Blindness to risk: why institutional investors ignore the risk of stranded assets^*

* 1st Global Conference on Stranded Assets and the Environment 2015.

ABSTRACT

There has been an apparent resistance amongst mainstream investors to integrate the risk of stranded assets into investment decisions. This paper considers if the structure of the investment chain causes investors to be blind to risks such as stranded assets. This paper considers how the interaction between financial economic theory, regulation and the practices of the fund management industry gives rise to the way the industry analyses and manages risk. The paper draws on a mixture of academic literature and the author’s own experience of industry practice. The paper finds that institutional investors are constrained to measure risk in relation to a benchmark; risk becomes a function of volatility and divergence from peers. The risk of stranded assets is invisible in the decision-making chain. The industry is further constrained by its culture, regulation and inappropriate incentives. The paper concludes that integrating stranded asset risk requires a drastic overhaul of the regulation of, and theory used in, the investment chain. This would better align the investment industry with the long-term capital allocation requirements of society.

KEYWORDS:

• Stranded assets
• risk
• financial institutions
• Complex Adaptive Systems
• agent-based modelling
• cultural theory

Disclosure statement

No potential conflict of interest was reported by the author.

Notes on contributor

Nicholas Silver is an actuary and economist whose specialities include risk management, social insurance and environmental finance. Nick is a director of Callund Consulting, a specialist consultancy which advises governments on developing social insurance, pensions and capital markets, in which capacity he has worked in over 30 countries. Nick is on Council (the governing body) of the Institute and Faculty of Actuaries, and recently won The President’s Award for outstanding contribution to the Profession. Nick is a founder and director of the Climate Bonds Initiative (CBI), an NGO focused on mobilising the bond market to fund climate change solutions. Nick is a visiting fellow at the London School of Economics, Anglia Ruskin University and Cass Business School and lectures at Trinity College, Dublin as well as these institutions. He has also written a number of papers and articles on economics, government debt, and climate change. Nick has been widely quoted in the media and two separate papers he authored have been cited in parliamentary debates. Nick has an MSc in Public Financial Policy from the London School of Economics.

Notes

* 1st Global Conference on Stranded Assets and the Environment 2015.

1. In addition to the paper referenced, this section also draws on the author’s own experience and interviews that the author has undertaken with other professionals.

2. In this section, I have taken the process that a pension fund would go through. Other institutions, such as insurance companies, would go through an equivalent process (see, e.g. Ahlgrim, D’Arcy, and Gorvett 2004).

3. In addition to Booth et al. (1999), this section also draws on the author’s own experience and interviews that the author has undertaken with other professionals.

4. In addition to the references cited, this section also draws on the author’s own experience and interviews that the author has undertaken with other professionals.

5. Chambers et al. (2005).

6. There are other models of governance, such as fiduciary management, but the outcome is often the same as described here.