ESG, or environmental, social and corporate governance, is pervasive throughout the finance and investing communities. ESG principles can be applied by not only impact investors, but all investors, to determine whether or not an investee has an understanding of their impact on the environment and societal issues. In 2020, the demand for sustainable investments through mutual funds and ETFs witnessed a 97% increase, for a total of $326 billion. Demand for sustainable investments has carried through the investments and asset management industries and into venture capital. Along with the growth in assets, ESG investing and reporting methods have improved as well. However, with the rise of ESG investments, reporting and measurement standards must continue to improve to ensure investments are being allocated towards the most impactful opportunities and outcomes. 

ESG standards often are dependent on the reporting organization. Criteria for the environmental effects may include things like energy use, CO2 emissions, waste-disposal policies, ownership of contaminated land, and animal treatment. A more forgiving environmental measurement may be whether or not the company is compliant with government regulations. Criteria for an organization’s social impact can range greatly.  In general, it outlines the company’s business network, as well as relationship with certain stakeholders. A company may choose to vet their business network to make sure their suppliers and customers share similar values. The company’s stakeholder relationships – often including employees and local community support – is another way to identify an organization’s support for social development. Governance criteria involves the leadership and internal policies of the company. Some questions that may arise include: does the company use transparent accounting standards? How is shareholder voting structured? How are board members selected? Does the company make political contributions? However, these criteria are subjective, as each investor has different priorities, and each company reports under different circumstances.

With all this ambiguity, why was there such a dramatic increase in the demand for sustainable investments in 2020? It is clear that the weltering 2020 catalyzed the demand for ESG investments. However, ESG has been taking off for years. Since 2015, the number of both ESG funds and firms in the venture capital industry quadrupled. In turn, 12% of the VC funds launched in 2019 had an “ESG thesis”, meaning ESG principles are applied to the portfolio in one way or another. Demand for ESG investments has gone up dramatically due to public sentiment, but also their financial performance. According to a McKinsey meta analysis of over 2000 studies, 63% found a link between ESG and positive financial performance, whereas only 8% found a link between ESG and negative financial performance. Additionally, 69% of ESG investors thought their ESG investments helped them manage downside risk. This could be due to the ways ESG is linked to value creation as well as risk mitigation like, cost reductions, regulatory/legal interventions, or productivity uplift. For example, the cost reduction associated with increased monitoring and control of energy and utility usage could increase top-line growth. Or an energy producer might be able to mitigate the risk of a lawsuit or other regulatory action due to high carbon emissions or water contamination.

Graph showing the percent of venture capital raised by ESG VC firms has been steadily rising since 2015Graph showing the percent of venture capital raised by ESG VC firms has been steadily rising since 2015Different Funds

Identifying how this trend has trickled into startup funding is difficult due to lack of public data. However, according to sampled startup founders, 90% thought ESG policies were important due to the coronavirus pandemic. Furthermore, 66% noted they intend to implement further diversity and inclusion policies following the recent deaths of George Floyd, Breonna Taylor, and others in 2020. In addition, 69% of founders think operating using ESG principles will increase sales, and 91% think it will help attract and retain talent.

Graph showing venture capital raised each year by ESG-focused VC firms has been steadily increasing since 2015Graph showing the number of VC funds raised each year by ESG firms has been steadily growing since 2015Different Funds

With the growth in Millenial and Generation-Z investors, ESG investing is likely to continue its surge in popularity. The share of ESG assets compared to all professionally managed assets in 2018 was 26%. Deloitte projects this to grow to 50% by 2025. Furthermore, the share of both retail and institutional investors that apply some sort of ESG principles to their portfolio jumped from 48% in 2017 to 75% in 2019.

Looking towards the future, some regulatory events will likely come into play for ESG investing. The International Accounting Standards Board, which sets the International Financial Reporting Standards, also created the Sustainability Accounting Standards Board. SASB has frameworks tailored to each industry, with accounting items in each that help paint a picture of a company’s ESG compliance. Since these are all accounting items, they are comparable within each industry to a certain extent. Furthermore, European Financial Reporting Advisory Group, a public interest group involved with financial reporting standards in the E.U., announced they would develop a roadmap for sustainability reporting standards in March 2021. 

Today, impact investing firms have a diverse range of impact approaches. Some investors set stringent standards, whereas others may cast a wider net and simply eliminate the most egregious ESG violators. Standardization may determine who can call themselves an “ESG fund”, which could help individual investors get a clearer picture of a company’s sustainability, and perhaps compare more effectively. Eventually, it could encourage companies and investors to be more transparent in reporting their sustainability, impact, and compliance. 

Although most impact investors have an honest approach to their investment decisions, 53% of investors are concerned about the reliability of ESG data. 66% of investors think greenwashing is the biggest challenge facing the impact investing market over the next five years. Greenwashing, also referred to as impact washing or SDG washing (referring to the UN’s Sustainable Development Goals), is a misrepresenting information about a company’s impact on environmental or social issues. Claiming inaccurate impact can lead to further environmental and social damage.  Capital and resources may be allocated to firms that are not as ESG friendly as they might seem. From the investor perspective, a VC fund, ESG-oriented ETF or company may cut corners when measuring and not fully comply with ESG principles they claim.

Good impact measurement and management is the best way to avoid SDG washing . There are easy ways to get started with IMM. First, companies must measure outcomes, not just outputs. A firm can align with SDG specified targets or indicators, not just the broader SDG goals. These targets are outcome metrics that can be measured and monitored to see how well the firm is progressing. Unfortunately, not all activities will lead to the expected positive outcome. Negative impact is real and it should be mitigated. The organization working for change should also understand the problem fully and focus on what they can do with their resources.  Within any problem, an impact-driven firm should bring together experts and gather feedback from those that are most affected. These stakeholders will inform on what really matters and if what an organization asserts is leading to real change.

Whether you are an investor, large organization or community partner, impact measurement and management is a must. With an impact measurement strategy, organizations have a firm understanding of the current state of the problem they are attempting to solve, and develop a tangible way of measuring their contribution to a solution. This is important from the startup to the large corporation level, as well as their potential investors. A 2020 impact investing report by the GIIN, found that 48% of impact investors use SDGs to report impact performance – a considerable increase from 28% in 2017. However, nearly 85% said that sophisticated impact measurement practice is still a challenge. Standardization and validated impact measurement criteria will certainly help this challenge. Until then, how else can we ensure that impact investment dollars are maximizing our potential to improve an environmental or social problem?

Basil Data helps prevent impact washing through creating impact measurement strategies for early-stage companies and small nonprofits. Feel free to connect with us directly at impact@basildata.com.