Systemic Investing and Transformation Capital


I define systemic investing as the practice of deploying capital to catalyze directional transformative change of socio-technical systems.  There is a lot of jargon in this definition, so let me unpack it.

The Importance of Intent

What distinguishes Transformation Capital as an investment logic from long-term investment approaches (such as ESG investing and impact investing) is its strategic intent. The goal is not to reform capital markets toward new steady-state orthodoxies such as patient capital and triple-bottom-line investing. Instead, Transformation Capital seeks to instigate and catalyze transformative change of socio-technical (sub-)systems in a specific direction and within the time left to prevent dangerous climate change.

Transformation Capital is rooted in the axiomatic understanding that today’s conception of money has outlived its ability to serve as a useful proxy for human prosperity. This not only implies a broader definition of value beyond monetary concepts. It also requires new approaches to sharing risk and reward, particularly between public and private actors, toward what Professor Mariana Mazzucato calls a “symbiotic innovation ecosystem” in which returns are shared fairly by the “collective group of actors that absorb the uncertainties that drive the innovation process through space and time.”

Investors set as their priorities based on what they care about. Systemic investors interrogate the universe of investable assets with different frameworks, using different metrics to evaluate potential, success, and failure. They bring a different spirit to their investment practice, embracing collaboration over competition. In short, systemic investors will engage with a different mindset.

Mindsets matter because complex challenges are shared challenges. The culture of today’s financial industry is dominated by notions of competition, tribalism, exclusion, and ego. These values fundamentally sit at odds with the notion of a sustainable and equitable world.

To have the opportunity to generate truly transformative impact, investors must value and promote collaboration, community, inclusion, and humility. They must accept responsibility for their action, recognizing the power of individual agency to solve — or perpetuate — the problem.

Understanding Evolutionary Possibility

Investing with a transformational intent must reflect how transformation occurs within complex adaptive systems.  Systems move from one state to a future state through an evolutionary process. One of the marvels of evolution is that it produces a great variety of designs that are fit for a specific purpose. Just consider the myriad of ocean creatures fit for the purpose of swimming. For the same reason, there is a multitude of different “system designs” that could accomplish a specific mission. What counts is not to perform a precision landing on any individual design — but instead to arrive somewhere within a general landing zone.  In the context of climate change, for example, that landing zone is typically described as “low-carbon and climate-resilient”.

As economist Eric Beinhocker explains in The Origin of Wealth, a system can only evolve toward a new design if there are intermediate niches that act as developmental bridges between the old design and the new design. If the two designs are too far apart, the system cannot just “jump”. They progress along a path, evolving forward through a series of what complex system scientist Stuart A. Kauffman calls adjacent possibles. These are spaces of possible future states that originate in the system’s past and represent a (concealed) menu of all the ways in which a system can reinvent itself. Systemic investors must understand the transition pathways a socio-technical system could reasonably take, given its current resources and configurations.

A visualization of the idea of adjacent possibles — all those things that are one step away from what exists, connecting the present state of a system with the space of possibility. (Credit: V. Loreto via MIT-TR)
Leveraging System Dynamics

This still leaves the question of what to invest in. The key question for systemic investors is: Where could a relatively small investment trigger a larger change that becomes irreversible, and where non-linear feedback effects act as amplifiers?

This means that Transformation Capital must identify and engage Sensitive Intervention Points (SIPs) — those places in a system “where a relatively small change can trigger a larger change that becomes irreversible, and where non-linear feedback effects act as amplifiers.” There are two kinds of SIPs. The first kicks the current state of the system, moving it onto a new trajectory without any change in the underlying system dynamics. For example, governments could subsidize renewable energy technologies that are close to tipping points. The second shifts the underlying system dynamics, where the rules of the system itself change. This may include a change in key concepts or institutions such as the move from the rigid Kyoto Protocol to the more flexible Paris Agreement.

In either case, the goal is to design purposeful interventions that drive nonlinear amplification in complex systems, including through investments in infrastructure, technology start-ups, insurance products, public subsidy schemes, or other capital deployment mechanisms.

In Norway, tax and toll exemptions have made electric vehicles (EVs) cheaper to buy and operate than liquid fuel cars. Together with use-related benefits, these incentives have pushed the share of EVs on total vehicle sales above 50%, making the systemic shift to widespread electric mobility seem inevitable. (Credit:
Strategic Portfolios: Blending for Synergistic Effects

A single intervention rarely pushes the system past a tipping point. Instead, fundamental change results from multiple forces acting together.  Systemic investors create strategic portfolios of assets that can mutually reinforce each other’s impact potential. Creating strategic synergies is key for producing the right type of change dynamics with respect to the transformation agenda. This implies a move away from the single asset paradigm — one stock, one bond, one project — that dominates today’s investment practice, toward a strategic blending paradigm to unlock or accelerate transformational effects in combination with other assets in the portfolio.

Where capital alone is not enough to unleash transformative dynamics, systemic investors should align themselves with actors engaging other, non-investable levers of change in the system, such as policy and education. Oftentimes, these are public sector actors or philanthropic organizations. The purpose of such nesting is to ensure that the portfolio of real economy assets is well aligned with a broader set of systems interventions, all designed for their collective, synergistic ability to generate transformative dynamics.

Evaluating Performance

What constitutes risk and reward depends on what one wants to accomplish. In traditional investing where the primary intent is the multiplication of capital, the key metric is financial return on investment (fROI). Risk, then, is defined as the quantifiable uncertainty that such a return actually materializes.

Systemic investors, who are primarily interested in transformative change, require a new conception of risk and return; one defined in relation to their transformation agenda. The key metric is transformational return on investment (tROI).

In some cases, it will be possible to measure success using well-known indicators. For instance, in its 2017 annual report, the UK Green Investment Bank states that its renewable energy investments will generate an estimated lifetime reduction in CO2-equivalent emissions of 154 million tons. Yet the energy system is a relatively neat system, with rationale investors, predictable technological performance, mature supply chains, and well-functioning markets.

Other domains of human civilization — such as transportation, industry, and cities — are messier because of the human agency that sits at their core. When intervening in these systems, outcomes can often not be attributed directly to any specific intervention, let alone be expressed in a quantitative metric. The cause-and-effect relationships in these systems are simply too opaque, and the latency between action and impact is too long. But systemic investors don’t need to provide all the capital required for a system’s transformation. They only have to lead it to its tipping points.

So how can such transition dynamics be measured? The beginning of an answer is offered by the Transformative Innovation Policy Consortium (TIPC), which has started to develop an evaluation framework for transformative change in the context of innovation policy. Frameworks like these can be adapted to the specific context of investment, offering a new lens through which to conceptualize investment return.

Engaging Emergence

As the interventions in the system take hold, the system will inevitably start expressing new properties. System scientists call this phenomenon emergence. Emergence requires rethinking the concept of asset allocation. Today, such asset allocations are relatively static constructs, designed once and mainly as a function of an investor’s asset base and risk appetite. Systemic investing requires a more dynamic understanding of asset allocation. It requires an idea of what the strategy consultancy Axilo calls “optimal capital allocation” — right-sizing the investment portfolio for a specific mission. It also necessitates the patience required to spread investments over time as well as the ability to dynamically adapt the asset mix in response to the revelation of leverage points.

The Promise of Systemic Investing

The world faces a massive investment gap to achieve a transition to a more sustainable and just society. While estimates of that gap vary by source, the consensus is that it reaches into the trillions of Euros per year.

Given how little time we have to reverse our emissions trajectory, there is now an urgent need to rethink the way we will deploy capital over the next decade. For not all money must be a passive entity in society, flowing to whatever opportunities emerge in the real economy. If we want to succeed at coping with today’s gravest challenges, some of that money can — and must — become an active agent of change, carving the landscape of real economcaies to create more sustainable “basins of attraction” for passive, rent-seeking capital.

Dominic Hofstetter is Director- Capital & Investment and Member of the Group Executive Board of Climate KIC.  This blog is adapted from a post on Medium published Aug. 23, 2019 with the title “Innovating in Complexity (Part II): From Single-Point Solutions to Directional Systems Innovation”.

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