How to achieve systemic resilience: The vital role of universal owners in navigating ‘unhedgeable risks’
Clarisse A. Simonek explains why investors, in particular ‘universal owners’, need to work together to tackle systemic risks and create an orderly transition in the face of ‘unhedgeable risks’
In recent years, there has been a growing recognition among institutional investors that traditional investment strategies, focused solely on seeking alpha, fall short in addressing the complex challenges across global economies. In particular, they increasingly recognize ‘unhedgeable risk’ – that is risks that cannot be effectively mitigated or hedged through traditional investment approaches. They often arise from systemic and existential threats, like climate change, social inequality, and biodiversity loss.
Institutional investors – in particular, so-called ‘universal owners’ with diversified portfolios representing a significant portion of the global market – have a unique role in addressing systemic risks. They are also uniquely exposed to ‘unhedgeable risk’ at the system-level. A Cambridge study, to which I contributed, quantified the potential loss of diversified portfolios due to a shock to the system, and how much of that loss could be hedged. The finding was that “no strategy will offer more than 50 per cent coverage” of the negative impacts of climate change. This suggests that using environmental, social, and governance (ESG) factors to search for alpha may not be as effective an investment strategy as using them to enhance the stability of the financial system as a whole.
Universal Ownership in the Anthropocene Era
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.
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 Climate 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.
You may also like…
September 18, 2023Clarisse Simonek
Why 'Nature' matters for Financial Stability
August 25, 2023Tom Herbstein4 mins read
Why the Principles for Managing Climate-Related Financial Risks is a game-changer for banks
August 22, 2023Tom Herbstein5 mins read
Five reasons why Sustainable Finance is the future for the finance sector