How investors can go beyond the ESG formula, and perform better

Climate Finance

How investors can go beyond the ESG formula, and perform better

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“Systems-level” investing offers a serious rethink of how to manage portfolios in an increasingly risky world

ESG can measure risks to cash flows, but “systems-level investing” offers a more complete view of where corporations might be vulnerable over the long term.

ESG analysis helps investors consider how environmental, social and governance factors could affect long-term corporate value.

For large, institutional investors such as asset managers or pension funds, which own a slice of the entire economy and can’t diversify away from system-wide risks, that may not be enough. That’s why more are leaning into “systems-level investing,” an approach that aims to generate superior long-term, risk-adjusted returns by studying the complex systems that drive economic and financial outcomes. 

The fundamental approach

Systems-level investing considers how changes in one part of the system — such as climate change — can create feedback loops and ripple effects across an entire system.

Focusing only on ESG factors can create a misalignment between the interests of individual companies and the long-term health of the economy they depend on, according to systems-level investment principles. A company might increase its value by externalizing costs, including those from carbon emissions, but that expense is borne by the broader economy and thus becomes a net drag on the long-term performance of diversified investors.  

Systems-level investing considers how changes in one part of the system — such as climate change — can create feedback loops and ripple effects across an entire system.

“You can’t achieve sustainability through asset allocation. That’s moving deck chairs on the Titanic,” said Sara Murphy, chief strategy officer at shareholder advocacy nonprofit The Shareholder Commons. “The greatest store of value for an investor is the systems that support a thriving economy.”

Overcoming this disconnect starts with reframing the fiduciary duty of asset managers so they practice more active “systems stewardship.” This deprioritizes individual company returns in favor of optimizing portfolio returns.

Ellen Quigley, a research associate and special adviser to the chief financial officer of the University of Cambridge, led some of the foundational work supporting systems-level investing. She recommends investors use “ungameable” metrics that measure real-world impact from companies. That might mean considering the amount of company capital expenditures that go toward decarbonization or requiring fund managers to report on their support for directors on the basis of their climate beliefs and credentials.

The Investment Integration Project (TIIP), a group that develops tools for pursuing systems-level investing, released a report last week highlighting “first-mover investment teams” embracing these practices.  

The report offers insight into how investors are bridging the gap between systemic issues and investment decisions. It includes detailed case studies about the California State Teachers Retirement System (CalSTRS), Domini Impact Investments, Saint Paul & Minnesota Foundation, University Pension Plan (UPP) and Wespath Benefits and Investments.

Following are examples of how these organizations use systems-level investment approaches.

  • Incorporating systems-level values into investment policies. CalSTRS updated its investment beliefs to explicitly recognize the materiality of ESG factors and climate change risks to long-term returns. This highlights a distinguishing factor between traditional ESG investing and systems-level investing: the clarity of an investor’s investment beliefs. “The investment belief statement is the litmus test on whether an investor is committed to addressing the foundational environmental, social and governance systems that enable long-term value creation,” said TIIP Founder Steve Lydenberg.
  • Engaging with portfolio companies on systems-level issues. CalSTRS uses its proxy voting power to hold companies accountable. A prominent example was its successful campaign to push Phillips 66 to make emissions reduction commitments. The oil and gas company now publishes a lobbying activity report demonstrating alignment with the Paris Agreement.
  • Developing a climate action plan. UPP committed to net-zero emissions across its portfolio by 2040 or sooner. A key aspect of the plan is its commitment to evaluate climate-related risks and opportunities, using a framework for assessing the climate transition alignment of companies it’s already invested in and companies it may invest in.
  • Engaging in advocacy: UPP engages with regulators and policymakers to advocate for improved corporate disclosure and other policies that support the long-term health of financial, social and environmental systems. This aligns with its investment beliefs, which state its responsibility to “promote the health of the capital markets and the financial, social and environmental systems on which capital markets rely.”

“Requires investors to fundamentally change how they think”

The now-fizzling ESG investing boom increased awareness about the relationship between climate risk and investment risk for the financial sector. “True systems-level investing is still an emerging practice that requires investors to fundamentally change how they think about the connection between their portfolios and the broader world,” Lydenburg said.

Overcoming institutional inertia will be a challenge. But the potential damage to business assets from climate-change risks such as fire, flooding, increased storm intensity and land loss will likely drive investors to move beyond mere portfolio-level ESG to an approach that considers the entire system.

This article originally appeared on as part of our partnership with GreenBiz Group, a media and events company that accelerates the just transition to a clean economy.

Written by

Grant Harrison

Grant Harrison is Green Finance & ESG Analyst, GreenBiz. He leads on program development for GreenFin — the premier ESG event aligning the sustainability, investment and finance communities. Harrison previously served as senior account executive with GreenBiz.