Let’s cut to the chase: in the post-COVID economy, we ignore ESG at our own risk. From raging wildfires to catalyzing incidents of social injustice, the so-called Great Resignation and millennial workers’ willingness to put values over salary, we ignore ESG at our own risk. The heightened need for corporate accountability, coupled with an increased need for risk mitigation in the form of ESG compliance – tightened by current and oncoming regulation – is essential to success in the “economy 2.0.”
The numbers reflect this reality. Far from the niche market it once was, ESG assets are now predicted to exceed US$50 trillion worldwide by the year 2025. In Europe alone, this figure is expected to reach nine trillion euros. Similarly, the world of private equity and venture capital has also come a long way from a specialized corner of finance to a leading player in the world economy – with assets likely to surpass $11 trillion by 2026.
In contrast to public markets, private equity (PE) and venture capital (VC) markets have a direct responsibility for the companies or start-ups they invest in, often holding board seats in these companies. This direct-stakes approach to raising capital, along with responsibility to their own boards members who typically have considerable wealth at risk, means PE and VC firms will be held to a far higher standard of accountability as the mainstreaming of ESG continues. It also means they are perfectly suited to steer their portfolio companies towards robust ESG policies that bolster both the viability and profitability of the companies they oversee.
In a major move, the United States Securities and Exchange Commission (SEC) is expected to publish new rules, later this year, mandating climate-related financial disclosures for public companies. These disclosures are expected to align with recommendations from the Task Force on Climate-related Financial Disclosures (TCFD), the leading global ESG framework for reporting on climate and sustainability. And while the first step of ESG legislation focuses on public markets, the SEC has also said that it is looking to greater scrutinize private funds as well.
In Canada, TCFD-aligned reporting will be enforced in 2024. The International Sustainability Standards Board, with offices in Montreal, has also just released its much awaited climate disclosure standards to harmonize sustainability reporting policies worldwide.
In Europe, the EU enacted the Sustainable Finance Disclosure Regulation (SFDR) in March 2021 to combat greenwashing by providing rules on what can and cannot be categorized a “green” financial product. Soon afterwards, the UK became the first country to legislate TCFD-aligned reporting in April 2022.
VC firms, in particular, can be especially well-suited to remain ahead of the regulatory curve. By investing in start-ups and disruptive technologies, they have the opportunity to integrate ESG into their portfolios from the get-go during the early stages of a company’s life cycle. By weaving ESG into the very culture and fabric of start-ups, which by their nature are incubators of innovation, VCs are in a unique position to shape the post-COVID economy.
Given political, social and, critically, climate volatility characteristic of our still young 21st century, genuine ESG credentials will become critical in strengthening a portfolio’s ability to weather a storm, encourage longevity and minimize risk of all kinds. Thus, for institutional investors, ESG performance will play a not insignificant factor in price negotiations and valuations. In fact, in a KMPG survey of private equity general partners worldwide, 54% had reduced a bid after carrying out ESG due diligence, while 34% increased one. Firms that ignore ESG will suffer down the line in their fundraising efforts or if limited partners inquire about their ESG credentials. Reputationally, millennial consumers (along with Gen Z, who will come into their own in the next two decades or so) have repeatedly reported themselves as willing to boycott companies on poor ESG grounds. It can all go downhill with a meme.
While the ESG pressure is building on public markets, the PE and VC spheres are still relatively new to the game. Though this is slowly changing, a dearth of market tools or advisory services exist to cater to the needs of investors who will now face additional scrutiny and pressure to collaborate with ESG-forward companies.
ESGTree advises that PE and VC firms begin with a baseline collection of solid, reliable and verifiable data before crafting strategies and policies. In our experience, firms often dive into sustainability reporting in the absence of both proper data and an ESG strategy on which it should be based (and low emissions industries should nevertheless collect robust environmental data as well). Data is the edifice upon which real ESG rests. Much has been written about the dismal – but evolving – state of ESG scoring and ratings by ESG ratings agencies. A company can receive wildly differing ESG scores based on the provider. The data that ratings are based on is self-reported, opaque and sketchy, and in the absence of any meaningful benchmarking analysis, these scores lack meaning. In the words of a Tufts University professor, “garbage in, garbage out.” Hardly a stable foundation on which to enact policy.
Based on this data, a company can extract meaningful ESG metrics to see where it stands. Benchmarking these metrics against global standards such as those published by the Sustainability Accountability Standards Board (SASB) can provide a barometer on whether a portfolio is performing well, averagely or poorly on ESG. The United Nations Principles of Responsible Investment (UNPRI) has also issued a number of frameworks and toolkits related to private capital markets and ESG.
So far, ESG is largely viewed as a hurdle, albeit one to the tune of trillions. For the PE and VC industries, it can be a shining opportunity to position themselves and shape the future.
ESGTree provides powerful data solutions to help private equity (PE) and venture capital (VC) firms gather, collect, analyze, benchmark and report their ESG data and that of their portfolio companies. Our carbon calculator, customizable and automated ESG frameworks, multi-level report viewing, trends analysis dashboard, and other features aimed to make ESG a value creation tool rather than a reporting burden.
Click here to learn more about our ESGTree’s data solution for Private Equity & Venture Capital.