A tragedy of perception

Read this article to understand:

• Why sustainability has been left out of business, finance and economic models
• How our perception and sense of reality gives rise to ESG blind spots
• Why we need to take a systems approach to fix market failures

I recently read a quote that left me reeling. Within the space of a few words, physicist Geoffrey West managed to convey what I had known in my heart for years but had no clear way of expressing.

“I once did a little exercise: I took about half a dozen economics books, the big fat ones like Samuelson’s, and so on, and I looked up in the index: do the words ‘energy’, ‘entropy’, or ‘thermodynamics’ ever occur? Not once in any of them.” 

I knew instantly he was right, save for a few pioneers like the Limits to Growth authors and Herman Daly, who have (so far) failed to turn the tide of mainstream thinking. I began to wonder whether the same was true for finance and corporate strategy. Though I heavily suspected the answer, I needed to validate my impulse.

Sustainable firms?

Let’s look at corporate strategy first.

Academic theorists have always played catch up with innovative practitioners like Henry Ford and Alfred Sloan who, among many other achievements, invented the production assembly line and organisational chart respectively. Business leaders had to take leaps of faith, plunging their economic ventures into the unknown as there was no sure-fire academic model capable of predicting whether their bets would pay off.

Many would argue not much has changed and the theory of the firm still lags the practice. However, where theory tends to meet practice most acutely today is on the campuses of business schools and within the meeting rooms of management consultancy firms. Questions of how a firm should be organised, the role of management, and other strategic considerations have all been hotly debated and codified by thought leaders from these professional vantage points for decades.

Management gurus like Michael Porter, Tom Peters and Peter Drucker all cut their teeth in these institutions and found riches in blending the newfound science of management with the art of business. Save for an enlightened few – such as John Elkington of Triple Bottom Line fame (although he has since ‘recalled’ that concept¹), George Serafeim at Harvard Business School and Bob Eccles at Oxford’s Saïd Business School – the legacy of leaving out sustainability in management thinking lives on through the everyday business decisions inspired by Messrs Porter, Peters and Drucker.

As for the enlightened few, while their work has not been given the prominence within their institutions it deserves, they would all also likely decline the ‘management guru’ moniker.

A recent article by Sarah Murray in the Financial Times emphasised the gaping flaw in the most influential management frameworks. She wrote: “Between 1998 and 2012, the Aspen Institute’s Beyond Grey ­Pinstripes ranking, which every two years assesses the sustainability content in schools’ curricula, routinely found that environmental topics were covered as separate modules or elective courses but were missing from core MBA programmes.”²

The same article highlights comments made by a group of academics in the February edition of the Harvard Business Review: “Although evidence of climate change has been emerging for more than four decades, business schools have been late in acknowledging and responding to this urgent and existential issue”.³ A UN Global Compact report we funded found similar results.⁴

On reading this, I dug out my Harvard Business Essentials 2005 edition on Corporate Strategy. I flicked to the index and found no reference to words like ‘responsible’, ‘sustainability’, ‘stakeholders’ or ‘energy’. The edition is admittedly quite old, which makes the academic in me uneasy. And while the situation will clearly have improved, how frequently do business leaders update their corporate strategy library stock? Sadly, the sustainability story of the firm feels eerily familiar to that of economics.

In fairness, both Porter and Drucker have made attempts to weave sustainability into their grand theories.

However, Porter’s attempt – Green and competitive⁵ – seems to have both fallen flat and been too little, too late. Similarly, Drucker’s belief all institutions have a responsibility to the whole of society fell on deaf ears. In his 1973 Management: Tasks, Responsibilities, Practices, Drucker wrote: “In modern society there is no other leadership group but managers. If the managers of our major institutions, and especially of business, do not take responsibility for the common good, no one else can or will.”

Until the recent ESG boom, there has been scant evidence of Drucker’s more expansive definition of managerial responsibility in boardrooms across the world. Increased engagement, voting, corporate disclosures and regulation are helping to turn the tide and shift mindsets – but there is still a long way to go.

Sustainable finance?

Finance is slightly different in that mathematical theories portrayed an illusion of precision, resulting in an almost immediate transfer of knowledge from theory to practice.

Harry Markowitz, Bill Sharpe, Eugene Fama, Kenneth French, Myron Scholes, Fischer Black and Robert Merton have been key personalities in ‘professionalising’ finance. Their respective works on modern portfolio theory, efficient-market hypothesis, capital asset pricing model and derivatives pricing have come to shape and define risk and portfolio management in finance and investing. Add in discounted cashflow analysis, and you have all the major theories and thinkers covered.

One of my colleagues has studied their work extensively and found references to sustainability distinctly lacking in their models and equations. Without exception, they are brilliant intellectuals: among the best minds ever to turn their attention to finance. Yet they also suffered from a narrowness in perception, and the false assumption the system (or market) itself cannot be influenced.

Their beautifully neat equations missed a crucial point about market integrity – that alpha means nothing if beta implodes. Over the long term, chasing alpha is pointless if you completely ignore systematic risks. Existential threats like climate change jeopardise the very foundations of society. If society starts breaking down, markets will too. After all, unwavering faith in the idea the market (the aggregated view of its participants) is always right got us into this mess in the first place.

The same FT article referenced earlier pointed out the myopia around sustainability at universities and other academic institutions is not limited to MBAs and corporate strategy. “Failure to integrate climate change into courses such as finance, accounting, marketing and operations has long been a cause for complaint among those pushing for management education to focus on climate change,” wrote Murray.

Even now, the Chartered Financial Analyst course mainly bolts ESG onto the curriculum rather than integrating it throughout. The feedback loop between corporate activity and how companies and assets are valued mean that this will inevitably change over time but, given the scale of the problem, it needs to happen soon.

Elephant in the room

These mainstream failings across finance, companies and economics represent staggering oversights. To build models of the world so far removed from reality, which ignore planetary boundaries, social injustice and the value of life-giving natural ecosystems, is nonsensical.

It is logical to wonder how and why this has occurred. An ancient Indian parable can help us understand why.

Figure 1: The blind men and the elephant parable

Source: Aviva Investors, August 2022

As the story goes, a group of blind men stumble across an elephant. Unaware of what they have found, they try to piece together the full picture by touching it. They each feel a different part of the elephant’s body and describe it based on their narrow experience. Unsurprisingly, their descriptions vary wildly, and they even come to suspect dishonesty in the group members.

The moral of the story, I hope, is clear. We tend to claim absolute truth based on our limited and subjective life experience. In search of peace of mind and clarity, we conveniently ignore the perspectives of others, as well as the simple fact we can never see the ‘whole’ picture.

In true siloed form, while all the influential papers and thinkers in finance, corporate strategy and economics lack the perspective of sustainability, the opposite is also true: all major texts on sustainability lack any real depth of reference or understanding of business, finance and economics. It is a tragic case of intellectual and spiritual tribalism – one group feeling the elephant’s leg while the other pulls on its tail.

Bridging the gap

With this in mind, I recently re-read Limits to Growth, a ground-breaking piece of systems thinking. It was the first serious scholarly attempt to think of the global economic system through the lens of planetary and resource boundaries. In doing so, it incorporated sustainability into its economic analysis.

Commissioned by the Club of Rome, this 1972 work – updated in 1992 and 2012 – has inspired many within the sustainability movement, despite having no discernible effect on the global economic system. Yet on re-reading it, I was struck by how little finance and investment features. Even the best systems thinkers have biases and blind spots.

As with corporate strategy, there are a handful of books and papers that attempt to bridge the gap between economics and sustainability. Economists like Mariana Mazzucato and Kate Raworth are two leading lights. But when you dig into their work, although economics and, to some degree, business are covered, finance – particularly banking, insurance and investment – receives little attention. And given its pivotal role in allocating capital across the global economy, this must be addressed.

This lack of general understanding of the financial componentry humanity has placed at the heart of its growth machine is a problem. Capitalism systematically extracts short-term value regardless of the long-term consequences for future generations. There is nothing within capital markets that values future generations. Quite the opposite. They discount their interests and ignore the consequences of our current consumption on their very existence. As for capturing nature’s true value – of a mangrove, say – we are a long way off.

We don’t necessarily do any of this intentionally; we just don’t understand the system we have built or our impact. Fritjof Capra – a physicist, systems theorist and deep ecologist – believes we need a new way of looking at the world:

“The more we study the major problems of our time, the more we come to realise that they cannot be understood in isolation. They are systemic problems, which means that they are interconnected and interdependent. … Ultimately these problems must be seen as just different facets of one single crisis, which is largely a crisis of perception.”

Building on Garrett Hardin and Mark Carney’s respective tragedies (of the commons and horizon), I have come to agree with Capra’s bigger, more pervasive and pernicious tragedy: of perception.

Maybe if we heed Capra’s advice and take a systems view of the world, working with others to help fill in our blind spots but recognising finance as the lifeblood of the economy, we can create a more desirable and sustainable system.

Macro stewardship and changing the system

Systems thinking is the only proper starting place for attempting to solve the planet’s climate, nature and social crises. The interlinkages are profound and highlight why I have become particularly obsessed with what we now call macro stewardship.

I see macro stewardship as the only way finance can become sustainable, or even deserve to call itself responsible. It can help remove a blind spot in pure ESG integration, overcome some of the limits to which ESG engagement can push companies and potentially become the litmus test of whether a financial institution is greenwashing or not. Conducted transparently, it can and should be a support function to democratic processes and policymaking.

Mark Versey, our CEO, sets out in detail in Redefining stewardship⁶ what we mean by this. In essence, it means taking a more holistic view of our stewardship responsibilities and actively engaging with policymakers, industry bodies and peers, regulators, standard setters and other influential parties to advocate and push for changes that will help create a more sustainable economic system.

The (albeit imperfect) client signals we have indicate there is real demand for this work and approach. We are also running a consultation to further validate this and welcome feedback from all corners of the industry and beyond – most importantly, from our clients.

Combined with micro stewardship (active corporate engagement) and capital allocation, macro stewardship can make a real difference. A recent initiative of ours was to convene a collaborative group of global industry stakeholders and public policymakers to call for an International Platform on Climate Finance (IPCF). The goal is to put robust plans behind Article 2.1c of the Paris Agreement and ensure that ‘finance flows are consistent with a pathway towards low greenhouse gas emissions and climate-resilient development’.

We are also announcing a partnership between Aviva Investors and Forum for the Future on a School of Systems Change to help financial practitioners and other changemakers educate and learn from each other on how and when to influence the economic system in the face of market failures. We will continue to support PhD research programmes in this area too – in particular, to help find ways to best judge and further enhance macro stewardship’s impact and effectiveness, but also with an aim to supplement finance theory itself.

Lean in and work together

We must all start to lean in and empathise with others and place sustainability at the heart of all our efforts. Only then we will better understand the intended and unintended consequences of our actions on other disciplines and parts of the system.

Economics is not the same as finance and vice versa. However, the severing of the two disciplines is partly responsible for this situation as few economists truly understand how finance works. Equally, corporate strategists and sustainability activists need to work harder to understand each other’s respective worlds.

We have to work together to build a more sustainable future. The alternative is a reversal of the enormous progress that economics and finance has delivered since the industrial revolution. In other words, systems collapse that brings an end to civilisation as we know it.