Using Systems Thinking to Avoid ESG Investing Blind Spots

Systems thinking is a well-established framework for solving complex problems that emphasizes interdependencies and feedback loops. It is an integrative approach that considers all system components and how these interrelate dynamically within and across systems. For investors looking to enhance ESG risk management and the long-term impact of sustainability efforts, a systemic approach can help identify interventions that will most effectively mitigate the risk of negative outcomes or divert the chain of events towards a more sustainable trajectory. Typically, this involves moving from single-issue or company-specific tactics to progressively integrate system-level considerations in ESG strategies. Targeting systemic change through active ownership is one way to acknowledge and start unravelling the dynamic web of global challenges.

Thinking in Systems

Worldwide, the interconnectivity between economies and people has, over the past century, been exponentially increasing to the extent that the World Economic Forum calls the current era, Globalization 4.0, “globalization on steroids”.[1] The past 1,5 years have served as a prime example of how not only ideas and goods swiftly cross borders, but negative impacts can also quickly spread in the global system without (or before) the source and magnitude being known or understood. The multiplier effect can have unpredictable and devastating consequences. Colossal problems cannot be solved by any actor alone and addressing one aspect in the whole can have undesirable knock-on effects on another.

The same applies to ESG risks. They are often intertwined and mutually reinforcing. Investors have typically centered their ESG strategy on addressing urgent, financially material risks, often combined with a focus on selected companies, sectors or incidents that warrant special attention. However, because ESG issues rarely exist in isolation or present with simple correlations, investors would benefit from expanding to a more holistic approach. As we look to improve the sustainability and post-pandemic resilience of societal structures and corporate actors, the interdependencies and systemic vulnerabilities underlined by the COVID-19 crisis make a case for applying a systems lens in ESG analyses all the more pertinent.

Systems behave dynamically and are never fixed. All components in complex systems are interlinked with different relationships and impacts across the value chain. Some elements form their own systems within the system, with distinct interdependencies and dynamics to consider. System behavior is driven by the various interconnections, the (positive, negative, or balanced) feedback loops among elements and how these loops influence the flows and variables in the system, which can best be understood as the inputs and outputs/outcomes of the system.

The predictive power of systems thinking and the best potential for impact lies in understanding this dynamic nature. Every event and outcome - desirable or undesirable - affects and is affected by another part of the system, directly or indirectly.

Applying the Systemic Approach to Investments

Sustainability challenges create a complex web of interconnected root causes, risks, and impacts, linked to various societal matters and stakeholders globally. Fixing or eliminating one weak link or negative event in the chain - or in a portfolio - rarely solves the actual problem or has a long-lasting impact on the underlying risk factors. The disparate reactive measures may need to be repeated over and over again. Instead, it can be much more efficient and impactful for investors to acknowledge causal relationships and develop more proactive, coordinated, and structural approaches. Systems awareness can help shape such a strategy.

Systems thinking is also in line with universal ownership. Large investors with exposure to practically every market are inevitably exposed to numerous ESG risks. In this case, a systemic approach has clear advantages over targeting the sustainability of individual companies, which typically only has a negligible impact on the overall risk profile.

Still, the systemic and focused approaches are not mutually exclusive. Tackling critical ESG incidents and paying special attention to high-risk companies should continue. In addition, system-level thinking provides context for understanding dynamics and interconnections, helping investors take more strategic, long-reaching, and multifaceted measures to manage current and future ESG issues.

There are challenges to the systemic approach too. It requires broader and more profound analysis than the more focused ESG strategies, and thanks to the myriad of complexities and interdependencies, the ultimate outcomes of even the best-planned efforts are not guaranteed. Individual investors have limited abilities to generate transformative change alone. Fiduciaries and other stakeholders are increasingly expecting investors to evidence the impact of their ESG activities, but because of the long-term perspective and the nature of system-level measures, it can be hard to claim additionality and the impacts can be difficult to measure. Similarly, material links are more apparent when looking at individual companies’ ESG performance, and affirmation from external stakeholders is usually more forthcoming when acting on the urgent headline items.

Nevertheless, Sustainable Development Goals (SDGs) already provide a way to view ESG issues as a web of mutually enforcing and interdependent topics; many investors are currently addressing mutuality without necessarily thinking of their actions as explicitly systematic. Moreover, investors are leveraging active ownership to pivot toward systems thinking.

Active Ownership Can Shape the Next Normal

Sustainalytics’ Thematic Engagements take a holistic approach to emerging and intensifying ESG challenges and seek to effect system-level change. One example is to alleviate root causes rather than treating the symptoms, which can have significant material benefits in the long term - the perspective that responsible investors are typically expected to assume. For instance, protecting a certain location from imminent deforestation or biodiversity loss is commendable, but applying a systems lens sets up a more impactful path to secure thriving biomes across the globe and more enduringly mitigate CO2 emissions pertaining to unsustainable use of natural resources. Acknowledging the systems linked to the degradation of ecosystems, investor focus should be expanded to overall forest management and agricultural practices, among other things. These are complex systems in their own right, where positive feedback loops and multiplier effects can result in benefits much larger than the sum of its parts. Accordingly, our Climate Change - Sustainable Forests and Finance and Feeding the Future engagements aim to tackle the deep-seated structural challenges pertaining to forest commodities and food production respectively, to muster systemic shifts and avoid crossing critical tipping points.

Neglecting the context and addressing ESG issues in silos can have unintended consequences on the other components and relations in the system, which may evolve into new or increased ESG risks. For example, investments in renewable energy are only truly sustainable if they don’t have negative impacts on interconnected elements and synergies relating to affected communities, workers and the ecosystem throughout the different stages of the product lifecycle of the relevant technologies. Otherwise, new problems and reputational risks may arise, including poor working conditions in mines to irresponsible end-of-life waste disposal as examples. Our Responsible Cleantech Thematic Engagement sheds light on these pitfalls and blind spots to ensure a just and sustainable transition.

Sustainalytics’ Feeding the Future and Responsible Cleantech engagements are also part of our Next Normal bundle, together with the thematic engagement on Human Capital and the Future of Work. This holistic, future-focused solution centers on the necessary change in certain practices and industries that will be essential building blocks in the next normal. Collectively, the three themes offer exposure to over 50 companies and multiple entry points for furthering improvements in various markets and throughout the value chain. With focus topics ranging from feeding the growing population within planetary boundaries to workplaces navigating their way to robust and fair human capital management strategies in the face of technological changes, this bundle addresses various systemic dilemmas and almost all Sustainable Development Goals.

Sustainalytics currently offers eleven Thematic Engagements focusing on affecting change on company, sector, and system level on business-relevant topics ranging across the ESG spectrum. To learn more, please contact our Stewardship Services via your preferred client advisory channel or send us an email.