Systems Thinking Part 2 - visualizing the system

From $100 billion surplus to a $38-68 billion deficit in the span of a single year. What happened in California?

This story from Marketplace Morning Report jumped out at me as an excellent framing device for introducing the visual tools we use in systems thinking, an approach that helps us uncover and understand the structures, events, and mental models that combine to form a complex system.

California as a climate action microcosm

While there is some disagreement on the exact deficit figure, and the state has a healthy rainy day fund to help cover the essentials, it's clear that Governor Gavin Newsom has a big problem on his hands. Among the causes identified: a tax filing deadline extension, with climate change blamed for weather disasters that prompted the extension. Also in focus is the state's tax revenue structure, which relies heavily on capital gains taxes that have declined substantially this year thanks to a dearth of new public offerings for tech companies.

I've often thought of the State of California as a microcosm of climate issues and climate action, and it's a great system to use for these types of thought exercises. As the world's fifth largest economy, California has both the financial resources and the independence across a wide footprint to act as a living laboratory for climate solutions. California operates its own electricity grid (albeit subject to some oversight by the federal government), and the state has demonstrated long-standing, sustained support for decarbonization. The state itself is enormous, almost twice the size of the UK, and hosts a wide variety of climates and ecosystems, many of which are especially sensitive to climate change.

We're going to unpack some of the factors contributing to California's budget challenges using some of my favorite visualization tools for systems thinking - an iceberg and a systems mess map - which will reveal the ways in which climate change is contributing to some of these challenges.

Iceberg models

An iceberg model is a great way to get your feet wet in systems modeling and visualizations - pun fully intended. For the audiovisual learners among us, this video is an excellent introduction to the exercise.?

You begin with an event, the thing that is easily observed, at the tip of the iceberg. Then you dive deeper, considering the patterns, systems and structures, and mental models that are all interacting to produce the observable event. This is a thought exercise, not intended to be an exhaustive evaluation of the problem but a way to think more expansively about the broad factors that could be contributing to the issue.

Systems Mapping

Now that we have broadened our consideration of the California State budget system, we can use this iceberg model as inspiration for a more dynamic system mapping exercise. Here's another excellent video introducing different types of system maps and the ways they can help us identify relationships and interactions that might be self-reinforcing to create system change or balancing loops that help the system resist change.?

My favorite way to visualize complexity in a system is using a mess map. By translating the individual actors, physical or social structures, behaviors, inputs, and outputs into individual elements, and connecting them together in ways that reflect how they interact, you can make sense of the complexity. I've built a fairly simplified mess map based on the work we did with the iceberg model.

We can begin with the two most basic elements contributing to the budget deficit: tax revenues, and public spending:

The dotted line means that the relationship is oppositional. An increase in X drives a decrease in Y, and likewise that a decrease in X drives an increase in Y. On the other hand, the solid lines represent supporting relationships, where an increase in X yields an increase in Y, and vice versa.?

Here we have already identified a balancing feedback loop. An increase in the state budget deficit will eventually drive a decrease in public spending in an attempt to balance the budget. All things being equal (like tax revenues remaining static), a decrease in public spending will then result in a decrease in the state budget deficit. On the other side of the balance sheet, an increase in tax revenues would drive a decrease in the budget deficit (again, all things being equal like spending remaining static).

If we zoom out on tax revenues, we can see that the primary sources of revenue for the State of California are capital gains taxes and regular income taxes. With this type of tax structure, the State becomes highly dependent on maintaining its population of high net worth individuals (HNW). According to CalMatters, two-thirds of California's budget comes from personal income tax, and the top 1% of earners are responsible for around half of that revenue.

While 2022's economy served this model very well and helped the State notch its $100b surplus, broader economic factors have since taken a toll. Higher interest rates have hit the stock market and changed the outlook for Silicon Valley more broadly. Higher cost of capital presented a sudden disruption to business models that relied on easy access to cheap money, and a stock market in a downturn is a terrible time to take a company public.?

These macroeconomic factors are bad news for both of California's major sources of revenues – Silicon Valley companies have laid off people by the thousands, leading to a hit to the income tax account. Meanwhile, many of those companies have traditionally offered stock as part of employee compensation, and the sudden wealth generated when a company executes a successful IPO is a huge source of capital gains tax revenue. Fewer IPOs and stock market losses mean fewer capital gains. The market has rebounded somewhat in recent months, so this could offer some hope for next year's revenue opportunity.

Here we can see a new area of the system come into focus - housing. Home sales are another important contributor to capital gains taxes. (I have called out capital gains as separate from income taxes because they have distinctly different drivers, but California does not actually tax these types of income at different rates, unlike federal tax structures.)

The availability of housing has become a major issue in California. If we focus on that area of the system, we see climate issues begin to play a direct role in California's budget challenge.

Weather-related disasters are a huge drain on state coffers in California, and they are growing more frequent, deadly, and costly with climate change. Insurers have taken note, and are beginning to substantially reduce their coverage in the state, or even leaving the state altogether. Lack of affordable home insurance will have a negative impact on housing values over time. A drop in home values would lead to a reduction in real estate transactions and less tax revenue. The vulnerability of California's housing stock to climate-driven weather disasters is being exacerbated by development sprawl. Zoning regulations often limit the density and type of residential construction permitted in a municipality, contributing to this outward growth. However, climate-related costs and policies place additional strain on state budgets.

An important structural driver is also revealed in this area of the system: reliance on home equity for retirement. Let's bring in some additional demographic segments to consider the needs and desires of California's non-HNW residents.

There is enormous tension between the needs and desires of middle-class families in California and those of retirees. As the stock market underperforms, stock portfolios that have become replacements for more traditional pension plans deliver less income to retirees. It becomes even more important for retirees to retain the value of their homes. However, high home values are hugely damaging to middle class families. Both of these social classes benefit considerably from social safety nets and public spending, but their contributions to the state's balance sheet come in very different forms - primarily taxes on wages for middle class families, while retirees may be contributing through capital gains on their stock portfolios or real estate.

The system, when taken as a whole, can feel overwhelming. By identifying causal loops and interdependencies, we can begin to make sense of the chaos and look for leverage points where a reinforcing loop can be amplified or interrupted and shift the outcome of the system.

Next week, we will dig into how to identify opportunities for intervention in this system. The solutions are far from simple, and we must be mindful of unanticipated consequences when proposing major economic and structural change. Please stay tuned as we continue this special series leading up to the release of Groundwire Strategies' first macrotrends report, which can help guide your climate and sustainability work throughout 2024.