System Change Investing – Defending ESG and Making It Sustainable
Frank Dixon
February 2, 2023
www.GlobalSystemChange.com
ESG (environmental, social, governance) investing is approaching two major transformations. It is likely to become the dominant form of investing globally in the 21st Century. It also is likely to experience the most significant shift in focus since positive screening was introduced in the 1990s.
Over the past 20 years, ESG has grown more rapidly than traditional investing, rising to over $40 trillion. It currently represents about one-third of global assets under management. Superior ESG investment returns and concerns about growing environmental and social problems are driving rapid growth. Over the past two years, ESG assets in the US grew by more than 40 percent.[i] At current growth rates, ESG could soon represent the majority of global assets under management.
A main goal of ESG is to improve environmental and social conditions. However, in spite of ESG success, environmental, social, economic and political problems are growing rapidly in many regions. ESG provides substantial financial and sustainability benefits. But it cannot resolve climate change and other problems addressed by the UN Sustainable Development Goals (SDGs) for three main reasons.
It largely is focused on changing companies instead of the systems that control them. It is almost completely focused on addressing symptoms such as climate change instead of root causes. And like much of human society, it is reductionistic. It largely is not based on the higher level, whole system thinking that Einstein said we must use to solve our most complex challenges.
Empowering ESG to resolve climate change and other major challenges requires a shift in focus to system change, root causes and whole systems thinking. System Change Investing (SCI) is a new ESG investment strategy that does this. Given its potential to resolve major problems, protect business and society, and achieve superior investment returns, SCI is likely to become the dominant ESG investment style of the 21st Century.
From 1998 to 2005, I was the head of research for the largest ESG research firm (Innovest Strategic Value Advisers, purchased by MSCI in 2010). I developed the SCI approach in 2003 and have written about the corporate and financial sector roles in sustainability and system change ever since. This experience is used for two purposes in this article – to defend ESG by rebutting recent criticism and to summarize the rationale, mechanics and benefits of SCI.
ESG has become mainstream. Nearly every large financial institution offers ESG products and services. However, criticism of ESG has grown recently. Common arguments include:
- ESG is politically motivated
- ESG sometimes underperforms
- The ESG focus on benefiting shareholders harms other stakeholders
- ESG invests in oil and other companies that substantially harm the environmental and society
- ESG is not solving climate change and other major problems
The first four arguments largely result from misconceptions about ESG. The fifth one is highly valid. It can drive the transition to a more effective form of ESG. Addressing the criticisms in order:
Financial Versus Political Motivation
Political division is growing in the US and many other countries. Citizens often are pressured to blindly support their party’s political views. Climate change and other environmental and social problems frequently are seen as liberal or Democratic issues. As a result, political leaders in Florida, Texas and some other Republican-controlled states are attempting to restrict or discourage ESG investing.[ii] They argue or imply that ESG issues are politically motivated, and therefore should not be taken into account when investing.
Businesses and financial institutions must be sensitive to political issues. However, the emphasis should be on facts and logic. Ignoring financially relevant so-called political issues threatens business survival and prosperity.
ESG is a financial, not political issue. ESG metrics sometimes are called nonfinancial because they do not directly measure costs and other explicit financial factors. But ESG issues are financial in the sense that they often have large and growing material impacts on companies. These issues include how well companies attract and retain high-quality workforces, sell safe and appealing products, efficiently use energy and materials, facilitate market access and project development, and minimize lawsuits and regulatory action.
Ignoring issues that materially affect business risks, opportunities, profitability and competitive position violates the fiduciary obligation to protect shareholders. The growing financial relevance of ESG issues is a main reason why the market has grown so rapidly.
Early ESG was based on negative or ethical screening. Investors avoided sectors and companies to which they were ethically opposed. This often reduced portfolio diversity, increased risk and lowered returns. ESG investors frequently were willing to accept lower returns to support their ethical views. In the same way, some investors might be willing to ignore material ESG issues and accept lower returns to support their political views. But most investors probably would not want to do this.
ESG Performance
ESG critics often point out underperforming ESG funds and argue that taking so-called nonfinancial issues into account lowers investment returns. But some underperformance occurs in all investment areas. In theory, positive screening ESG always outperforms traditional investment funds because it assesses financially relevant ESG issues that are not addressed by traditional financial analysis. Negative screening often reduces returns, but positive screening can increase them. Instead of avoiding sectors and companies for ethical reasons, investors shift investments to companies that are more effectively addressing material ESG issues.
While positive screening ESG always outperforms in theory, in practice, outperformance generally requires the same factors as in other investment areas – high quality research, fund construction and fund management. When positively screened ESG funds underperform, it never is because this type of ESG underperforms in general. Underperformance often occurs because fund management and research quality were inadequate.
There are many ways to produce ESG data and ratings. Early data usually was gathered through company questionnaires. This information generally was biased (i.e. greenwashed), incomplete and not focused on financial materiality.
Innovest pioneered a new approach to ESG research. We gathered information from many sources, reviewed company literature and websites, and interviewed companies. Our rating models overweighted ESG factors with the highest financial impacts. As a result, in nearly all sectors, ESG leaders, taken as a group, substantially outperformed laggards. Innovest’s ESG ratings produced alpha by uncovering significant, often intangible value that was not disclosed by conventional financial analysis. We pioneered ESG business case arguments that became mainstream many years later, as shown in a 2002 Oxford University Press paper.[iii]
Ongoing improvements to ESG fund management and research (for example through the use of artificial intelligence) are better aligning theory with reality. Many studies show that ESG outperforms traditional investments. For example, Morningstar research found that US large cap ESG growth funds achieved an average annual return of 14 percent over the past five years, compared to 11 percent for conventional non-ESG growth funds. Morningstar research also found that global and European ESG funds outperformed.[iv]
As environmental and social problems expand and ESG issues become even more financially relevant, outperformance will grow. ESG will replace traditional investing as the dominant investment strategy of the 21st Century because addressing financially relevant ESG issues is true responsible investing. Ignoring them no longer will be seen as responsible or prudent.
Shareholder Versus Stakeholder Focus
ESG critics sometimes assert that the ESG focus on increasing shareholder returns harms other stakeholders. This largely reflects a misunderstanding of how ESG ratings are produced. At Innovest, we gave the highest ratings to companies that most effectively addressed material ESG issues, reduced negative environmental and social impacts, and benefited all stakeholders.
We argued that sustainability was a complex challenge that required sophisticated management skills. As a result, sustainability performance is a strong indicator of management quality, the primary determinant of stock market performance. We demonstrated this by showing outperformance in nearly every sector.
High ESG ratings enable companies to more easily attract investment. In effect, we were incentivizing and rewarding companies for providing the greatest benefits to all stakeholders. MSCI and other leading ESG research providers largely have continued this ESG rating strategy pioneered by Innovest.
Arguing that the shareholder focus harms other stakeholders is valid in the sense that even ESG leaders cause negative environmental and social impacts. ESG rewards companies that provide the greatest stakeholder benefits. But stakeholder harm still occurs. Flawed systems often create conflicts between shareholders and other stakeholders. This systemic issue is discussed under SCI below.
Negative Versus Positive Screening
ESG funds have been criticized for investing in oil, coal and other sectors that exacerbate climate change and other SDG problems. This position partly reflects a misunderstanding of negative versus positive screening. As discussed, positive screening can provide larger financial benefits than negative screening. It also can provide greater sustainability benefits.
With negative screening, avoided companies have no chance of attracting ESG funds. As a result, ESG investors using this approach have little to no influence over these companies. (Negative screening can reduce harmful sectors by restricting access to funds. This is most effective when the capital markets broadly restrict investment, which usually does not occur.)
Positive screening uses a different approach. Rather than exiting harmful sectors, investors often stay in them and shift investments to sustainability leaders (frequently by underweighting laggards and overweighting leaders). This best-in-class approach provides far more influence over companies. Positive screening engages and influences entire sectors because all companies potentially can attract ESG funds. Leaders seek to improve sustainability performance to maintain access to funds. Laggards seek to improve to increase access. Positive screening reduces risk by maintaining portfolio diversity and increases return potential by overweighting presumably better managed companies.
As discussed below, flawed economic and political systems compel all companies to harm the environment and society. It is impossible to only invest in companies that cause no harm because these companies do not exist. One could argue that using positive ESG screening to invest in companies or sectors that cause the most harm can produce the highest sustainability benefits because the improvement potential is greatest.
In addition to negative and positive screening, engagement is another major form of ESG investing. It involves using corporate ownership to drive sustainability improvement. However, minority owners often have limited ability to influence corporate strategy, unless they work together, for example, through shareholder resolutions. Positive screening often is the highest impact ESG approach. It powerfully rewards companies for sustainability leadership through increased access to capital, which frequently raises share prices.
Over the past 20 years, new ESG investment strategies have been developed, such as ESG integration and impact investing. Most of them essentially involve positive screening – shifting investments to sustainability leaders, often with the goal of improving financial and sustainability performance.
ESG Cannot Solve Major Challenges
This is the heart of the ESG problem. Failure to resolve climate change and other major challenges is a highly valid criticism of ESG. Environmental, social, economic and political problems are growing rapidly in many regions, despite ESG investing and corporate sustainability becoming mainstream. The sustainability movement has provided substantial benefits. Society would be far worse without it. However, ESG and broader sustainability only have slowed the overall rate of environmental and social descent. Failure to resolve major challenges severely threatens businesses, investors and society. Implementing new forms of ESG that have the potential to reverse environmental and social decline and achieve the SDGs is essential.
For many years, I oversaw the ESG analysis and rating of the worlds 2,000 largest companies. I saw thousands of examples of companies increasing profitability by reducing negative environmental and social impacts. But this was always only true up to a point. I estimated that companies could profitably mitigate only about 20 percent of tangible and intangible, short-term and long-term, negative environmental and social impacts. Beyond this point, costs usually went up. If companies continued to voluntarily mitigate, they would put themselves out of business long before reaching full impact mitigation. Beyond a certain point, voluntary corporate responsibility equals voluntary corporate suicide. Flawed economic and political systems unintentionally put business in conflict with society and humanity in conflict with nature.
These reductionistic systems compel all companies to degrade the environment and society. They are the root causes of climate change and nearly all other major challenges facing business and society. Improving them (system change) is at least 80 percent of the sustainability and SDG solution. But until recently, system change got little attention in the ESG movement.
ESG is almost completely focused on changing companies, instead of the systems that compel their harmful behavior. The movement is based on an irrational premise. Companies are encouraged to voluntarily eliminate negative impacts under systems that will put them out of business if they do so fully. ESG also is almost completely focused on addressing symptoms, such as climate change and other SDG problems, instead of the root causes of these problems (flawed systems).
A whole system perspective shows why ESG has not reversed environmental and social degradation (and cannot reverse it in its current form). Current ESG cannot achieve the SDGs. The focus on company change and symptoms makes this impossible.
System Change
There are many economic and political system flaws that compel companies to degrade the environment and society. These include externalities, limited liability, time value of money, emphasizing economic growth instead of social well-being, and allowing regulated entities to influence regulators. (Specific system flaws and how to resolve them are extensively discussed in my Global System Change books.)
All of these system flaws could be rolled up into one overarching flaw – the failure to hold companies fully responsible for negative impacts. This is the general mechanism that makes it impossible for companies to end negative impacts in competitive markets. Current systems unintentionally compel companies to profit by harming the environment and society. If the meta system flaw is the failure to hold responsible, the meta solution is to hold companies fully responsible. Under these sustainable systems, companies maximize profits by fully benefiting and not harming the environment and society.
I saw nearly 20 years ago that ESG could be used to drive system change in the same way it has successfully encouraged companies to engage in sustainability. As ESG investors shifted investments to sustainability leaders, companies were compelled to implement sustainability strategies. Twenty years ago, few companies had these strategies. Now nearly all large companies have them. Owner interest (ESG) was the primary factor driving this. As investors shift investments to system change leaders, companies also will be incentivized to implement system change strategies.
In 2003, I developed the first SCI model. Like ESG, SCI rates companies on system change performance and uses this research to guide investment decisions. Called Total Corporate Responsibility (TCR®), the model was introduced in a 2003 Ethical Corporation magazine article.[v] Since then, I developed several more SCI models, ranging from introductory to full whole system approaches.
Business Case. ESG is now mainstream. However, in the 1990s and 2000s, the financial community was skeptical. They thought it would reduce investment returns. Strong business case arguments were needed to engage the financial community in ESG.
The same will be true with SCI. Financial community leaders often will resist changing systems that provided record profits and investment returns for many years. As occurred 20 years ago, strong business case arguments will be needed to broadly implement SCI.
The business case for system change is clear. As the human economy expands in the finite Earth system, negative corporate impacts return more quickly to harm companies, often in the form of market rejection, lawsuits and reputation damage. Companies protect themselves and investors by reducing negative impacts. These benefits strongly drove ESG growth.
However, businesses only can unilaterally mitigate about 20 percent of negative impacts before they violate the obligation to maximize shareholder returns. Flawed systems often make it impossible to stop causing climate change and other SDG problems. This poses rapidly growing risks to businesses, investors and society. Companies cannot profit indefinitely by degrading the environmental and social systems that enable business existence. At some point, unintentionally destructive economic and political systems will collapse, unless we change them first.
Whole System Perspective. A whole system perspective illuminates the causes and solutions to human unsustainability. For 3.8 billion years, the laws of nature controlled all life on Earth. These laws are objective, observable requirements for living system success at all levels. They include seeking balance not growth, producing no waste, and living on renewable resources. Species that violated these laws changed or disappeared. Throughout human history, all flawed systems that violated natural laws changed, usually by collapsing quickly (e.g. American and French revolutions, end of US slavery and USSR communism).
Over the past 100 plus years, system change could be pushed off into the future. But at some point, the future becomes the present. Unprecedented, often unexpected events (i.e. Covid-19, Ukraine invasion, democracy decline in the US and other countries, climate change and many other rapidly growing problems) show that humanity almost certainly has entered a phase of rapid system change. We might only have five to ten years to voluntarily change our unintentionally destructive systems, before they involuntarily change through collapse.
System change is the most complex challenge facing business and society. Societal-level system change often occurred through collapse, probably because voluntary change was too difficult. However, we have unprecedented incentives and capabilities to voluntarily change human systems. Involuntary change will bring unprecedented disruption because human society is larger and more interconnected than ever before, and we are near or beyond many environmental and social tipping points. This strong incentive combined with extensive sophisticated technologies give us the ability to do what previous societies frequently could not do.
Corporate Responsibility. System change is the most important, and therefore most financially relevant, sustainability issue. Traditional corporate responsibility strategies involved reducing negative impacts until doing so violated the obligation to maximize shareholder returns. In 2003, Total Corporate Responsibility provided a new approach. With TCR, companies mitigate when doing so is profitable. But instead of stopping there, they take full responsibility for all harm they impose on society. They go beyond traditional corporate responsibility by working with others to evolve systems into forms that make full impact mitigation the profit-maximizing strategy.
The corporate and financial sectors often used their strong influence of government, media and the general public to block systemic changes that threatened profitability and shareholder returns. But we are entering a new phase of human society. Flawed systems increasingly threaten and harm, rather than help, companies. As the corporate and financial sectors better understand the business case for system change, they can use their influence, creativity and resources to powerfully and quickly drive it.
Many financial institutions and companies highly value their leading ESG and sustainability reputations. Going forward, ESG and corporate sustainability leadership will increasingly require a strong system change component. System change leaders will attain the same benefits as current sustainability leaders. These include enhanced reputation and goodwill, improved stakeholder relations, increased market share, facilitated project development and market access, and enhanced workforce quality.
Effectively engaging the financial and corporate sectors in system change requires a new ESG approach that largely shifts the focus to system change, root causes and whole systems thinking. SCI provides this.
System Change Investing
There are many ESG models and strategies, in spite of extensive efforts to standardize ESG over the past 20 years. There are even more ways to do SCI because the approach is more complex than ESG. The frame of reference is much broader. A main ESG frame of reference is negative corporate impacts. Understanding this enables analysts to determine how effectively companies mitigate impacts. The frame of reference for SCI ultimately is the whole Earth system and its sub-element human society.
ESG models often use optimal corporate sustainability performance as a standard against which companies are rated. However, the optimal corporate system change strategy cannot be identified until system change overall is understood. Once this is clear, the most effective corporate role in system change can be ascertained. Aspects of this become metrics in SCI rating models.
Rating Models. After developing the first SCI model, I saw that much more information was needed about whole system approaches to human sustainability. I wrote the Global System Change (GSC) books to provide this. They provide a three-part roadmap for human sustainability and system change. GSC uses the laws of nature to describe main characteristics of sustainable society. With the endpoint clear at a high level, systemic changes needed to get from here to there are identified. Then actions required in all areas of society to bring about these changes are described. This provides the framework needed to accurately rate corporate system change performance.
The whole system SCI model is segregated into three metric categories – traditional ESG, mid-level system change (sector, stakeholder, environmental/social issue-level change), and high-level system change (economic, political, social system change). Sample SCI metrics include system change strategy, business consciousness (e.g. whole system thinking), system change collaboration, government influence activities, media campaigns, supporting system change organizations, and system change results and benefits.
There often will be high correlations between sustainability and system change leadership. Unilever, for example, is a long-term sustainability leader. They would receive high SCI ratings due to their ESG leadership, extensive sector-level collaboration (mid-level system change), and proactive work with government on policy reform (high-level system change).
To illustrate how SCI can drive system change, the degradation of democracy is a major problem in the US. It severely threatens economic and capital market stability and success. Democracy degradation is driven in large part by deceptive media. Social and mass media often divide society into debating factions, such as conservatives and liberals. It pressures citizens to blindly believe their party, rather than rationally think for themselves.
The corporate and financial sectors have strong influence over media through ownership, advertising, lobbying and other means. They have the power to rapidly reduce media deception and division. Uniting citizens and empowering them to work together on their many common interests, such as protecting environmental life support systems, is one of the most important system changes. It facilitates all other necessary systemic changes.
As a result, the GSC/SCI framework heavily weights these factors. Companies are rewarded for compelling media to unite and empower citizens, and penalized for deceiving and dividing them. For example, companies that own or advertise on media that promotes irrational, harmful views, such as climate change is not real, often would get lower SCI ratings. They usually would be seen as unsophisticated companies that likely will underperform. Through this mechanism, SCI holds companies responsible for the systemic harm they impose on society, and thereby strongly incentivizes them to end this harm.
Complexity. Complexity does not need to be a barrier to corporate and financial sector engagement in system change. It is not necessary for companies to understand all the actions required to evolve systems into sustainable forms. They only need to take a few early steps and begin to collaborate with government and civil society (because high-level system change only can be achieved through collaboration). Once they apply their attention, ingenuity and resources to system change, they can drive it.
The key issue initially is to begin sending the system change signal from owner/investors to companies (by shifting investments to system change leaders). SCI does not seek to change systems directly. Instead, it incentivizes investors and companies to collaboratively change them. SCI is a form of indirect system change.
The corporate and financial sectors are powerful. They largely are controlled by investing. SCI uses this strong lever to engage these powerful sectors in the most important sustainability issue. It potentially is the single most powerful short-term strategy available to humanity to drive voluntary system change.
Implementation. SCI is relatively easy to implement. It involves adding system change metrics to ESG models. Then these enhanced ESG ratings are used to develop the same types of funds marketed through the same channels. SCI can be used as an overlay on nearly all types of investment funds – value, growth, index, equity, debt, public, private. All companies can be rated on system change performance. This enables nearly all of the capital markets to be used to drive system change.
Benefits. SCI represents a large opportunity for the financial sector. It enhances reputation, assets under management and investment returns. Shifting the focus to system change and root causes enables SCI funds to provide greater sustainability benefits than current ESG funds. Given a choice between funds that slow environmental and social degradation or reverse it, investors often will choose the latter. Offering SCI funds enables asset managers to attract new investment and position themselves as global ESG leaders.
SCI increases returns by assessing systemic risks and opportunities that are not addressed by conventional financial and ESG analysis. More importantly, it enhances returns by providing a strong indicator of management quality and stock market potential.
SCI also provides a large opportunity for the corporate sector. As investors shift investments to system change leaders, companies will be incentivized to implement system change strategies. This will increase demand for system change advisory services. SCI models provide a roadmap or template for corporate system change. They define the most important aspects of system change strategies, and thereby facilitate implementation.
System change is getting increased attention in the corporate and financial sectors. The best-selling book Net Positive: How Courageous Companies Thrive by Giving More Than They Take strongly advocates it. A growing number of consulting firms and NGOs provide system change services, such as helping to establish and manage collaborative system change groups and develop government policy initiatives.
SCI models a new level of business thinking. Nearly all business strategy efforts focus on the company level. However, businesses are parts of larger environmental, social and economic systems. Developing corporate strategies in isolation is reductionistic. It produces unintended consequences, such as environmental and social degradation. Higher-level, whole system thinking is essential for placing business in a reality-based context. This higher-level thinking is necessary for developing the most effective corporate-level strategies. SCI is based on it.
The shift to system change, root causes and whole system thinking is the most significant ESG transformation since the introduction of positive screening. Superior sustainability and financial benefits enable SCI to become the dominant ESG strategy of the 21st Century.
Frank Dixon is a sustainability and system change pioneer and leader. He saw 20 years ago that system change was the most important sustainability issue. As a result, he established Global System Change and developed the System Change Investing (SCI) approach. It provided the first model for rating companies on system change performance and integrating system change into corporate sustainability strategies. He also developed a true whole system approach to sustainability, described in the Global System Change books. It provides systemic solutions for all major areas of society. In the financial and corporate sectors, SCI offers the most advanced and effective sustainability strategies. Before writing the GSC books, Frank Dixon was the Managing Director of Research for the largest corporate sustainability research firm in the world (Innovest/MSCI). He developed ESG rating models and research processes that consistently provided superior investment returns. He advises companies, investors and governments, including Walmart and the US Environmental Protection Agency, on sustainability and system change. He has presented at many corporate and financial sector conferences around the world, and spoken at leading universities, including Harvard, Yale, Stanford, MIT and Cambridge.
Frank Dixon has an MBA from the Harvard Business School and is a Fellow of the World Academy of Art and Science.
Copyright © 2023 Frank Dixon
[i] ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence, www.Bloomberg.com, January 24, 2022.
[ii] Frances Schwartzkopff, GOP Fury Over ESG Triggers Backlash With US Pensions at Risk, www.Bloomberg.com, August 25, 2022.
[iii] Frank Dixon, Financial Markets and Corporate Environmental Results, Environmental Performance Measurement: The Global Report 2001-2002, Oxford University Press, 2002.
[iv] Frances Schwartzkopff, GOP Fury Over ESG Triggers Backlash With US Pensions at Risk, www.Bloomberg.com, August 25, 2022.
[v] Frank Dixon, Total Corporate Responsibility: Achieving Sustainability and Real Prosperity, Ethical Corporation Magazine, December 2003.