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For investors that invest over the long term across a broad range of companies and assets, looking only at risks and opportunities at the level of individual companies is not always enough.

System-level risks, such as declining economy-wide productivity, labour shortages affecting a broad range of industries, weakening household purchasing power or social instability, can affect many companies across the economy and cannot be adequately diversified away simply by increasing the number of holdings. They can therefore affect the long-term returns of the portfolio as a whole.

This is why there is value in applying a system-level lens alongside entity-level analysis: looking beyond individual companies to the wider social and economic system and seeking to understand what changes arise as the activities and impacts of multiple actors interact.

In a recent NLI Research Institute paper, Why TISFD Emphasises System-Level Risks, I examine this distinction in more detail.

Looking beyond individual companies with a system-level lens

The reason this matters in the social domain is that the relationship between businesses and people does not begin and end within the boundaries of a single business.

Businesses depend on skilled and experienced workers, consumers’ purchasing power, relationships of trust with local communities, stable societies, effective institutions and functioning public services.

At the same time, business activities and impacts, in combination with those of other businesses, governments, households and other actors, can contribute to shaping the state of social and economic systems, including income distribution, human capital, labour markets, consumer demand and social trust. Businesses themselves are then affected by the state of the systems that emerge from these interactions.

A system-level lens therefore broadens the unit of analysis beyond the individual entity to the social and economic system itself.

Why this matters to a diversified portfolio

For a long-term diversified investor, decisions that are rational for an individual company do not necessarily align with the interests of an investor holding a broadly diversified portfolio.

Consider wages. Containing labour costs may be rational for an individual company. But if similar behaviour becomes widespread, it may weaken household purchasing power and consumer demand.

Likewise, if many companies reduce investment in workforce development and rely instead on recruiting workers with the required skills from the external labour market, the result may be an insufficient supply of appropriately skilled workers, greater labour shortages and skills mismatches and, through lower productivity, potentially weaker potential growth.

These examples illustrate why long-term diversified investors depend on the health of the economy as a whole. An action that benefits an individual company in the short term may impair the long-term returns of a broadly diversified portfolio if negative externalities weaken the foundations of the social and economic system on which many investee companies collectively depend.

What a system-level lens means for investors

A system-level lens helps distinguish two different relationships between companies and wider social and economic systems.

The first is contribution: how a company’s activities and impacts on people, together with those of other actors, can contribute to changes in social and economic systems and to the formation of system-level risks.

The second is exposure: how a company may be affected, through its dependencies, by risks and opportunities arising from changes in those systems.

The distinction matters because the two do not necessarily correspond on a one-to-one basis. A company may have only a limited effect on income distribution across an entire country, but if it depends strongly on domestic household consumption, it may be significantly exposed to weakening purchasing power and consumer demand. A small contribution to a system-level risk therefore does not imply a small exposure to that risk.

For investors, analysing exposure can inform company assessment, investment decisions and portfolio risk management. Analysing contribution can help assess how widespread corporate behaviour generating negative externalities has become and where action may be needed to mitigate system-level risks.

How TISFD is supporting a system-level view

The Taskforce on Inequality and Social-related Financial Disclosures (TISFD) is developing a framework to help businesses and financial institutions understand, assess and report on their impacts and dependencies on people, and related risks and opportunities.

TISFD is seeking to bring this wider, system-level view into its framework.  It does not replace the existing approaches of financial and impact materiality. Rather, it aims to provide an additional and complementary lens that connects entity-level activities and information to broader social and economic systems, helping to capture how companies both affect and are affected by those systems.

Nor does this mean seeking an ever-expanding range of information from companies. The goal is to identify information about important drivers and pathways associated with system-level risks, focusing on information that is suitable for cross-company analysis, is feasible for companies to obtain in practice and useful for investor decision-making.

For long-term diversified investors, progressively building the connection between entity-level information and system-level analysis can provide a clearer basis for understanding risks that affect many investee companies, assessing portfolio-wide exposure and considering the appropriate level of investor response.