Why VCs need to think harder about ESG if they want to build better companies

With officials from nearly 200 countries having gathered for COP26, the well-known annual United Nations Climate Change Summit, Environmental, Social and Governance (ESG) issues are top of mind for business leaders.

In a world that is rife with division as humanity grapples with changes and challenges caused by an ongoing global pandemic, ecosystem collapse, supply chain issues, inflation and worsening income inequality, exploring and understanding how these risks impact investments has become a necessity.

When faced with systemic, persistent global challenges, it’s easy to quickly become overwhelmed by negativity. Yet, so many in the startup ecosystem, including myself, have a positive outlook on the future and hope that humanity and compassion will prevail. What part does the investment ecosystem, and specifically Venture Capital, play in this hope?

GD1 operating partner Heather Gadonniex

Enter ESG frameworks and their (often underestimated) importance. ESG and Corporate Social Responsibility (CSR) measurement frameworks have been in use, in some form or another, for decades.

They have proven invaluable in helping organisations assess their sustainability performance and embed sustainability across their portfolios. More recently, more robust ESG frameworks have been adopted by institutional investors to measure portfolio risks associated with often overlooked externalities.

In praise of ESG

The business case for ESG is a strong one. Studies from as early as 2010 show that companies who take ESG seriously consistently outperform their peers financially.

It’s also become part and parcel of consumer expectation, with PWC’s Consumer intelligence series reporting that 83% of consumers think companies should be actively shaping ESG best practice.

Mind the Gap

But while more than $100 trillion in assets under management (AUM) today are subject to ESG principles; and by 2025, ESG assets may hit $53 trillion, a third of all global AUM, it has been increasingly challenging to apply traditional ESG frameworks to Venture Capital.

An article from just last month in the Stanford Social paints a bleak reality: Just 5 of the world’s top 50 largest VC funds mention ESG or a commitment to sustainability on their website, while only a few dozen more have made public commitments to ESG (among the more than 2,900 VC firms worldwide).

Even more concerning?

An Amnesty International study found that almost none of the world’s largest funds consider human rights in their investment process and only one topic – diversity, and inclusion – has seen widespread focus among VCs so far.

Why the lack of ESG adoption in VCs?

First and foremost, it’s much more straightforward to implement ESG programs for publicly listed companies.

Listed companies have the time and resources – both human capital and financial – to dedicate to implementing robust ESG programs and reporting frameworks.

Startups that are in the early stage, or even in growth stage, very rarely have the time, energy, or capital to think beyond quarter to quarter growth and scale.

Additionally, it can be difficult for start-ups to quantify ESG aspects. While there is an increasing cohort of organisations dedicated to embedding impact into their business models from the start, this is not the norm.

Is there a better way?

There is, however, increasing appetite and momentum from the VC community to adopt ESG principles at startup scale. This involves taking policies and principles aimed at large-scale business and right-sizing them for immediate, consistent impact across their portfolio of startups.

Firms that are just beginning to embrace ESG principles often start by including terms that relate to ESG in their terms sheets, such as Diversity and Inclusion or reporting on climate impact.

While this is admittedly a ‘light’ approach, it gets founders and teams thinking about how to operate in a more ethical and responsible manner.

Firms that are farther along in their programs typically rally around a list of exclusionary criteria, for example, not investing in companies that manufacture nuclear weapons or are involved in fossil fuel exploration. And, those that are even further down the spectrum of ESG adoption align investments with the United Nations Sustainable Development Goals.

It’s also common for firms that have a strong commitment to ESG to become signatories of various organisations focused on responsible investing, such as the PRI or RIAA.

Given the current state of global affairs, now is the time for VCs to adopt ESG as not only a risk mitigation strategy but also a way of championing these principles across companies who have previously been excluded from conversation around ESG.

What’s more, the benefits far outweigh the drawbacks, create a sense of purpose for fund managers, and are proven to lead to greater returns.