Why system-level thinking is required of responsible investors in an inflationary environment

As investors increasingly realise that their future returns are tied to global sustainability challenges, either as sources of system-level risk or targets for impact, they look to progress on sustainability goals to inform their investment activities. But progress on the most used goals – the SDGs – is falling behind expectations. As a result, it is becoming increasingly important for investors to consider the interconnectedness of sustainability issues and their role in shaping real-world sustainability outcomes.

Addressing the system-level risk of climate change, for example, creates inflationary pressures through internalisation of negative externalities. The system-level risk of widening income inequality and declining labour income share, if left unaddressed, will combine with rising inflation to further reduce households’ purchasing power and hence well-being. If this happens, momentum toward net zero could be lost, and anti-ESG and anti-SDG sentiment could increase and spread globally.

To avoid such an unintended outcome, responsible investors need to adopt system-level thinking with a macro-socio-economic perspective, focusing on the interconnectedness of the financial system, the environment, and the social system. In addition, to mitigate interrelated system-level risks, policy engagement is becoming increasingly important, and the scope of policy makers to be engaged should be widened. For example, given the inflationary pressures that would result from the rapid pursuit and achievement of sustainability goals, investors should engage in deeper dialogue with central banks on sustainability issues.

Dialogue between investors and central banks can help navigate several contemporaneous economic forces. Externalities must be internalised, purchasing power (and well-being) of low-income households must be improved, and inflationary pressures must be better understood and flexibly responded to. For central banks, this means the need to identify sustainability-related inflation in the conduct of monetary policy. This is because sustainability-related inflation may be tolerable where it results from sustainable-structural adjustment in economies or is accompanied by a subsequent increase in productivity. Investors can help central banks better respond to sustainability-related inflation by providing information and insights on economic transition from their stewardship activities.

The alternative for both investors and central banks is alarming: a stalled sustainable economic transition with cascading systemic risk. The sustainable development of national economies would be undermined, and investors’ long-term financial returns would decline.

Cost-push shocks caused by internalisation of negative externalities

The term “greenflation,” which combines “green” meaning decarbonisation and “inflation” meaning rising prices, has become widely known. As investment in coal has been curbed, demand for natural gas, which can have lower greenhouse gas emissions than coal, has increased, causing energy prices to rise. Prices have also risen for a variety of metals and commodities, including copper and lithium, which are needed to drive renewable energy growth.

The cost-push (supply) shocks of such decarbonisation occur in the process of internalisation of negative externalities by companies. The spread of corporate management engaged in sustainability issues has led to the internalisation of negative externalities in areas besides decarbonisation. For example, protection of human rights in the supply chain and the deforestation-free movement have made it more difficult to rely on cheap labour and raw materials. New mine developments are also taking longer to come online due to concerns about the environment, residents, and miners’ human rights. These adjustments in business practices are necessary to pursue sustainability goals, and failing to address them can be counterproductive. Lack of fairness and inclusiveness in the process of transitioning to a net-zero economy generates frictional costs: the Q3 2023 strike by the United Auto Workers (UAW) in the U.S., for example, was driven by union concerns arising from the shift in production from gasoline to EV vehicles.

To increase the sustainability of corporate management, it is necessary to maintain, preserve, and enhance non-financial capital, such as natural capital and human capital, and this comes at a reasonable cost. These costs are passed on in no small measure in market prices. For example, compared to internal combustion engine vehicles, which damage natural capital through greenhouse gas emissions, EVs, which damage natural capital to a lesser extent, are still more expensive to produce. The airline industry has offered green fares to passengers who want to offset their carbon footprint by using more expensive SAF (Sustainable Aviation Fuel): consumers pay a premium and offset their flight shame. In addition to natural capital, the costs of human rights considerations and investments in human capital (e.g., training costs) are gradually being passed on in the prices of products and services, even though subsequent productivity gains will alleviate some of the inflationary pressures.

Institutional investor actions on sustainability goals

The impact of cost-push shocks associated with the internalisation of negative externalities is likely to become more widespread in the future as society pursues the SDGs and any intermediate targets or successor goals that are introduced.

The SDGs were adopted unanimously by UN General Assembly members in 2015 as global goals to be achieved by 2030. A mid-term wrap-up of SDG achievement in 2023 shows that less than 20% of the SDG targets are on track to be achieved globally by 2030, and little or no progress or backsliding has occurred with respect to more than 80% of the targets. Therefore, the global community will have to accelerate considerably its actions if the goals are to be achieved by the target date. Missing the 2030 goals is not going to make the underlying sustainability failures go away. If anything, they will become more acute and demand even more ambitious actions and goals from governments. As a result, institutional investors are expecting to gear up as national economies transition in pursuit of sustainable development goals. For example, the PRI’s survey of signatories conducted in late 2022 and early 2023 confirms rising expectations to act on real-world sustainability outcomes in investment activities. Investors expect to intensify their efforts to encourage portfolio companies to reduce negative impacts as well as transition to sustainable business models through their stewardship activities. In the process, the magnitude and impact of cost-push shocks will become more pervasive.

Beneficiary preferences for system-level outcomes

Why is sustainable economic development important to institutional investors?

It is now clear around the world that beneficiaries and clients are increasingly showing a preference for achievement of sustainability goals, as well as financial returns. In Japan, for example, according to a survey conducted last year by Nippon Life Insurance for its policyholders, 65% of policyholders expect Nippon Life Insurance to consider the achievement of the SDGs as well as financial returns when it comes to asset management. Another 14% of policyholders expect the company to prioritise the achievement of the SDGs regardless of financial return.

In addition, even for beneficiaries who are only interested in financial returns, the achievement of the SDGs is actually very important from a long-term perspective. Environmental and social sustainability underpins the business foundations of all companies around the world, and if it is undermined - if the SDGs are not achieved - market returns will deteriorate on a global scale. If this happens, institutional investors will not be able to fulfill their fiduciary duties. No matter how well diversified their investments are, they will not be immune to the impact of system-level risks, such as global warming or biodiversity loss, that threaten the business foundations of all companies.

For this reason, the UK Stewardship Code encourages institutional investors to address system-level risk. The PRI has developed guidelines for Active Ownership 2.0, a stewardship initiative to limit system-level risks, and collaborative engagement among investors is expanding.

Declining labour income share and widening income inequality

As noted above, the pursuit of sustainable development goals is inflationary. So, if beneficiaries want investors to contribute to the achievement of the SDGs, will they accept the resulting inflation? That depends on wages.

Even if beneficiaries and society want to achieve the SDGs, it would be difficult for them to accept a consequence in which only prices rise without wages increasing. If price increases were not met with wage gains (i.e., household purchasing power does not improve), consumer demand for more expensive goods and services that address sustainability goals would not increase, and as a result, the SDGs would not be achieved.

In relation to the purchasing power of households, it is noteworthy that the labour income share has been declining over a long period of time on a global basis. In other words, the growth of real wages for workers has been less than the growth of labour productivity, and a growing fraction of productivity gains has flowed to capital. This has accelerated the concentration of wealth among shareholders and increased income inequality. This is not sustainable. Such income inequality is significantly undermining the productivity of the economy as a whole, as shown in numerous of empirical studies. In other words, the declining trend in the labour income share and the widening of income inequality is itself a system-level risk.

While addressing the system-level risk of climate change creates inflationary pressures through internalisation of negative externalities, another system-level risk of widening income inequality and declining labour income share, if left unaddressed, will combine with rising inflation to further reduce households’ purchasing power and thus well-being. If this happens, momentum towards net zero could be lost, and anti-ESG and anti-SDG sentiment could spread globally. To avoid such a situation, it is increasingly important to consider the interconnectedness of sustainability issues.

One implication of making our society more sustainable, and a conundrum for capital markets to contend with, is a shift from an emphasis on shareholder profits to an emphasis on the interests of all of companies’ stakeholders. As corporate activities are increasingly linked to sustainability impacts, expectations for profit share would shift. This could naturally lead to expectations for an increase in the labour income share and the redress of income inequality. Since addressing income inequality raises the productivity of investee companies and the economy as a whole, it will also benefit shareholders in the long-run. While measures to address income inequality in investee companies, such as paying living wages, require additional expenditures and would reduce profit margins in the short term, allocating more resources to labour is an investment that helps the investee company realise long-term benefits. Improving working conditions and paying living wages lead to increased employee retention and loyalty. An increase in the number of motivated employees would lead to higher productivity of investees, which provides long-term financial gains to investors.

For stakeholder capitalism to take root in capital markets, responsible investors need to comprehensively evaluate various sustainability issues surrounding their portfolio companies. Leading European investors have started incorporating living wages into their social investing approach, highlighting the connection between climate issues and social issues. Such investors’ approach has been facilitated by the regulation in the EU, where the European Sustainability Reporting Standard (ESRS) requires companies to disclose information on working conditions, including adequate wages, and equal treatment and opportunities. In the U.S. as well, a coalition of institutional investors has called on U.S. companies in traditionally low-wage sectors, such as hospitality and retail, to start paying workers a living wage as inflation continues to erode incomes.

Clearly, in their stewardship activities, capital allocation and field building, responsible investors are required to adopt “system-level thinking” based on the interconnectedness of the financial system, the environment, and the social system, with a macro-socio-economic perspective in mind. This is essential if investors are to contribute to shaping sustainability outcomes in the real world and realise the benefits in their future returns.

Dialogue between investors and central banks based on system-level thinking

Of course, investors cannot address system-level risk alone. To mitigate system-level risks, policy engagement is essential, and investors’ engagement with policy makers should be expanded. For example, given the inflationary pressures that would result from the achievement of the SDGs, investors should engage in deeper dialogue with central banks on sustainability issues.

In the future, central banks will be asked whether monetary policy should contribute to the achievement of the SDGs in addition to price stability. The argument that the pursuit of price stability will contribute to the achievement of the SDGs is not necessarily valid. This is because the pursuit of the SDGs by the private sector itself generates inflationary pressures through the internalisation of negative externalities, and managing monetary policy to curb those inflationary pressures would be a headwind for the private sector to achieve the SDGs. Thus, central banks will face a tradeoff between price stability and the achievement of the SDGs.

From a macro-socio-economic perspective, there should be consistency between investor stewardship activities and macroeconomic policy including monetary policy. A simple focus on price stability would require central banks to raise real interest rates above the natural rate of interest in response to cost-push shocks associated with achieving the SDGs, thereby curbing corporate activity; capital investment necessary to achieve the SDGs (e.g., green investment necessary to achieve net zero) would be reduced; and internalisation of negative externalities by firms, including wage increases to address income inequality, would be suppressed. In other words, if investors encourage portfolio companies to internalise negative externalities through stewardship activities in order to achieve the SDGs by 2030, but the central bank tightens monetary policy in response to the resulting inflationary pressures, the achievement of the SDGs would become more difficult and the sustainable development of the economy would be undermined.

On the other hand, even if central banks become more tolerant of higher inflation and do not rush to raise interest rates in response to cost-push shocks associated with the achievement of the SDGs, rising inflation could worsen household purchasing power as a whole and further deteriorate macroeconomic performance, unless system-level risks of widening income inequality and declining labour income shares are mitigated. To avoid such a situation, investors need to strengthen their stewardship activities, capital allocation, and field building to mitigate the system-level risks of income inequality. In their policy engagement, the need for a whole-of-government approach, including fiscal and labour policies, to address system-level risks should be emphasised more than ever.

The dialogue between investors and central banks now needs a new angle: pursuing SDGs. While it is difficult for central banks to identify SDG shocks that are causing inflation among the various cost-push and demand shocks, investors can provide information to central banks on how they are encouraging their portfolio companies to internalise negative externalities through their stewardship activities. Of course, even if SDG shocks are identified, how central banks should respond to the inflationary pressures associated with achieving the SDGs is a new issue and could be debated in different ways. Further complicating the issue is the uncertainty that central banks face about the extent to which the SDG shock will be accompanied by subsequent productivity gains and the extent to which these will ease inflationary pressures. However, what is clear is that system-level thinking based on a macro-socio-economic perspective is required of both investors and central banks.

Information sharing between policy makers for economic development is commonplace. As custodians of pension savings, insurance pools and household wealth, there is an important role for institutional investors to exchange information on policy approaches with policy makers, independent of individual buy, sell, hold decisions. Increasingly investors see the importance of this role on policy dialogue and have been willing to support it, as the growth in organisations such as the PRI, and the investor climate groups indicate. These or similar channels could support the type of exchange that is now needed. We look forward to a deeper dialogue between investors and central banks on how best to achieve the SDGs.