ESG, despite its flaws, offers the best chance we have to ensure businesses have a “license to operate” in the future. Dismissing it as too difficult, irrelevant or distracting is the biggest mistake the business community could make within the coming decade.
In the past few months, headlines such as “ESG is dead'' have become ubiquitous - on the cover of magazines, keynotes at events etc. From where we stand, they could not be more wrong.
What they seem to be saying with such a headline is that ESG got too complicated before it even started - the amount of organizations, frameworks, guidelines and consultants looking to - at best support, at worst take advantage - of the ESG frenzy have multiplied at great speed.
At the same time, the playing field for an entrepreneur with limited resources can appear impenetrable, while balancing the current pressures of a recession against expectations of helping to save the planet or promote human rights in faraway countries.
ESG has been taken hostage by an industry wanting to access, funnel and monetise on capital and funding, risking losing one of the most important frameworks ever put in place to future-proof ours and our children's world.
Critics argue that ESG has become a distraction from companies' primary task to generate profit, that it is still not possible to measure in a meaningful way, or that the causal link between ESG and profitability is not proven. ESG has also been accused of being a hyped PR gimmick glamorized as the business community's response to societal challenges. So we have come full circle, the industry is giving up before having even tried and nothing has really changed. And so the headlines perhaps have a point.
ESG 1.0 is dead
ESG 1.0 at least is truly dead. Having grown so big and noisy so as to implode. But the importance of ESG is fundamental, and its effect is now binary: either we build businesses that contribute to our future, or we build businesses that won’t survive: customers won’t buy their products and services, talent will not join their ranks, they will lose their “license to operate” and capital will cease to flow their way. We have therefore passed the point where it was conceivable to make sense of ESG through a cost lens, where short-term profit needs to outweigh costs. ESG is, in fact, a prerequisite for a company to exist at all.
So where have we gone wrong? Let's look ourselves in the mirror. We as investors have failed to convey two important things; that ESG is seriously a matter of survival for entrepreneurs - not least when it comes to accessing capital - and subsequently to help entrepreneurs with the practical steps to implement ESG in an appropriate and relevant way. So how do we take responsibility for how we invest our money and take ESG to the next level as an ecosystem?
Welcome to the age of ESG 2.0.
Part of the reason that “ESG” has been allowed to be used in divergent and sometimes contradicting ways lies in its origins (for more on its history and uses, read this paper from a scholar at the University of Pennsylvania). But the fact that it can’t be simplified by a paragraph in a term sheet or a statement on a website is not an excuse to shy away from the opportunity to build a better future, one we all want to see and one we all have a responsibility to create together. Especially since the risk of not doing so could make us as investors, obsolete.
So if we are to make 2023 the year of ESG 2.0, what does that look like?
The regulatory frameworks are relevant
A common misconception is that the regulations around sustainable investments, SFDR (Sustainable Finance Disclosure Regulation), have been created so that the business community will jointly solve all the challenges society faces (in short, save the planet). This is not the case. SFDR has primarily been created to evaluate a company's sustainability risks in order to ensure the company's long-term success.
From this perspective, SFDR is both economically justified and can be made digestible. The regulatory framework consists of three pillars:
1) Assessment of sustainability Risks
Assessing the ESG risks the company may be exposed to that could affect its “value” and also how the company may affect the outside world (sometimes referred to as “externalities”): first how the company's actual ability to conduct its business could be affected (for example by environmental degradation), and secondly in which areas the company risks going wrong and may lose its "license to operate" if efforts are not made and measures not followed up on. A typical risk assessment here with a sustainability lens is useful to gain visibility. See here a summary of ours.
2) Make positive contributions to ESG
ESG is also about how a business might contribute positively to an ESG “area”, ie “opportunities”. A business can contribute to or influence positively a few selected areas, e.g. by starting with the UN's Sustainable Development Goals (the so-called SDGs). For a framework that can bring ESG closer to early stage businesses, one could also use a broader list of issues falling under ESG. Here is a non-exhaustive list for inspiration:
3) Transparency and Good Governance
Transparency by reporting on reasonably standardized metrics as well as putting in place basic good governance practices to support progress on the “risks” and “opportunities” points above. For measures, we recommend you refer to the Principle Adverse Impacts framework from the SFDR regulation’s Regulatory Technical Standards (it’s less scary than it looks at first glance!). And for good governance you can also see key actions we implement in our portfolio depending on levels of maturity (see further below). Note that forward-thinking companies also build follow-up on ESG metrics into financial reporting.
A practical approach
At Wellstreet, we’ve always had the ambition not to run after self-proclaimed unicorns but have focused on building profitable and sustainable companies. And so integrating ESG into the DNA of our portfolio has been a very natural progression for us, alongside our other foundational work with our portfolio companies. We aspire to build the companies of tomorrow by being super hands-on in implementing ESG through all our other operational work, be it in a product roadmap workshop, a commercialisation strategy session or Google Ads training. We help our portfolio companies understand that ESG is a layer in each business process as opposed to a separate (siloed) track in building a company.
Practical recommendations for getting started
For you as an entrepreneur:
⬥ Build in ESG right from the start as part of both the business model and all the company's processes: consider the environmental, social and governance implications of the choices you make with regards to e.g. setting up your supply chain, how you distribute or charge for your products and services, terms and conditions with customers, compliance monitoring and how employment conditions you offer promote equality and diversity. Start simple and build up (use the ESG areas below as well as levels 1, 2 and 3 of our framework as a starting point).
⬥ Actively look for investors who, in both word and deed, work with ESG investment principles. Set requirements for practical help you expect from them with regards to training and implementation of ESG in your company.
⬥ Build early trust with your stakeholders by sharing your ESG work in your internal and external communications and start collecting data (according to PAI) even if this is at small scale in the beginning.
For those of you who invest in companies in the early stages:
⬥ Carry out a review of ESG risks in companies as part of the investment process, both to inform the investment decision and also during due diligence. This shows companies that ESG is critical to getting your backing.
⬥ Go through with your entrepreneurs how a risk assessment is made and explain that sustainability work is absolutely necessary for the company's long-term survival.
⬥ Invest time, build up your knowledge base and work with real experts to develop your own approach. Work with ESG at all levels with your portfolio companies. Recognize that it is our responsibility as investors to act as protectors of the future. It should not be run by a separate person, sent in a questionnaire once a year, or talked about at board level once in a blue moon. It affects every aspect of your relationship with your entrepreneurs, and all the small and big pieces of advice and input you give them. From who should be their next investor, to them discussing promotions of staff members or option packages, through their choice of suppliers and creating advertising campaigns. It is our duty to be the guardian of their future and guide, challenge and influence. No one else will. In 2030 this will be hygiene level, and the market won’t be so kind.
⬥ Register your fund as at least "light green" according to SFDR, or Article 8, so that you as investors submit yourselves to the same regulations and standards. If we as investors do not actively work to build the companies of the future and abide by the same rules, what is our “raison d’etre”? Hold yourselves accountable for which businesses you choose to support and how you empower them to be the better companies of tomorrow.
ESG is fundamentally a good framework for companies to preserve their “license to operate”.
However, the guidelines and frameworks published by various bodies, as well as the reporting requirements, can appear opaque and burdensome, especially for small startups, and could potentially also be misleading and, in the worst case, confuse and distract companies from the main objective of the approach.
We at Wellstreet aim to take ESG to the next level by actively working with our portfolio companies and embedding ESG in their DNA. We as a VC industry have the responsibility to support our founders to future-proof their businesses while there is still time. In 2030 this will be hygiene level, and the market won’t be so kind.
We hope you find the above approach and tools useful and we will keep sharing our progress as we continue to implement our ESG framework in our portfolio. Please feel free to borrow from it, improve it or reject it, but please don’t ignore it. Let us know how you have used it and share your findings and reflections with us!
Read our take on the topic also on:
DI Debatt: ESG är dött – länge leve ESG!
Breakit Debatt: Vilsen kring ESG? Dags att kavla upp ärmarna