How fragile are our economic systems?

0:12Hello and welcome to the latest episode of Margin Notes with me, Simni Kiriakou, editor of FT Advisor. This year, as regular listeners will know, I've been focusing on various aspects of risk in this podcast series. Today, we are looking at another aspect of risk, how overlapping climate, geopolitical and social stresses can combine to turn isolated shocks into systemic financial risks that can ripple through global markets and communities. And we're all too familiar now with experts warning the UK has to stockpile food and readiness for war, but what are the implications for investors, namely, that is, your clients?

0:51Well, in March, the University of Cambridge's Institute for Sustainability Leadership published a report in collaboration with the Investment Leaders Group. The report was called Breaking Down Silos, Navigating the Intersection of Environmental and Social Risks for Investors. Well, joining us here to discuss the report is the author, Trisha Marnie. She's a Senior Project Manager within the ILG at the University of Cambridge's Institute for Sustainability Leadership. Welcome to Margin Notes, Trisha. Thank you for having me. It's a pleasure to be here. That's great. Could you tell us then in a nutshell what the report is about and why the Institute published it?

1:29Trisha Mani: Thank you. So in a nutshell, what our research is looking at is essentially how environmental and social risks intersect, how they act and why when we don't understand these interlinkages, we risk underestimating financial risks. So this has a financial material impact on investment portfolios. And the agri-food systems is a good example to bring this to life. So when I walk into a supermarket today in the UK, I see that a big part of our fruits and vegetables, our basic produce, comes from different parts of the world. We have tomatoes from Morocco, bananas from Ecuador, green beans from Kenya.

2:12Trisha Mani: To me, it's quite impressive, the sort of strength of the international supply chains. But what this also means is that a crisis in any one of these regions could quickly ripple down into impacts not only of what we see in our supermarkets, but also on what we can afford. And of course on companies and communities, both here in the UK and across the world, right? Exactly. And this is something that we've all experienced as well. So in the UK last month, the food inflation rates rose to about 3.5%. And at an individual level, we've seen this in terms of the rise in food prices for all of us within this country.

2:56Trisha Mani: But at a systemic level, the story is much more serious because we see how fragile our food systems are and really who is actually most impacted from these crises. So, for example, low income households are most impacted from the rise in food prices or producers in vulnerable regions struggle with sort of systemic climate shocks. And that's really what our research is about. It's looking at how social inequalities often make communities more susceptible to climate change, but also how climate change often exacerbates social inequalities. Yeah. So we're looking, obviously, we understand that climate change does have effects.

3:39You know, we see mass flooding or we see impact of extreme drought. These are often seen as being overseas issues. For a UK investor, we think, OK, so there might be extreme drought in West Africa or East Africa. There might be plagues of locusts even in some countries. and then you don't really sort of think about how that impacts on you as a consumer and certainly not necessarily on you as an investor but then it all it takes is a disruption that global supply chain doesn't it to to bring that message home a ship gets stuck in the Suez Canal people can't get hold of their produce for for a few weeks and now with the recent sort of crisis in the Middle East.

4:22We've seen people putting pressure on oil, which then leads to pressure on whether we can get chicken or pork. You know, there's now questions about will we see shortages in the supermarkets, which of course then leads some people to excessive consumption or purchasing, and then the shops are empty. It becomes a sort of vicious cycle, doesn't it? What's the sort of report trying to achieve though? Because we sort of understand that these risks happen and that we're all interconnected but what's the report hoping to achieve?

4:50Trisha Mani: So at its core the the report is trying to to kind of focus on three three key shifts so on one level we're looking at a mindset shift so we've gotten into the space in the sustainability space today where we often look at these things as in silos we look at climate social nature themes all independently and it's the same for financial institutions as well. When they're evaluating risks for portfolios, you have a separate climate framework, a separate social framework. And what we don't capture is these interlinkages. And that's actually where a lot of the hidden underestimated risks lie. And so the first level, we're looking at a mindset shift of moving away from silos to really understanding a holistic view of how this plays out in reality.

5:38Trisha Mani: At the second level, for financial institutions, it's important to translate this into actual risk frameworks. So we need to be building the right kind of models that account for these interlinkages. So for example, how does a climate risk translate into impacts on GDP, on migration, on labour and productivity, social issues like this? And finally, at the policy level, it's important to look at how can we best protect those most vulnerable. And this is important whether we're sitting in the UK or we're sitting anywhere else in the world, because often it's those at the bottom of the pyramid that are hit the hardest.

6:16Trisha Mani: And so when we know some risks are happening, for example, in the case of the climate crisis, how do we make sure that those most vulnerable are protected? Let's look at that mindset shift for just the climate and sustainability. You know, we're starting to see in some circles a political bias against ESG and against sustainability and it's very powerful and it's very pervasive and it's starting to sort of impact on the UK and Europe as well, perhaps seeing this coming from America in particular. That mindset shift against ESG has almost made ESG a very unpopular acronym. Can we sort of like just unpack that?

7:00Is there some merit in some of the accusations leveled against ESG investing? How do we unpack this particular mindset shift that we're dealing with right now?

7:09Trisha Mani: So it's true. I think we live in quite a different time than we did a few years ago when we actually saw the ESG and the sustainability boom in some senses. However, over the past few years, what we've seen happen is that ESG has often been conflated with impact or a sort of value-based approach where that's not actually what ESG was originally set out to do. It was not meant to be something that was focused on doing good in that sense. What ESG actually looked at is essentially a risk management tool. So it's meant to be a tool to help institutions understand how a company is exposed to environmental, social and governance risks.

7:53Trisha Mani: And for financial institutions, it's important because it helps them understand how they can accurately price these risks. But over the past few years, what we've seen is that ESG has been kind of become this catch-all term for... A sticker, a badge that people just stick on anything. Exactly. A catch-all term for either some sort of sustainability ambition or to reflect a moral positioning of some sort. And we've seen it being used in terms of branding and marketing and kind of this, it's been conflated. Exactly. And so in that sense, it's kind of moved beyond what its original purpose was, which is essentially risk management.

8:32Trisha Mani: And for financial institutions that we, I mean, around the world, and we work with a lot of different financial institutions as well, the concept of risk management is something that is not only relevant, but it's increasingly critical in today's world where things are very much more interconnected. and we need to understand how environmental, social, geopolitical risks impact a company but also impact a portfolio as well. Yeah, so let's look at those risks and unpack them. I know you referred a couple of times earlier to sort of agri-food and the risks associated there, but what are the risks of environmental shocks or what happens if we just ignore them or do nothing about them?

9:14Trisha Mani: So the challenge with the environmental shocks is that if we were to ignore them or just do nothing about them, what's happening is that they are going to become increasingly more severe, but also there's a potential for them to become irreversible as well. And the University of Exeter, for example, is leading research around climate tipping points, which are essentially thresholds within our ecosystem, where if we move beyond a certain threshold, any small change to the ecosystem will have much larger systemic effects. So can you give us an example of what that means in financial terms? Yes. So JP Morgan actually recently put out some research of what do these climate tipping points actually mean for financial portfolios?

10:03Trisha Mani: How do we begin pricing these risks in? And what they did was they showed how when you start accounting for climate tipping points within your forecast projections, you see the actual change in the net present value of your losses. And that's a dramatic increase. And so if you start looking at these projections over a period of time, which most investors do, you see that as we start approaching some of these tipping points, they are having increasingly more drastic but also financially material impacts on the portfolio. And this is without looking at the social aspect of this concept. So in the EU, for example, only about 25 % of economic losses from natural disasters are insured, meaning that actually most climate related damages are absorbed by households themselves.

11:02Oh, right. So the price of stuff just goes up and the taxpayer pays.

11:05Trisha Mani: Exactly. And if you were a household with low income, without savings, without, say, access to generational wealth or anything like that, you would be one of those that are hit the hardest from some sort of climate shocks. So social inequality in sort of Western European countries could become greatly more exacerbated by issues that are hundreds of thousands of miles away. It could be by issues that are hundreds of thousands of miles away through sort of the supply chains. But with the climate crisis, what's important to recognize is that these issues are coming closer to home. Yes, of course.

11:46Trisha Mani: We've seen flooding in the UK. We've seen the low levels of the Rhine in Germany in the summer last year, which impacted trade and commodity prices. Floods in the UK have led to sort of higher home insurance, things like that. We saw this with tomatoes, didn't we, about four or five years ago? I think there was something to do with that. Either Spain had had some forest fires or some too hot to grow tomatoes. So there was a tomato crisis. So we're all thinking, oh, my gosh, we've got to grow our own tomatoes now at home. You know, it sort of went and sort of disappeared off the news radar. But I suspect these things are going to come back to haunt us more frequently, right?

12:30Trisha Mani: Exactly. And this is what we're trying to say with this research is that it's not only that the crises are happening more frequently and to a larger extent. And it's also that because of the interconnected system that we live in, things that are happening on one side of the world are increasingly having an impact on us on the other side of the world. And for example, the Middle East crisis is a good example to bring this to life. We're seeing energy prices skyrocket, but we're also seeing food price inflation because of fertilizer shortages or, yeah, exactly, energy prices rising. And so this is also something that we're trying to unpack with the research here.

13:14I read a lot of the Swiss re-insured, Swiss re-documents. They come up with a lot of research about sort of who's taking up flood insurance or who's using quantum surveying to see where potential earthquakes might be. It's very, very interesting research. And sometimes it's very sort of on a very scientific, very micro level. But if you look at the macro picture, if you're saying that only 25 percent of these sort of companies are insured against environmental shocks in Europe and we're seeing a higher potential impact on lower income housing, lower income households, sorry, a social impact. this, I guess, comes up to the policy level.

13:56And you can talk a little bit more about the policy aspect of the paper and what we need to do and how we need to work with policymakers to help protect us all against this.

14:07Trisha Mani: That's exactly true. And I think at the first level with the policy, what's most important is building these sort of right kind of social security measures that address some of the structural inequalities. and at the domestic level. So insurance, access to sort of housing, education, health care, these kinds of things that can essentially reduce the impact of whatever climate disaster happens in the future. And that's where we focus on within the policy space. It's called sort of adaptation-focused investment. So both on the policy level but also for financial institutions. it's essentially focusing on how can we increase the adaptive capacity of our communities to respond to certain climate shocks so that when a shock hits and that that will happen in the case of sort of the climate crisis how do we make sure that it that it doesn't persist that it that we're able to quickly recover from it and that comes from building up the sort of social security measures within the communities that are most likely to be impacted.

15:18Which sounds like a big financial ask of governments. And, you know, obviously, we've got this government and the previous one was very keen on pushing the get Britain investing, invest in British, invest in infrastructure, invest in building. But I guess we also have to be careful of the natural economy in terms of where we build and how we build. So we have to be a lot more mindful, don't we, about that kind of if you're investing in infrastructure to help build these resilient communities, you also need to be mindful of the natural economy, Britain's agricultural land, the waste, the sort of pollution that comes with construction.

15:56There's just so many risks that we need to factor in, right?

15:58Trisha Mani: Exactly. And I think there are increasingly solutions that address these challenges. So for example, nature-based solutions are one example of how you can build sort of flood defense mechanisms and things that are still conducive to supporting the sort of natural ecosystems around, but can also then protect the communities that are at the coast or that are at risk of flooding. And so it's, I guess the ask is to kind of leverage these increasing, these solutions that have been developed to essentially address both the climate and the social aspects, but also in a way that can protect us from sort of future or more persistent shocks as well.

16:44And could you sort of then talk about perhaps what a robust, I'm going to use the term ESG, you know, sustainable. How can we sort of like look at then a sustainable portfolio? One that isn't just greenwashy or just a nice little badge. What does that sort of look like and how does this then translate into long-term financial sustainability?

17:05Trisha Mani: So if we take a step back and think about what kind of portfolios we should be constructing, I think the key word here is to build sort of resilient portfolios. And what we've done with our research is create this sort of conceptual framework around what does that mean. So if we're looking at a specific sector, a specific region, we look at both the climate and the social risks that exist within that sector, but also how they interact and propagate. So, for example, what are the risks at the geographic scale? So how does a local shock translate into a sort of macroeconomic international impact?

17:44Trisha Mani: We look at sort of the different stages of the supply chain. So where are the regions that are most vulnerable? How do we protect not only domestic supply chains, but also international supply chains so that the shocks don't ripple out into the broader economy? And at the third level, it's also looking at sociodemographic vulnerabilities. And what this means is essentially the different communities that are impacted by these risks and how those different communities are impacted differently. So how do we protect those that are most vulnerable and make sure that we're supporting the building the adaptive capacity for them as well?

18:23Trisha Mani: and so taking into account these three sort of dimensions of risk will help financial institutions kind of evaluate the best or sort of the most robust or a resilient form of a portfolio that can address some of these challenges as well. It's essentially taking a step back from sort of our silos of okay if this is a good climate investment then it must be good for social inequalities as as well and looking at actually if something might look resilient on paper if we don't look at the underlying social inequalities within that region financial institutions may really be underestimating the risks or within that or misallocating capital in that sense that's a really interesting way of looking at it because you know i've sometimes spoken to fund managers who are they might select best of breed and they'll say well we're investing in an oil major because the oil major is targeting 30 % renewables by 2030 or something and we like what it's doing.

19:31But they don't really pay attention to its corporate governance or its supply chains. But then you think of another company, I think of a tobacco company, which I can't name here, but it's doing amazing work in terms of social construct. It's building schools, it's funding roads, it's funding education programs and meals programs in different communities around the world where it's operating and yet it's selling cigarettes. So there's huge ramifications, isn't there? I think when we've tried so hard for decades or over a decade to unpick what ethical investing is or ESG investing, but I like what you say about resilient investing because then it sort of unpacks all of that and then looks at what will be a good, safe, long-term, sustainable investment over the next 10 years not necessarily exactly you know do we have to do a trade-off between someone selling cancer sticks and someone selling someone supporting children

20:30Trisha Mani: exactly I think that's the focus at the moment when we say when we talk about resilience is we're talking about resilience of communities as well of people but we're also talking about resilience of the ecosystem and the natural ecosystem that we live in and I think in the context of of building a portfolio as well in the long term if you if you would want a resilient portfolio it needs to be in line both with the natural ecosystem but also with with the people at the heart of of of the portfolios as well this could radically transform stock markets as well because it would force all companies to think about their long-term sustainability because if they want to be invested in and have investors back them they're going to have to think about their long-term sustainable and rather than just sticking a badge on or exactly paying carbon credits it's a more i think intentional way of looking at things if we take a step back and look at kind of all of the dynamics and i think that's also what we're trying to talk about within with this research is that i think we've gotten used to looking at things in kind of a client like in a in silos of a climate a social and a nature space and we have a plethora of sort of taxonomies and tools and resources.

21:48Trisha Mani: But in reality, that's not actually how these risks play out, right? They all collide and they impact different communities differently. And that's what we're trying to kind of communicate with this research is that we have to look at the system as a whole and we have to look at how we can build resilience, not just in one of these aspects, but in all. Yeah, and how then could that sort of good resilient portfolio approach help investors themselves and their advisors, of course, identify how risks can compound across those three dimensions, you know, the geographic scale, value chains, and the socio-demographic vulnerabilities?

22:29Trisha Mani: So if investors kind of look through each of these dimensions of risk, so for example, in the geographic scale, looking at vulnerabilities of specific regions that they're investing in, what those sort of linkages are, would be a helpful way to map out the compounding effects. So for example, a local shock in an agricultural region might stay contained to that agricultural region in the form of say, credit defaults or loan defaults or things like this. However, when multiple breadbasket regions in the world are faced with the same shock, that can lead to a much larger international sort of economic effect.

23:10Trisha Mani: So looking at kind of where they're invested in what are the sort of um uh what are the sort of climate and and social factors at play within these regions and then how do they translate is one on one level on the second level if we look at the value chain itself so looking at each stage of the value chain and understanding where those hidden dependencies are so where are what parts of this chain are most susceptible to, say, climate or social risks? And how do we protect those parts? And protecting those parts can be in the form of value chain finance, for example, extending capital expenditures or operating expenditures, exactly, to those vulnerable parts of the supply chain so that we strengthen the chain as a whole.

23:55Trisha Mani: And on the third level, it's looking at socio-demographic vulnerabilities. So looking at which communities are most impacted by the business or by the company that's operating there and how do we protect the the most vulnerable within these communities and that can be in the form of for example blended finance tools or catalytic finance essentially there's different types of financial structures that can help ensure that the those that are most vulnerable stay protected but also that then your portfolio as a whole, it can be more resilient as well. Excellent. I think that's a much more logical and understandable way of explaining sustainable investing to clients and certainly gives clients a more holistic understanding of where their portfolio sits geographically and all these different intersects.

24:50I think that's really fantastic. And actually, it's a very positive note, actually, to end on, Tricia, because, you know, I like to end my risky podcasts on a positive note. So thank you very much. And sadly, that is all we've got time for.

25:05Trisha Mani: No, thank you for having me. It was great to be here and talk about this with you. No, thank you very much. And again, despite the clear risks outlined in that report, there are obviously positive steps we can take to mitigate the effect on our coffers and our communities. So until next time, thank you very much for listening.

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