ESG has been under the microscope for the past 12 months with pressure from some Republican politicians in the U.S. who have called for investment managers to pull their clients’ money from ESG-focused investments.
Simplistically, their argument is that ESG prevents investors being able to access assets like fossil fuels and, by doing so, they will have missed out on soaring fossil fuel company valuations driven by rising energy prices. Those on the anti-ESG side argue that continuing to follow ESG doctrine in today’s market is therefore a failure of fiduciary duty by investment managers.
This of course overlooks one rather fundamental challenge: The Intergovernmental Panel on Climate Change (IPCC) in its recent AR6 report stated that the G7 economies needed to hit net zero by 2040, not 2050, if we are to avoid catastrophic climate change.
At the 2021 United Nations Climate Change Conference, countries pledged to scale down their use of oil and fossil fuels. The latest scientific evaluation from the IPCC sets the scene for a future climate change conference (not too far in the future) making the pledge to scale out fossil fuels and accelerate the already significant investment into an electrified and decarbonized future.
Whether you believe in ESG or subscribe to the “woke capitalism” viewpoint, it simply can’t be ignored.
So the fiduciary duty of investment managers when seen through that lens would suggest a long-term imperative to ensure that the funds they manage are not placed into assets that will become stranded or obsolete. In other words, investing using ESG metrics and favoring renewable and climate tech type investments makes economic and investment sense in the long term.
This approach is one that we follow, and we’re not alone. Despite recent controversy, the ESG investment market is estimated to be worth $53 trillion globally by 2025 and data, reported by Bloomberg, from the European Fund and Asset Management Association (EFAMA) has shown that the EU’s highest environmental, social and governance classification, known as Article 9, drew in €26 billion ($28 billion) in 2022. That coincided with bond funds seeing client outflows that were greater than since the global financial crisis in 2008, while equity funds also suffered, losing €72 billion over the same period.
Regardless of the critique, ESG-focused investing is drawing in significant funds and is set to represent around a third of all funds under management by 2025. Whether you believe in ESG or subscribe to the “woke capitalism” viewpoint, it simply can’t be ignored, and any company seeking funding needs to ensure that it is structuring its investment case accordingly.
Yet despite this, far too few companies, particularly at a scale-up stage, are thinking ahead to how they structure their investment case so that it appeals to a wide range of investors, particularly those that follow ESG criteria.
Data from EFAMA shows that significant money is flowing into Article 9 funds, yet in order to become a portfolio investment, startups must meet Article 9 criteria, otherwise they will fail to meet the investment criteria.
This means that having a brilliant idea, business plan, IP and a team to deliver it is no longer enough for startups looking to tap Article 9 investors. Instead, they also need to bake ESG metrics into their business model and demonstrate positive social and environmental impact from the start.
For many startups, this creates an additional knowledge barrier that they have to overcome, but addressing that up front will reap dividends, not only in securing early-stage funding but also in enhancing their scale-up potential, by making their business potentially more valuable, and by facilitating ease of exit.
That changes the parameters for both the investor and the investee. Investors need to accept that they have a role to play as coach and guide to help startup entrepreneurs understand what they need to report and the impact they need to demonstrate as part of the value they add to the businesses they are investing in.
At my firm, we have always seen our role as both a mentor and investor. Accessing funds from our LPs requires us to work with our portfolio companies to ensure that they are equipped to report success and impact in ways that sit beyond traditional P&L.
This becomes all the more important in a world where there is no single standard for what ESG means and how it is reported. This results in many entrepreneurial companies (and larger cap businesses as well) being utterly confused about what they should report and how they go about it.
It is therefore incumbent on the investor to help drive value and deliver impact through wider ESG performance to meet the reality of a world that seeks impact as well as profit from business.
In this new world we are seeing a reformulation of the role of the investor. No longer there just to seek return but also to add value, support growth and act as a steward of capital and also of impact.
Companies seeking investment need to understand that change in investor outlook and make it as easy as they can for investors to vet, approve and want to invest in their company. It means starting a business with a clear idea of how you will seek scale-up finance, what your exit plan might be and how you facilitate all those elements in your growth journey. That means baking ESG into the DNA of the business from day one.