Three Letters to Transform Capitalism

Say what you will about how awful 2020 has been — pandemics, racial unrest, climate change — but it has also served an important purpose for our collective future: normalizing the abnormal.

In turn, this has brought techniques that predict and manage abnormal risks out into the mainstream. The world’s biggest fiduciary-bound investors — pensions, sovereign funds, foundations, endowments, and so on — are now rethinking the very methodology upon which they invest. And this has created a unique opportunity to transform capitalism.

Specifically, and for the first time in my career, these investors are taking environmental, social, and governance risks much more seriously than ever before.

Their burgeoning interest is critical because these investors are the most important economic actors in the world today. Together, they represent roughly $100 trillion in assets and negotiate and set the incentives that drive much of our economic activity.

In the chain of intermediaries that makes capitalism work, fiduciary investors are the first link. With advice from consultants, lawyers, and placement agents, they allocate funds to external professional-asset managers who then invest, through brokers and bankers, into the companies and projects that drive economic growth.

The fiduciary investors, quite literally, put the capital in capitalism. And by changing the way they do this, the current crises may reshape our short-term, unequal, and externality-riddled form of capitalism into a positive force for social and environmental change. Because when investors with $100 trillion better understand the impacts and outcomes of their investments, a more sustainable version of capitalism will emerge.

Risk and resilience

I am optimistic that this will happen, albeit with a few hurdles to overcome, for two reasons.

First, fiduciary-bound investors can no longer ignore the future risk presented by ESG factors. Traditionally, many pensions or endowments thought they could ignore, for example, climate change because their fiduciary duty was to manage investment risks only — to the exclusion of climate change.

But after the fires, storms, and other climate catastrophes in the last few years, some assets are now uninsurable or vulnerable to repricing. The previous logic has been reversed: In a letter to CEOs, BlackRock CEO Larry Fink wrote, “Climate risk is investment risk.” This statement was a big deal, as it effectively obligated pension funds and other long-term investors to consider climate change in their decisions.

Second, we now know that managing ESG risks actually helps make portfolios more resilient (the same upside, with less risk on the downside). During the height of the pandemic and market volatility, 66 out of 74 sustainable indices tracked by MSCI and Morningstar outperformed their generic counterparts.

In other words, investing in ESG is not only good for the world; it’s also good for returns.

Find a common language

As noted, fiduciary-bound investors are obligated to do things that drive performance. And so, the silver lining of 2020 may be that we can finally integrate ESG into mainstream investing and create a more sustainable form of capitalism.

But, in order to deliver on this promise, there is still important work to be done: First, we now have endless amounts of ESG data coming at us. How do investors make sense of it? And what mechanism do we have to integrate this data into our decision-making?

Converting the ESG signals into financial signals generally requires an additional step that isn’t currently being taken. For example, some ESG data companies now measure climate hazards for specific real-asset properties and then communicate a subjective level of hazard as color ratings (green, yellow, and red).

But what do these ratings really mean, and how does an investor make use of color-based signals in their decisions? How does “red” fit into a discounted cash flow statement used to value a real asset? It doesn’t. It requires another step. So, now that ESG is going mainstream, we need better methodological tools to understand the value of ESG data and translate it into financial metrics that investors understand.

In the case of real estate, we can already predict future damages from climate change or probabilities of climate-linked default, which can be included in investment decisions fairly easily. The world needs a lot more focus on this kind of “last mile” integration.

Second, ESG may help us identify the long-term risks of an asset, but the interpretation of those risks depends entirely on the characteristics and preferences of the investor. In other words, there is no one-size-fits-all approach to ESG integration.

The pension fund using labor unrest data may be trying to identify companies that take a long-term view on employees and stakeholders, while a short-term trader might use that same data to signal cost-cutting and quarterly outperformance.

We need better tools to tailor ESG signals to investors’ needs. Today, most investors attempt ESG integration inside error-prone and “flat” spreadsheets that are not benefitting from contextual data that can augment the quality of insights. As Dane Rook and I argue in our recent book, The Technologized Investor, projecting ESG risks more accurately necessitates new technological tools that move us beyond the spreadsheet.

Now is the moment

We are on the verge of transforming the underpinnings of capitalism. Now that abnormal factors have come to the forefront, fiduciary-duty demands that investors bring the management of these abnormal risks into their normal course of business.

This is where ESG comes in.

But to do this well, it will take a generation of founders and startups to focus on two things: building new last-mile ESG integration methodologies so long-term investors can be rigorous in their understanding of these risks; and developing new data and analytics tools to project portfolios into the future and allow investors to model and understand ESG outcomes.

If we do both of these things well, we can redirect trillions of dollars to solutions for climate change, encourage sustainable development, eliminate wealth inequality, and so on.

Now is the moment. Never let a disastrous year go to waste.


Ashby Monk is the executive and research director of the Stanford Global Projects Center, and author of The Technologized Investor.

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