideration of climate impact is just the beginning of a broader shift towards addressing planetary boundaries. The Stockholm Resilience Centre has identified nine core planetary boundaries, including biosphere integrity, land-system change and freshwater change.  Six of those nine have been crossed, such pressures mean that regulators are increasingly concerned that financial institutions should  report not only on climate risk but also on their impact on biodiversity – a particularly complex systemic threat. The global rollout of the Task Force on Nature-related Financial Disclosures (TNFD) has received explicit support from the G7.

The importance of reporting on impact

Some jurisdictions such as the EU, which has a  Corporate Sustainability Reporting Directive require robust reporting on the impact of the company on the environment and society more broadly. This shift towards reporting on impact rather than solely on risk acknowledges the broader responsibility of financial institutions in safeguarding the environment and promoting sustainable practices.

Reporting on impact is one of the steps to addressing systemic risks related to environmental degradation and excessive social inequalities. In the context of the financial system commons, all institutional investors, including universal owners, must collaborate to ensure the collective well-being of the system. This requires a shift towards a more collaborative and cooperative approach in addressing systemic risks. The alternative, is the rise of ‘inevitable policy’, where  governments will be forced to act more decisively than they have thus far, leaving financial portfolios exposed to significant transition risk. The ideal solution, for financial institutions and our society, is an orderly transition. Let’s move now so that one remains possible.

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