How do I build an ESG-conscious venture?

Aug 3

by Marvin Cheung, Head of Research and Strategy

As a response to the rise of sustainability, ESG has been developed to bring transparency to a company’s operations with a focus on non-financial factors under the categories of Environmental, Social, and Governance. The EU Sustainable Finance Disclosure Regulation (SFDR) came into force on the 10th of March 2021, requiring a wide range of asset managers, including some VC funds, to disclose how sustainability risks are incorporated into decision-making, the principal adverse impact of investments (“PAIs”), and product-level impact, where sustainability is a primary objective.

Since large-scale adoption of ESG disclosure is quite new, it is unclear at this time how much weight individual funds and investors will give ESG factors or what benchmarks they will adopt. Some investors may ask for extensive ESG metrics, while others may not. It is important to recognize that ESG risks will drastically differ from company to company based on industry and organizational strategy. For example, a startup that uses AI may consume more electricity, thus increasing environmental risks, compared to another startup that does not use AI if all else is equal. SASB’s materiality map is a good starting point for identifying material ESG factors.

Most industry best practices are established by organizations such as TCFD, GRI, and SASB. At a basic level, TCFD focuses on organizational strategy, GRI focuses on broader operational metrics, and SASB focuses on financial metrics. Below we have provided practical guidelines for leaders looking to get ahead of change and prepare for ESG disclosure.

Compliance: You should always consult your legal counsel on the specific requirements based on your organization’s size, countries where you have operations, and your investors’ needs. For most pre-IPO startups, unlisted companies, or SMEs, your ESG disclosure obligations should be minimal.
Awareness: The management team is conscious of the physical and transitional risks climate change poses to your company’s operations as defined by the TCFD. Physical risks include damages to assets such as warehouses and supply chain disruptions. Transitional risks describe policy, legal, technology, and market changes related to climate change. We recommend examining how your venture will be impacted by climate-related risks and opportunities more closely if you belong to one of the following Non-financial sector groups identified by the TCFD. This includes: Energy, Transportation, Materials and Buildings, as well as Agriculture, Food, and Forest Products. While the TCFD also encourages the use of scenario planning methods to help determine short, medium and long term effects of climate change for 2°C or lower scenarios, there is still little consensus on best practices. If your company belongs to the non-financial sector groups or if you outsource the production of any physical goods, you should also be aware of certain human right concerns within ESG such as child labour or forced labour. This involves more rigorous vendor risk management programs and increased supply chain transparency. For more information, see GRI Standards 408-414, and UN Sustainable Development Goals (SDG).
Transparency: Most technology companies will be at this level and we recommend it as the bottom line even for new ventures. While many ESG considerations, especially social factors, are at a nascent stage for technology companies, Greenhouse Gas (GHG) emissions and diversity metrics have been at the forefront of the ESG conversation. GHG emissions can be reasonably calculated if you know the amount of electricity you consume on an annual basis, and with the help of the free toolkits provided by the Greenhouse Gas Protocol. Diversity metrics across gender, age group, ethnicity, and other minority groups should be regularly reported by your HR department. Cavalry, a well regarded VC in Germany, has a basic ESG questionnaire that covers GHG, Diversity, and a few other fundamental topics. It serves as a good guide to help technology companies begin thinking about ESG. While public disclosure is more in line with the ethos of operational transparency, a common understanding of ESG metrics internally is oftentimes more than sufficient if there is no other legal requirement. At the very least, the management team should be aware of how the company is performing on core ESG issues. For more information on GHGs, see GRI Standards 302, 305; For more information on Diversity, see GRI standards 405, 406. FinTech and InsurTech companies may be subjected to additional AI Ethics regulations depending on where they operate; UX and UXR Ethics standards are mostly self-enforced. We will elaborate on both topics in other Coursebooks, but they currently do not fall under the topic of ESG.
Active management: Once there is transparency, the management team can begin to take action. For most new ventures, we recommend beginning diversity initiatives early and staying away from GHG-intensive processes whenever possible. This is not as simple as it sounds. For example, if employees work from home, will they emit more or less GHG? How much of the employee’s GHG at home should be counted towards the company’s total GHG? What if employees need to make more long distance business trips? While some back of the envelope calculations suggest the WFH will reduce GHG, precise data is challenging to obtain since each firm has their own WFH policy. As a rule of thumb, start tracking and managing sustainability risks where data is readily available and acknowledge assumptions when you communicate the data. For existing ventures, transitioning from GHG-intensive processes or infrastructure will take time and deliberate planning. Carbon offsetting programs can help in the short term. Actively managing ESG risks and opportunities will help prepare you for public ESG disclosures. A formal audit, control system, domain expertise and dedicated personnel will be necessary if you intend to secure a leadership role in the sustainability space.
Impact-first: Impact-first ventures do not only use sustainability as a way of reducing harm but they actively seek to create a positive impact. These tend to fall under the category of social enterprises and are incredibly difficult to achieve unless they have been purposefully formulated to do so from the start. There are also a lot of nuances. For example, what if you achieve a positive impact in one area eg. by hiring minorities, and create a negative impact in another area eg. by using a GHG-intensive process? How much of a positive impact do you need to make and how do we view the intermediary steps we need to make in order to arrive at that benchmark? How will you prioritize impact and generate market-rate returns for your investor? GIIN’s IRIS+ sets the current standard for impact investment.

While we certainly would like to see more ventures do well and do good, there is still a long way to go. We often say that sustainability is a value-driven process. Committing to understand the unintended consequences of your company’s operations is a good first step, no matter where you are at your journey.

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