Net zero, SDG alignment, scope I-III emissions…if you keep coming across these terms and are left wondering what it’s all about, please read on. These terms fall under the umbrella of Environmental, Social, Governance (ESG), otherwise known as sustainability or corporate social responsibility.
Despite ESG being widely supported by most asset managers over the last few years, those in the venture capital space have been laggards. Only a handful of the biggest and most successful firms mentioned ESG or a commitment to sustainability on their website and only a few dozen more have made public commitments to ESG (among the thousands of VC firms worldwide). So why has venture capital been so slow to join the ESG movement?
The Failings of Rapid Growth
In a nutshell, it has revolved around the industries infatuation with growth at any cost. Highly scalable business models, great unit economics and strong margins have all been higher up the shopping list than healthy ESG performance.
Frameworks and principles developed by well-known VCs have been thrust into the minds of early-stage founders. Investors have been successful in helping them grow at a chaotic speed, but in doing so, critical ESG considerations remain uncovered. Building and testing minimum viable products in rapid time and repeating the process until product market fit was found, was considered much more important than understanding the true impact of a product or service on its userbase and surroundings.
Mark Zuckerberg’s infamous quote “Move fast and break things,” which was once the unofficial motto of all ambitious development teams, now feels a bit insensitive to a number of important factors and isn’t in the spirit of how businesses should be thinking about their roadmaps.
Unsurprisingly, Facebook has not performed well on the ESG front at different stages of its life. Facebook has been pulled into several scandals including hosting hate speech and misusing customer data.1 Similarly, Uber has a long history of issues regarding the conditions and protections afforded to its drivers and some serious questions around office culture.2 Both companies highlight the risks for all swiftly growing tech companies. You don’t need to be digging rocks out of the ground to perform poorly on an ESG level.
Facebook and Uber are also good examples of companies that had little to no pressure applied to them to change on account of their ‘excellent’ performance. However, in recent years, ESG has moved from the feel-good fringes to the centre of business decision-making. There has been a shift in mindset from society that now values the protection of both the planet and its own people as paramount for the future. Uber is now striving to become an unlikely icon in the rise of ESG in corporate governance after some well-documented historical failings. This is a great example of a company’s attitudes shifting over time.
The Business Case for ESG
Perhaps predictably, a major factor that has driven the adoption of ESG is the business case for it. There is now an abundance of data supporting the maxim that companies with high ESG performance outperform their poorer placed ESG counterparts. On the funding side, we have seen an influx of capital into funds that proactively look to adopt ESG principles within their mandate. According to 2022 PwC report, assets under management will triple to reach US$3.3 trillion in 2026 in the Asia-pacific (APAC) region.3
Underpinning this business case for ESG are consumers who are looking for brands with values that are aligned with their own. How successful a company has been in delivering a clear set of values and using them to engage with a particular demographic within a market will now have a huge bearing on its success. Well-known examples of this include Patagonia, V2 Foods and a myriad of green investment platforms.
We’re not only seeing shifts in consumer markets, but it is also becoming apparent in the attitudes of employee attitudes and behaviour founders. To attract the best talent, companies must not only present an incredible business opportunity but also be mission-driven and impactful through defined ESG principles. Canva and Atlassian have done this very well and it remains a major reason why they are able to recruit some of the most sought-after individuals in their respective markets.
Additionally, as the relative wealth of millennials (people born between the early 1980s and the early 2000s) increases, they will become a force to be reckoned with and companies will need to ensure that they are prepared to walk the walk regarding their ESG promises.
According to a 2022 Stanford University study, 80% of Gen Z/Millennials say their investment firm should influence the ESG policies or practices of the company even if it decreases the value of their investment.4
As is turns out, caring for the planet—relative to their generational predecessors—is a higher priority for Millennials than financial returns alone. The days of greenwashing (disinformation produced by corporates to promote an environmentally clean image) are over and an ESG revolution is coming.5
As such, VC investor managers upstream have been forced to think and act differently. Managers are beginning to review a company’s ESG performance at an early-stage and form a view on whether it is consistent with their policy.
The Future of ESG
The lens through which VC investors assess their portfolio is a critical part of a company’s ESG journey. By virtue of the stage that VC investors assess a company, the industry can ensure that the big tech companies of tomorrow have sound ESG practices, policies, and values from the outset. Changing direction has always been easier in a speedboat than a battleship.
But even the best intentions in the world do not solve for some of the challenges that investors face when identifying and measuring ESG. There is no doubt that large parts of the framework are still ambiguous and opaque, however, technology is quickly bridging that gap.
Artificial intelligence/machine learning, robot and big data applications are reducing the amount of time and manpower needed to sift through news, company information and third-party data required to make informed ESG decisions. For example, a company can now begin to understand its environmental Scope 1 (direct), Scope 2 (indirect — upstream) and Scope 3 (indirect — downstream) emissions from an early stage and build a strategy that is consistent with its ESG ambitions.
Companies, bar a small few, did not have the ability to do this until recently — as the costs and resources required were prohibitive. As all companies look to play their part in the race to net zero, (a balance between the greenhouse gases emitted into and removed from the atmosphere) the value of this technology cannot be overstated.
Similarly, companies are now able to seamlessly aggregate social and governance data across their organisation to monitor, set targets and report on their performance. While these measures are generally less complicated than those in the environmental category, they are no less important. For example, social and governance data can help quantify diversity, equity and inclusion; track staff turnover, incidents, and culture; and ensure policies and practices are in place to address issues such as corporate purpose and the roles of senior management.
The United Nations has compiled a list of 17 Sustainable Development Goals (SDG) that are interlinked and designed to be a blueprint to achieve a better and more sustainable future for all. These thematic SDGs exist across the three ESG pillars to help corporates align sector and company specific ESG factors with broader corporate responsibilities.
They include goals like; zero hunger, gender equality, clean energy and sustainable cities. Being aligned to a number of these goals should be the objective of each company’s ESG policy, with progress and success measured through appropriate data.
Having only been introduced in 2006, SDGs are now an important element of the ESG landscape. Adopted by the United Nations as part of the 2030 Agenda for Sustainable Development, their future success will depend on the ability of both investors and corporates to implement a systemic and data driven approach to monitor progress.
Looking ahead, there will be even more exciting applications that only become apparent as new methods and best practices are discovered. It is worth keeping in mind that ESG rating is still a young field with a rapidly changing definition of ‘sustainability’.
We believe that ESG should not be thought about as an ‘add-on’ but a core value in a VC fund — leading to better investments, companies and outcomes for all. We are actively reviewing a number of opportunities within our sustainability/impact thematic and look forward to contributing to the continued growth of this segment in Australia.
It has taken a while, but this notion of investing responsibly within the venture capital system is finally getting its time in the sun! Let’s hope it stays that way (but doesn’t get too hot).
Sources:
1. A Recent History of Facebook Scandals
2. Uber’s ESG Risks — Is the New CEO Up to the Challenge?
3. The Trillion-Dollar Opportunity in ESG Surge
4. The ESG Generation Gap: Millennials and Boomers Split on Their Investing Goals
5. Almost 8 in 10 Millennial Investors Put ESG First
This article was written by Tristan Terry of Aura Ventures. Read more about venture capital.
