Systemic Risk: A Ripple Effect in a Pond
Imagine dropping a stone into a pond—no matter how strong or prepared the individual fish are, they cannot escape the ripples spreading across the water's surface. Similarly, systemic risk, or market risk, is not isolated to specific sectors or entities—it affects the entire financial system, leaving even well-diversified portfolios vulnerable. Systemic risks are especially dangerous for pension funds, which rely on long-term stability to ensure workers' financial security during retirement. A sudden market shock can undermine years of careful investment planning, destabilizing the fund and jeopardizing millions of workers' retirement security.
A primary source of systemic risk is climate change, which poses escalating threats. Climate-related events—such as extreme weather and environmental degradation—destabilize financial markets, disrupt essential systems like supply chains, infrastructure and housing, and jeopardize community health. This systemic climate risk affects the entire economy, creating vulnerabilities across all sectors. If not mitigated, the climate crisis can exacerbate risk, resulting in cross-sector disruptions that weaken economic stability.
As noted in Loading the DICE Against Pensions: "Climate change is a systemic and systematic risk—an undiversifiable, un-hedgeable, and escalating risk that will affect all companies in all markets, one way or another, and have a diminishing impact on investments broadly."
For state pension funds, climate change introduces pervasive and unavoidable risks like regulatory shifts, physical damage, and economic disruption. Physical risks (such as facility damage) and transitional risks (economic losses from shifts toward net-zero-compatible practices) threaten long-term returns if left unaddressed, potentially eroding returns across portfolios over time. Transition risk also includes the economic and social displacements caused by the shift to a green economy. These displacements—such as job losses in carbon-intensive sectors—could lead to broader economic instability, particularly in communities most vulnerable to climate change's effects.
However, while these risks are significant, addressing them presents an opportunity. Transitioning to a green economy will require significant investments in new jobs, re-skilling workers, and infrastructure development. These efforts are not only crucial for mitigating the negative impacts on vulnerable communities but also offer the potential for long-term financial benefits. A study by Reuters estimates that industries supporting the shift to net-zero emissions could make $10.3 trillion in contributions to the global economy by 2050. Investing in green technologies, clean energy, and climate resilience and adaptation infrastructure can create new markets and drive economic growth, benefiting pension funds and their members.
The “ripple in a pond” analogy underscores the urgency of proactive risk management. Just as fish cannot predict or avoid the ripples from the stone, investors and institutions need strategies to anticipate and mitigate the impact of systemic risks before they affect the broader system. Risk management practices—such as integrating climate risk assessments and stress-testing investment portfolios—are essential in preserving long-term financial stability. This risk mitigation also includes aligning investments with stakeholder sustainability goals. While immediate portfolio changes may not always be necessary, evolving risk management strategies are essential to safeguarding investments and long-term financial resilience.
