System Change Investing: Next Generation Responsible Investing

System Change Investing

Next Generation Responsible Investing

Frank Dixon
Global System Change
fdixon@SystemChangeInvesting.com

System Change Investing (SCI) is a new paradigm approach to ESG that expands the focus to include system change and root causes. This makes it the first responsible investing strategy with the potential to achieve the UN Sustainable Development Goals (SDGs). The approach helps financial firms to enhance investment returns, reputation and assets under management. SCI is likely to capture substantial share in the over $30 trillion responsible investing market, as well as expand the market by attracting conventional funds.

Current ESG and corporate sustainability approaches are not resolving climate change and other major challenges. The path we are collectively on severely threatens businesses, investors and society. New approaches are needed. As discussed in more detail below, system change is the most important sustainability issue. It is essential for resolving major challenges and protecting business and society.

SCI is focused on this critical issue. Like positive ESG screening, SCI involves rating companies on system change performance and shifting investments to system change leaders. The goal is to strongly incentivize companies to add system change strategies to existing sustainability efforts.

System change is a broad term. It can refer to systemic change at levels ranging from the individual up to the largest system that humans substantially impact – the whole Earth system and its sub-element human society. SCI employs the Global System Change (GSC) framework to guide and assess system change. The framework describes sustainable society using the laws of nature, systemic changes needed to achieve it, and the actions required in all areas of society to bring about these changes.

Many aspects of system change have been studied and implemented for decades (e.g. systems theory, economic and political reform, collaboration). More recently, an increasing number of organizations and initiatives are using investing in a targeted way to drive different types of systemic change. New terminology is evolving to describe these approaches. Examples include system-level investing (e.g. assessing portfolio-wide impacts of environmental and social issues) and systemic investing (e.g. TransCap’s sustainable mobility transformation project in Switzerland).

The SCI approach is based on extensive ESG experience which has shown that no company can fully eliminate negative impacts and remain in business. Current economic and political systems were developed at a time when the long-term consequences of our actions were not yet clear. As a result, corporate profits are distorted by externalizing negative corporate impacts on to society. This drives many harmful actions, such as unchecked use of fossil fuels and seeing nature as a free resource. These short-sighted systems unintentionally compel all companies to harm the environment and society. They are the root causes of major challenges. Whole system thinking (i.e. effectively addressing all relevant factors and impacts) is needed to evolve modern systems into sustainable forms that compel responsible instead of harmful behavior.

SCI addresses the main criticism of ESG, i.e. that it does not resolve climate change and other SDG problems. These failures mainly occur due to the primary focus on:

Changing companies, rather than the systems that control them
Addressing symptoms, such as climate change, instead of root causes

SCI seeks to resolve these main ESG shortcomings. This article summarizes the why and how of SCI – why it is important and how it can be implemented.

The Importance of SCI

Over the past 20 years, responsible investing and corporate sustainability became mainstream. But despite this good work, environmental, social, economic and political problems are rising rapidly. To protect business and society, new responsible investing and corporate sustainability approaches are needed that shift the focus to system change and root causes.

The primary flaw of economic and political systems is the failure to hold companies fully responsible for the harm they impose on society. In competitive markets, this makes it impossible to fully stop harm. Under current systems, companies can profitably mitigate about 20 percent of total negative impacts. Mitigation beyond this point usually increases costs and ultimately puts companies out of business. System change is at least 80 percent of the sustainability and SDG solutions.

Current ESG and corporate sustainability strategies imply that companies can stop harming the environment and society if they implement more effective sustainability strategies. This largely is not true. Companies will cease to exist if they attempt to fully stop harm. That is why major problems grew while ESG became mainstream. As shown over the past 20 years, the best that current responsible investing strategies can do is slightly slow the rate of environmental and social descent.

The UN estimates that the cost to achieve the SDGs is about $7 trillion dollars per year through 2030. However, the key question is not, what is the cost of achieving the SDGs? It is, what is the cost of system change? And equally important, what is the cost of not changing systems?

SDG achievement estimates mostly focus on end-of-the-pipe solutions, such as implementing green energy. This approach does not adequately address the root cause question, why do SDG problems exist in the first place? The answer largely is that flawed economic and political systems create them. The SDGs cannot be achieved as long as these systems remain in current forms. What is the cost of achieving the SDGs under current systems? Infinite. They cannot be achieved this way.

What we should be asking ourselves is, how do we change current systems? And what is the cost of doing so? System change costs (e.g. lobbying, awareness raising) are low compared to SDG achievement costs (e.g. green energy, infrastructure, social welfare). However, SDG achievement costs will be substantially lower under sustainable systems for several reasons, including the following:

Under current systems, SDG resolution requires mitigating old impacts plus new ones being generated by flawed systems. New negative impacts are greatly reduced or eliminated under sustainable systems. This lowers mitigation/resolution costs.
Extensive green subsidies (i.e. environmental and social) are needed to offset brown subsidies under current systems that heavily subsidize fossil fuels and other harmful activities. Under sustainable systems, brown subsidies are removed. This greatly lowers the need for green subsidies.
Companies often oppose green/SDG solutions when they make more money on brown (i.e. harmful) activities. Sustainable systems make green the profit-maximizing activities. This converts companies from being barriers to drivers of SDG solutions.

What is the cost of not changing systems? As discussed below, unintentionally destructive current systems inevitably will collapse if we do not voluntarily change them first. The collapse of human systems and society cannot be priced. The cost is infinite.

In summary, from the financial and corporate sector perspectives, there are two main reasons why SCI is important:

Protecting current and future profits by preventing system collapse
Benefiting from next generation responsible investing

Preventing System Collapse

Throughout history, all flawed, destructive human systems changed, usually by collapsing quickly. Examples include the American and French revolutions and the end of US slavery and USSR communism. Collapse often occurs quickly because vested interests fight system change. This frequently causes negative environmental and social impacts to accumulate, become overwhelming, and drive rapid system breakdown.

For at least the past 100 years, companies could profit by degrading the environment and society. This is not sustainable. Businesses cannot continuously degrade that which enables business existence. It’s like burning the walls of a house to heat it. At some point, it becomes untenable. Flawed systems inevitably will change through voluntary or involuntary means.

It is highly likely that humanity has entered another phase of accelerated system change. Rapidly growing, often unprecedented problems show that human systems already are in the process of collapsing. We probably only have a few years to voluntarily change them before systems break down more extensively and cause vast disruption of business and suffering of humanity.

Concentration of wealth, deceptive media and many other factors have divided and disempowered citizens in the US and many other countries. Vested interests often strongly influence government. In this environment, the corporate and financial sectors usually are the only segments of society with the power and resources needed to drive voluntary system change. Without their participation and support, it almost certainly will not happen. Instead, investors are likely to lose trillions of dollars and many companies probably will go out of business.

The corporate and financial sectors largely are controlled by investing. SCI uses this lever to engage these powerful sectors in the most important sustainability issue for business and society. It is one of the most powerful strategies available to humanity for driving system change.

Avoiding system collapse could be seen as the SCI stick incentive. SCI benefits are the carrot.

SCI Benefits

As the most important sustainability issue, system change also is the most financially relevant. SCI funds will outperform for the same two basic reasons that ESG funds outperform on average:

Assessing financially relevant risks and opportunities that are ignored by conventional financial analysis
Management quality proxy. Sustainability is a complex management challenge. This makes ESG performance a strong indicator of management quality, the primary determinant of stock market returns. Leading ESG companies outperform on average mainly because they are better managed overall.

Beyond sustainability risks and opportunities addressed by ESG, flawed systems pose systemic risks and opportunities that typically are not assessed by conventional financial and ESG analysis. Businesses with the vision to effectively address system change will be better positioned to prosper during the many accelerating technological and other transitions facing business and society.

System change is an even more complex management challenge than sustainability. This makes it a stronger indicator of management quality and stock market potential. Going forward, corporate sustainability leadership increasingly will require a strong system change strategy. System change leaders are the new sustainability leaders. These visionary, well-managed companies usually will provide the highest investment returns.

When investors are given a choice between funds that slow climate change and other SDG problems (current ESG) or funds that have the potential to solve them (SCI), they often will choose SCI, especially because these funds generally will provide equal or better investment returns. Asset managers that launch SCI funds will increase assets under management and be seen as the global responsible investing leaders.

Whole System Approaches

Investment approaches that seek to drive system change usually focus on particular sectors, environmental/social issues, or aspects of system change. These provide many benefits. However, even more progress is required to drive voluntary system change in the limited time frame we probably have. True whole system approaches are needed. These seek to address and integrate all major aspects of human society embedded in the whole Earth system.

A higher level of business consciousness and thinking are required to effectively implement whole system approaches. Traditional business thinking sees companies as independent entities that seek to maximize their own monetary well-being. This narrow perspective appeared to work for over 100 years. And it is causing many problems.

In reality, companies are parts of larger environmental and social systems. They ultimately cannot prosper apart from these systems. New paradigm, whole system business thinking focuses first on the well-being of society. If companies serve society well, and do not harm it, they can achieve reasonable investment returns. Thinking at the level of society instead of the company presents a totally new level of management challenges and requires superior skills and capabilities. This further indicates why SCI ratings are strong indicators of management quality and stock market potential.

How SCI Works

SCI uses the proven ESG positive screening approach. Over the past 20 years, as investors shifted investments to ESG leaders, nearly all large companies were compelled to implement sustainability strategies. Like ESG, shifting investments to system change leaders will encourage companies to effectively address system change.

Two aspects of SCI enable it to drive rapid system change:

Whole system thinking
Broad, practical capital market applicability

Whole system thinking is essential for effective system change. Human society reflects human thinking. Nearly all major problems facing humanity originate in the human mind. The fundamental thinking problem is reductionism (i.e. considering parts without adequate reference to the whole system that contains them). All major aspects of the whole Earth system, including human society, are connected, and therefore cannot be effectively addressed in isolation. Yet considering everything at once is difficult.

As the complexity of human society increased, so did the fragmentation of economic, political, and other systems, exacerbating the inability to adequately consider all relevant factors and impacts. This produced unintended consequences, such as widespread environmental and social degradation. Only whole system thinking can change this. It is the response to reductionism. It takes all relevant factors into account, and thereby more effectively achieves desired outcomes (e.g. human survival and prosperity). SCI is based on whole system thinking, guided by the GSC framework.

Regarding applicability, every company can be rated on system change performance. This makes SCI broadly applicable in the capital markets. The markets are based on providing attractive investment returns. As noted, SCI benefits financial firms by enhancing investment returns, reputation and assets under management. SCI also is easy to implement. It is based on ESG strategies that nearly all large asset managers already are using.

Total Corporate Responsibility

Total Corporate Responsibility (TCR) is the corporate side of SCI. When it was initially developed, TCR expanded the definition of corporate sustainability by focusing on root causes and integrating systemic change into traditional ESG models. As such, it began to lay the foundation for a new standard rating model which is now SCI.

It is based on the observation that under traditional ESG and corporate sustainability, companies mitigate until it becomes unprofitable, which – apart from the undesirable economic consequences – typically implies a breach of obligations to shareholders. Very generally speaking, this leaves about 80 percent of negative impacts unmitigated. These impacts frequently return to harm companies and investors, often in the form of reputation damage, lawsuits and boycotts. Consequently, companies have strong incentives to mitigate beyond 20 percent. However, this only can be done when the systems in which these companies operate change.

Under TCR, companies take full responsibility for all negative impacts. They mitigate when doing so is profitable. However, instead of stopping there, they define necessary system change actions, e.g. working with others, to drive the systemic changes needed for further, and then full, impact mitigation. The formula is: ESG (20%) + system change (80%) = TCR (100%).

TCR segments system change into two categories – mid-level and high-level:

Mid-level system change refers to sector, stakeholder, and environmental/social issue-level change
High-level system change addresses overarching economic, political and social system-level change

In total, the model includes three metric categories – traditional ESG, mid-level system change and high-level system change.

Assessing corporate system change performance is a new field of ESG research. It expands the frame of reference of traditional ESG. Negative impacts are the main ESG frame of reference. Understanding them enables analysts to assess how well companies are mitigating impacts. The frame of reference for corporate system change performance is overall system change (i.e. sustainable society and the means to achieve it). Understanding this enables analysts to assess how well companies are driving system change, usually in collaboration with others.

System change work can be segmented into content and process:

Content refers to actual system changes.
Process describes the means of achieving them.

Both are essential. Much system change work focuses on the process-side, for example, by emphasizing collaboration and general principles of complex systems. SCI/TCR use the GSC framework to describe system change content. The framework provides a high level summary of system change overall. Understanding the whole system makes it possible to define the optimal corporate role in system change. Aspects of this become metrics in system change rating models and key components of corporate system change strategies.

Comprehensive Sustainability Risk Assessment & True Risk Management

A growing number of NGOs, universities and other organizations are quantifying and often monetizing ESG impacts and risks (e.g. Harvard Business School’s Impact Weighted Accounting project). This work is essential for helping investors to make well-informed decisions in the face of rapidly growing environmental and social challenges.

However, quantification only is the first step in full risk assessment. From a shareholder perspective, management of risk is at least as important, if not more so. Lower quantified, monetized ESG impacts can imply lower investment risk exposure. However, this frequently is not the case. Low ESG risks relative to peers can result from non-management factors, such as product mix and regulatory environment. The effectiveness of risk management indicates management quality. Research by Innovest Strategic Value Advisers (now MSCI) showed that companies with higher relative ESG Risks and superior risk management frequently outperformed, mainly because they were better managed overall.

Comprehensive risk reduction integrates system change. It recognizes that companies can only profitably mitigate about 20 percent of negative impacts. Quantification/monetization of ESG risks enables investors to shift investments to apparently lower risk companies. However, all companies degrade the environment and society because flawed economic and political systems compel them to do so. True investment risk reduction only can occur by mitigating/eliminating ESG impacts. As noted, about 80 percent of mitigation only can be achieved through system change.

In addition to segmenting impacts based on those that can be profitably mitigated and those that cannot, impacts could be segmented into three related categories based on legal requirements and financial relevance:

Held legally responsible.
Not held legally responsible, but financially relevant (often because companies are held responsible through other means, such as public opinion, reputation, boycott).
Not held legally responsible, not financially relevant (often because impacts are unknown/underestimated, there is little/no pressure to mitigate them, or there is little risk of being held responsible, e.g. difficult to win lawsuits).

Impacts in the first two categories often can be profitably mitigated. Mitigation in the third category frequently is not profitable. Pressure to mitigate generally is high for 1, medium for 2, and low for 3.

In summary, comprehensive sustainability risk assessment involves quantifying ESG risk/impacts and assessing impact mitigation through conventional ESG and collaborative system change efforts. SCI is the first corporate sustainability rating approach to provide this comprehensive risk assessment and opens the door to truly effective risk management.

SCI Models and Services

The SCI team provides SCI models and services for financial and corporate clients. It assists:

Financial firms with launching SCI funds and integrating system change into existing ESG funds.
Corporate clients to implement basic to the most advanced sustainability strategies by integrating whole system thinking and system change.

For financial clients, SCI models can be customized to facilitate implementation based on clients’ data availability, ESG models and existing funds. Models range from introductory to full whole system approaches. Initial SCI models and strategies usually would be basic, and then become more sophisticated over time, in the same way that ESG models evolved. Basic SCI adds system change metrics to ESG models. Examples of these metrics include system change goals, strategies, collaboration, accountability and results.

More advanced whole system SCI models identify the most relevant systemic changes for particular sectors and companies, and then assess corporate performance on driving them. One way to establish system change goals is to identify companies’ areas of largest negative environmental and social impacts, and the systemic factors that make full mitigation of these impacts impossible. Collaboratively resolving these factors becomes the most relevant systemic changes.

The GSC framework identifies necessary systemic changes for human sustainability. At a high level, this means evolving economic and political systems in ways that make full impact mitigation the profit-maximizing strategy. Apart from specific business-related reforms (e.g. ethical advertising and use of technology), this will involve more far reaching efforts like strengthening democracy, requiring honest media, and uniting and empowering citizens to work together on their many common interests. The degree to which companies collaborate to drive these types of changes also would be metrics in whole system SCI models.

Beyond SCI models, financial sector services include system change data acquisition and processing, ESG analyst training, internal and external SCI marketing and awareness raising, and fund management advice on integrating financial, ESG and system change analysis in ways that maximize financial and sustainability benefits.

For corporate clients, SCI services include assessing current strategies, suggesting improvements, establishing system change goals, designing strategies and systems needed to achieve them, and providing system change training, workshops and marketing support.

SCI Opportunity

SCI is a large opportunity for the financial and corporate sectors. Climate change and many other rapidly growing problems severely threaten companies, investors and society. Current ESG and corporate sustainability strategies are not resolving these problems. New approaches are needed.

SCI provides a powerful strategy for driving the scale and pace of systemic change needed to evolve systems and protect business and society. It is

Broadly applicable in the capital markets
Easy to implement
Provides attractive returns

The most important aspect of SCI is sending the system change signal from investors to companies. As investors shift investments to these new sustainability and system change leaders, companies will be encouraged to implement system change strategies. There are many experts and organizations working on nearly all types of system change.

Collectively, we know how to evolve human systems into sustainable forms. As companies address system change, they will seek guidance from these experts and help to scale up existing system change efforts.

Financial firms that launch SCI funds will be seen as the responsible investing pioneers of the 21^st Century. They also will be known as true sustainability leaders for launching the first responsible investing strategies that have the potential to achieve sustainability and the SDGs.

Frank Dixon is a leader and pioneer of system change and return-enhancing responsible investing. As the head of research for the largest, #1-rated ESG research firm (Innovest, now MSCI), he developed and refined the original return-enhancing ESG models that manage trillions of dollars of assets. Overseeing the sustainability analysis of thousands of companies showed that flawed systems make it impossible for companies to stop harming the environment and society. Recognizing that system change was the key to sustainability, in 2003, he created the concept of using investing to drive system change and built the first models for implementing it. He has been evolving SCI models and developing system change solutions ever since. He launched the Global System Change and System Change Investing companies and wrote the Global System Change books. They provide systemic solutions for all major areas of society. His SCI and Total Corporate Responsibility (TCR^®) approaches provide the most advanced responsible investing and corporate sustainability strategies. He advises leading organizations, including Investors for Purpose, Capgemini, Walmart, and the US EPA. Frank Dixon has presented at many conferences and universities, including Harvard, Yale, Stanford, MIT, and Cambridge. He holds an MBA from the Harvard Business School.

fdixon@SystemChangeInvesting.com