Special

Article 3

System Risk – Where Does
the Responsibility Lie?
By Govinda Finn
The central tenet of sustainable economics is that the capacity ofenvironmental, social, and human capital should be wholly
replenishable when the full benefits and costs of economic activities
are accounted for. That includes internalisation of the unpriced
components of both direct and indirect effects, or so-called
externalities.
Incorporating these externalities into economic decisions should
result in an efficient and sustainable allocation of resources.
However, how should we think about the unpriced costs of activity
over the long term? Internalisation of benefits and costs, which have
not yet been borne, is complicated. It requires both a discounting
mechanism to calculate a present value, even for activity in the
distant future, and a decision on the appropriate process ofinternalisation.
In this article, I choose to focus on the latter issue, considering
future costs and benefits through two prisms: an issue-specificassessment and a system-based assessment.1 I then consider the
merits of both the public and private sector process of internalisation
based on these diverging approaches and finally suggest somerecommendations for future developments.

Introducing System-Level Thinking
Any temporal assessment of direct and indirect costs and benefitsof sustainable economic activity must begin with an understandingof the capacity and adaptability of existing resources. In sustainable
research, this is often gleamed from resource-specific analysis
framed by a finite or exhaustible resource assumption.
This can result in some revealing analysis. For example, thedetailed analysis of biodiversity as an economic resource containedin The Dasgupta Review 2 and the striking claim that the economic
system is already using 1.6 times the serving capacity of thebiosphere.
Through this prism, costs can be identified and reduced by both
lower usage and increasing resilience at a resource-specific level. For
example, The Dasgupta Review argues that countries shouldde-emphasize GDP as an index of progress and instead should focus
on a national wealth measure that includes an accounting for natural
capital.
Yet, where Dasgupta succeeds in putting a price tag on natural
capital, it is not a comprehensive way to capture the unpriced costsof economic activity on existing capacity over time. Furthermore, any
attempt to assign prices as comprehensively as The Dasgupta
44 Japan SPOTLIGHT • July / August 2024

Author Govinda FinnReview across all resources, both finite and renewable, would lead togreat complexity and may prove extremely unwieldy.
This has led some scholars to conclude that a better way toquantify the costs of economic activity on potential capacity is tostop breaking down sustainability challenges into individual
analytical problems and instead consider them holistically. They
argue in favour of deploying an ecosystem approach which analyses
important interactions of multiple resources or factors, which may
be relevant from a number of fundamentally different operational andphilosophical perspectives.3
This holistic or system approach has garnered increasing interestin light of the failure to address numerous sustainability-related
challenges, for example climate change, marine pollution, or species
loss. Some researchers take the case for sustainable economic
analysis based on systems-thinking even further, arguing that“sustainability is a systems-based concept and, environmentally atleast, only begins to make any sense at the level of ecosystems andis probably difficult to really conceptualize at anything below
planetary and species levels.”4

System-Level Thinking in Action
When seeking to improve sustainability management, is there acase for alternative, and potentially enhanced, assessment criteria ofboth direct and indirect effects based on dynamic interactions within
and across interconnected systems? If so, what are the prospects ofrelieving existing bottlenecks and better allocating resources for thelong term?
We should begin by recognising that system-level analysis isalready widely used both in theory and practice. One such example isthe Financial System Report that the Bank of Japan (BOJ) firstreleased in 2005 and continues to publish biannually. The reportassesses the resilience of Japan’s financial system as a whole. The
key assumption is that the highly interconnected nature of financial
markets means analysis of a single issuer or asset class may offer anincomplete picture of the health of the financial system. The BOJ also
provides a useful definition of future costs embedded in the system,
noting that “systemic risk is when the insolvency of an individual
financial institution spreads to other financial institutions, othermarkets, or the entire financial system”.5
The benefit of looking at financial markets through a systemic lens
was aptly demonstrated during the Great Financial Crisis, when theinfluence of previously overlooked network effects became of great
https://www.jef.or.jp/journal/

Portfolio Risk

CHART
consequence. The response from policymakers also followeda system-level approach. For example, the Federal Reserve’s
The limits of diversification
measures to expand its role as the lender of last resort,introduce new liquidity facilities, and expand open market
operations were all designed to limit contagion and prevent asystem-level collapse.
Unsystematic risk eliminatedWhile the evidence suggests that central banks wereby diversification
prepared for a systemic threat to financial markets, what may
Total Stock Risk
have come as a surprise to some was just how
interconnected financial markets were at the time to othereconomic, social, and political outcomes – much of which
Undiversifiable Market Risk (Systematic Risk)
was far beyond the analytical purview of central banks.
The linkages between monetary policy and social andNumber of Stocks in Portfolio
political issues led to much wider, and perhaps unintended,
consequences from unconventional Federal Reserve policy,
Source: adapted from Statman, M. (2004), The diversification puzzle. Financial Analysts Journal,
60(4), 44–53
with some researchers arguing QE exacerbated wealth andconsumption inequality while contributing to a politicalizationof the Federal Reserve.6
And herein lies the challenge with a system-based approach. At
approaches to assessing costs and benefits of economic activity arewhat point do you limit the scope of your analysis? In the public
subject to a wide range of market failures. In particular, there is a
sector, the answer is relatively straightforward. Central banks arerecognition that information failures limit the ability of market
given jurisdiction over monetary matters, while other aspects ofparticipants to accurately price sustainability-related challenges. I
economic, social, or indeed political or geo-political policy are
touched on some of these issues in an earlier Japan SPOTLIGHT
entrusted to other ministries within the government. For system-level
article in January 2023.
analysis to succeed on issues that span across these fields, it isIf system-level analysis offers an alternative way to account fornecessary for government functions to partner together morethese costs and benefits, then it may also be beneficial for investors
effectively.
looking to allocate capital in a sustainable way. Indeed, there has
We have seen evidence of such action with publication ofbeen a growing acceptance from investors that system-level thinking
ambitious decarbonisation strategies that encompass all areas of
can improve their understanding of, and mitigate the risks associatedgovernment, such as the Net Zero Strategy in the United Kingdom inwith mispriced, or unpriced, costs and benefits.
2021 and the Green Transformation (GX) Basic Policy in Japan in
Furthermore, as our understanding of system-level challenges has
2023. Mechanisms to enhance coordination have also beenrisen, there have been increasing questions over whether attempts todeveloped. For example, as part of the climate transition bonds
insulate investor portfolios from negative shocks throughissued by the Japanese government earlier this year, a new liaison
diversification can provide sufficient protection to portfolios fromsystem between relevant ministries and agencies was established tosystem-level risks whether financial (e.g., global financial crisis),select appropriate projects.
environmental (e.g., climate change), or social (e.g., income
However, the challenge for the private sector of adopting a
inequality or political stability). As the Chart highlights, a highly
system-level approach to resource allocation is potentially both morediverisified portfolio still has substantial system-level riskspressing and more disruptive. Given their highly integrated nature,embedded in it. The case against passively accepting risks contained
financial markets are a useful place to consider how the private
in market-level returns, or beta, has been articulated by Jamessector approaches the issue of system-level stability.
Hawley and Jon Lukomnik (2021).7
So why have investors not sought to integrate market or systemSystem-Level Thinking in the Private Sector
level analysis into investment decisions more comprehensively? The
difficulty is partly a measurement problem. System issues are
In financial markets, it has long been accepted that standard
inherently more qualitative, and investors often find it challenging toJapan SPOTLIGHT • July / August 2024

45

integrate them as they are not as easy to quantify.
As with the public sector, it is also partly a question of where thelimits of system-level analysis should be drawn. Let’s examine thislatter issue in more detail. Under the shareholder-primacy model,
where fiduciary duty promulgated profit-maximising behavior as
investors’ sole appetency, the scope of system-level analysis has
been limited to issues with material financial consequences. That
emcompasses some system-level issues but not all.
However, a growing emphasis from asset owners on
environmental, social and governance has resulted in an increasing
appetite for non-financial objectives to be embedded in asset
allocation analysis and decision-making. This broadens theopportunity set of system-level investing and also strengthens thecase for analysis across complex interlocked financial, economic,
nature-based and social systems.
Regulators have been quick to recognise the benefits of a systemlevel approach and have begun to require the financial sector toaccount for system-level risk. For example, the UK Stewardship Codecurrently requires signatories to “identify and respond to marketwide and systemic risks” to promote a well-functioning financial
system. This Code will be revised in 2025 and close attention will be
paid to any further emphasis to incentivize system-level investing.

System-Level Thinking in Practice
While in the public sector, a growing emphasis on sustainableeconomic objectives has led to an increasing coordination between
previous disparate government functions, there is no readily
available private sector partner for financial firms to team up with toanalyse the impact of dynamic interactions within and acrossinterconnected systems. For this reason, the more limited definitionof systemic risk provided by central banks is insufficient for private
sector participants in financial markets. Instead, efforts have been
made to provide a broader definition of system risks that includes
both systemic risks, as conventionally defined by central banks, andsystematic risks which are defined more broadly by clients andregulators as “any risk which is non-diversifiable”.8
At present, there is little theoretical agreement on the boundariesof this enlarged grouping. As a consequence, it is practitioners whoare stepping in, aligning definitions with their interpretations of client
and regulatory guidance. One such example comes from theInternational Corporate Governance Network (ICGN), an investor-led
organization championing global standards to support value creation
while contributing to sustainable economies, which provides thefollowing examples of system-level risk:
46 Japan SPOTLIGHT • July / August 2024

• Macroeconomic risk, including market and credit risk andchanges to political, legal, regulatory, and fiscal instruments• Environmental risk, including climate change, water scarcity andpollution• Social risk, including human rights, income inequality andpopulism• Governance risk, including corruption, expropriation of control
and corporate culture• Technological risks, including artificial intelligence and cybersecurity.9
At first glance, it may appear eminently sensible to account for theabove factors in asset allocation decisions. However, for wideranging definition such as those from the ICGN to be justified, theallocation of resources should maximize the net issuer-related
benefits and systemic benefits without depleting resources overtime. This decision requires an estimation of the benefits received
from all possible ways of allocating resources after accounting for
associated trade-offs.
For example, the benefits at portfolio level or system level must be
offset by the costs that may be borne by an individual company, as
well as the considerable costs associated with monitoring acrossthese far-reaching dimensions.

Do the Numbers Add Up?
In the next section, I examine whether a system-based approachto analysing and internalising costs and benefits can yield better
sustainability outcomes and consider what is necessary for the casefor a system-level approach to be strengthened.
When seeking to estimate the benefits of system-level investing,the obvious first question is whether private sector actors have thecapability to influence system-level outcomes? The fate of many of
the themes identified by the ICGN above are unlikely to be dictatedby the actions of individual investors. Instead, there is a need formechanisms that encourage investors to develop new knowledge
and tools to better understand and influence the outcomes
associated with system-wide issues. This may include establishing
new sustainability research teams, bringing in external expertise anddeveloping appropriate internal risk and governance frameworks. For
example, much effort has been made to understand net zerotechnologies, such as carbon capture, biofuels, or e-fuels, but how
should investors integrate net negative technologies such as direct
air or ocean capture, or direct cooling technologies such as solar

radiation management, into long-term asset allocation?
Equally importantly, investors should seek to partner with otherleading organizations to increase their capacity to influence systemlevel outcomes. This can occur through collaborative engagement ininvestor initiatives such as the UN Principles for Responsible
Investment or Climate Action 100+.
These initiatives are more effective if they are capable of aligning
efforts from different regions and stakeholders. A collaborative
engagement that is conducted across multiple jurisdictions may be
more successful at preventing a race to the bottom, as international
rivals refrain from exploiting near-term transition costs borne by afirm that has been pressured to shift behavior on a material issue ata local level. For example, the Asia Engagement Working Group of
the Climate Action 100+ coordinates engagement with companies in
the Asian market while understanding the institutional sensitivities
and specific engagement nuances in local markets.
Another important way to increase the impact of system-level
activities is to enhance capabilities for coordination across private
and public sector stakeholders. By implementing a multiengagement approach which extends beyond the usual issuer
engagement to other influential entities such as government, civilsociety and business associations, investors can raise the impact of
their activities on system-level outcomes.
The second part of the equation relates to minimising the costs
needed to generate positive system-level outcomes. This includes
costs incurred by firms at an individual level from changes investors
have agitated for to generate benefits at the portfolio or wider
economy level. In corporate law, directors are obligated to put theinterest of shareholders in an individual firm first. Investors must
respect this principle and engage in two-way dialogue with firms,
fully exercising their rights and responsibilities, to ensure that eachengagement with firms is value-creating in the long term, rather than
abdicating responsibilities for problem firms in favor of making
decisions only at the portfolio aggregate level.
Another important requirement to improve the cost-effectivenessof a system-level approach is the development of investment tools
and datasets to address and monitor systemic environmental andsocial concerns and the establishment of new norms that canregulate system-level investing. In a recent report, the Investment
Integration Project (TIIP) set out a range of investment techniques
used by system-level investors. These included conventional
methods, such as statements of investment beliefs, whole industry
minimum thresholds and engagement, and system-level due
diligence, as well as advanced techniques such as field building,information sharing on system interconnections and standards

setting.
A greater availability of effective tools may help lower the cost of
system-level investing. However, in reality many of the options
raised by the TIIP are currently inaccessible to most asset managers
and owners. If this is to change, then more efforts and resourcesmust be deployed to strengthen system-level capabilities. Inevitably
this will require trade-offs between new system-level tools andexisting capabilities.

The Importance of the Market Mechanism
If the private sector is to begin to integrate systemic thinking into
its decision-making, it is important that its contribution to systemwide outcomes is understood. It is highly unlikely that a single
company or investor can achieve system-level change alone.
However, the private sector will only take collective action if its
contribution is recognized and remunerated.
Unlike with some other public goods, the case for excluding noncontributing entities from the benefits of system-level solutions is
not a valid approach. There is certainly a case for governments toplay a larger role through traditional tax and subsidies designed toencourage better behavior and tackle the free-rider problem.
However, there is a limit to how effective the state can be inmonitoring complex and interlinked sustainability outcomes.
Instead, governments would be wise to think about strengthening
market incentives to integrate system-level analysis into decision
making. Transparency and accurate reporting are critical to
overcoming the free-rider problem. First, information disclosure canform the basis on rewards and penalties for investor groups, bothfrom clients and from government monitoring of subsidies andtaxes.
To facilitate greater client engagement on system-level issues,
more incentives must be introduced to align incentives across theinvestment chain. By understanding asset owners, consultant andend-beneficiary preferences on systematic issues, it is possible tostrengthen intrinsic motivation to integrate systemic risks into
decision-making.
Second, the alignment of ambitions on system-level issues shouldbe embedded more clearly in collaborative investor groups or global
initiatives. Collaborating with like-minded investors can reduce
information costs by sharing resources, skills, and expertise amongcollaborators. It can also facilitate peer-group level monitoring either
by other contributing parties or by specified and agreed governanceframeworks. For example, for selected collaborative engagements,
the UN Principles of Responsible Investment Secretariat is also
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47

responsible for monitoring and engaging investors.
Finally, more work must be done to offer an independent
assessment of contributions, with a process of external auditing ofsystem-level analysis and decision-making imperative to ensure that
good behavior is rewarded and bad behavior disincentivized.
It is important that the adoption of system-level analysis issustainable from a commercial perspective. This requires not only
firms to better articulate the value added of system-level monitoring.
This may include measuring how integrating systemic risk indecision-making may reduce volatility of returns, but also
demonstrating how systemic stewardship is delivering on thesustainability objectives of clients and contributing to the improved
functioning of markets that regulators have been requesting.

Conclusion
System-level thinking is not a cure-all for the economic system. It
is quite possible that the standard cost/benefits analysis can offer
improved sustainability outcomes if we are better able to measureexternalities and orientate asset allocation to longer-term
considerations of the direct and indirect effects of economic activity.
However, there is growing concern that the complexity of modern
and highly globalized economic systems may not be sufficiently
captured by the myopic approach to internalization of costs andbenefits preferred by individual firms and investors. Furthermore, inthe last decade or so, the shortcomings of the economic system
when it comes to sustainability have become increasingly apparent.
A system-level approach offers a different and potentially more
impactful alternative for analysing sustainable economic issues andallocating resources for the long term. However, there will be tradeoffs and costs associated with this approach that will need to bejustified.
For system-level thinking to succeed, it will be necessary toenhance the benefits derived from system-level solutions and help tomitigate the costs. I argue this requires the acquisition of new
skillsets and analytical know-how. It also necessitates a morecollaborative approach, with new coalitions to be formed both
between the public and private sector and within the private sector.
That does not mean that there is not a place for more effective
government regulation to deliver better and more sustainableeconomic outcomes. But to deliver environmentally or sociallydesirable goals, system-level solutions will require fully mobilized
and incentivized private-sector action.
A critical facilitator of these sustainability coalitions will be greatertransparency. Within the private sector, I call for greater monitoring48 Japan SPOTLIGHT • July / August 2024of system-level activity across three key components: 1) clientmonitoring, 2) peer monitoring, and 3) third-party audit. By
understanding and assessing each entity’s incentives, activities, andoutcomes, it is possible to enhance accountability for system-level
outcomes and embed incentives to deliver better and moresustainable economic outcomes.

References
1 Williams, A., Kennedy, S., Philipp, F., and Whiteman, G. (2017).
“Systems thinking: A review of sustainability management
research”, Journal of Cleaner Production, 148, pp. 866-881.
2 Dasgupta, P. (2021), The Economics of Biodiversity: The
Dasgupta Review. Full Report. 610 pages. (London: HM
Treasury).
3 Holling, C.S. (2001). “Understanding the Complexity of
Economic, Ecological and Social Systems”, Ecosystems, 4, pp.
390-405.
4 Gray, R. (2010). “A Re-Evaluation of Social, Environmental andSustainability Accounting: An Exploration of an Emerging TransDisciplinary Field?” Sustainability Accounting, Management andPolicy Journal, 1, pp. 11-32.
5 https://www.boj.or.jp/about/education/oshiete/kess/i06.htm
6 Juan A. Montecino and Gerald Epstein (2015). “Did Quantitative
Easing Increase Income Inequality?” Working Papers Series 28,
Institute for New Economic Thinking. And Saroj Dhital, Senyuan
Jiang, and Jillian Reese (2023). “Effects of monetary andgovernment spending policy on economic inequality”, Journal of
Macroeconomics, Elsevier, Vol. 77(C).
7 Lukomnik, J., and Hawley, J.P. (2021). Moving Beyond Modern
Portfolio Theory: Investing That Matters (1st ed.).
8 Jeffrey N. Gordon (2021). “Systematic Stewardship”. Columbia
Law and Economics Working Paper No. 640, European
Corporate Governance Institute – Law Working Paper No.
566/2021.
9 ICGN, 2019. ICGN Viewpoint: Investor Framework for Addressing
Systemic Risks.

Govinda Finn is a “Next-Gen Pioneering Research Programme” scholar under
the Japan Science and Technology Agency based at the University of Kobe,
Graduate School of Economics. He is a former Japan and Developed Asia
economist at the Research Institute at Aberdeen Standard Investments based in
Singapore. Prior to that he worked in global strategy within the AberdeenStandard Investment Multi-Asset Investment Team based in Edinburgh. He ison the international advisory board of the Asia Scotland Institute.