The ESG reality and opportunity for early-stage startups

Zomato, a food delivery platform, recently unveiled its ESG (Environmental, Social, and Governance) goals on World Environment Day (June 5, 2022). Deepinder Goyal, Founder and CEO, Zomato, talked about 500,000 tonnes of carbon offset with electronic vehicle deliveries in FY22, 300 tonnes of plastic reduction, and 50 percent women directors on the Zomato board, among a list of other initiatives aligned with the six UN Sustainable Development Goals (SDGs).

Zomato’s journey from not thinking much about its environmental footprint to talking on explicit targets reflects a rapidly changing world of investor expectations and corporate responsibility. There are positive and cynical points of view on their transformation, but no one can argue that it is not a good thing. One can expect to see a lot more of this going forward, and this expectation could rapidly shift from public to private companies and even early-stage startups. And rightly so.

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While ESG is an oft-used phrase, there is still some confusion among startups, especially those in India, in terms of what it entails. At the most basic level, depending on the business of the startup, there are simple steps one can take to play their part.

Think about it. Why would a company not want to have a more responsible approach to the environment (for instance, reducing the company’s carbon footprint and plastic waste and using eco-friendly materials with some changes on your side)? Why not have a socially responsible organisation (i.e. one with equal opportunities, gender diversity, fair wages, and data privacy)? Why not set an example with governance, with clear guidelines on ethics, workplace harassment, and worker-friendly policies?

With limited information and based only on hearsay, some founders worry about ESG requirements being too onerous or not relevant for early-stage startups. This is a dated view, and a number of forward-thinking founders have started paying more attention to ESG and incorporating aspects early on.

There are many advantages to this, but the first big point to appreciate is how much has changed in terms of capital allocation for sustainability.

New global flows into sustainable funds increased every year, from $30 billion in 2016 to $360 billion in 2020. According to BlackRock’s 2020 Global Sustainability Investing Survey of 425 investors in 27 countries, representing approximately $25 trillion in assets under management (AUM), respondents planned on doubling their sustainable AUM, from 18 percent in 2020 to about 37 percent in 2025.

With countries seeking to achieve their own climate and sustainability ambitions and investors demanding greater transparency from companies on their ESG reporting, the pressure is on companies to account for their own environmental and social impact. In 2019, 90 percent of the S&P 500 companies reported ESG metrics, compared to only 20 percent in 2011. Investors want asset managers to improve their ESG data research and analysis as they try to understand the ESG risks of their portfolios. Moreover, asset managers are obliging; Nasdaq research shows that the top 150 asset managers globally hire eight ESG analysts on an average per firm.

So, the pendulum has already shifted in public markets. While ESG has always been in the direction of public good, there is nothing like the good old carrot and stick approach. Asset managers and companies go where asset allocators and regulators nudge them to go.

There are plenty of issues, and ESG reporting remains an evolving area. There are several studies—including this—that point out the gaps in supply chain reporting, which make ESG metrics from large companies like Amazon and Walmart incomplete and misleading. Just like accounting standards, there will soon be a global set of recognised and acceptable metrics over the next few years.

Private Equity (PE) firms, though still lagging behind public markets, are recognising that assessing the ESG performance of prospective portfolio companies is no longer just a risk mitigation exercise for value protection but is also essential for value creation. PE firms are integrating ESG into every aspect of the investment value chain, in screening, due diligence and portfolio management, aiming to produce a better investment during exit. PE firms that fail to do so could face the possibility of value erosion. In PWC’s 2021 Global Private Equity Responsible Investment Survey of 209 global private equity firms, 66 percent stated that value creation is among the top three drivers of responsible investing or ESG activity, and 72 percent always screen target companies for ESG risks and opportunities at the pre-acquisition stage.

Limited partners (LPs) are also increasingly demanding a bigger commitment to ESG initiatives, making it a critical factor in raising capital. PE firms are thus expecting more ESG-related information such as alignment with SDGs, net-zero goals, diversity, equity, and inclusion initiatives from their portfolio companies. In September 2021, California Public Employees’ Retirement System (CalPERS) and PE firm Carlyle led a collaboration that included GPs (general partners) and LPs representing more than $4 trillion in AUM to track and report six ESG metrics: greenhouse gas emissions, renewable energy, board diversity, work-related injuries, net new hires, and employee engagement.

Indian firms are also understanding that if ESG risks are not identified and assessed, it could pose a significant threat to operations and profits and have a negative impact on shareholder value. Like their global counterparts, Indian firms are also seeing a shift in consumer behaviour.

Millions of consumers now want more environmentally and socially conscious products. ESG issues such as climate change, data privacy and security, workforce diversity, and inclusivity rank high among consumers and employees alike.

According to a Capgemini consumer products and retail survey of 7,500 respondents from nine countries including India, 79 percent of global consumers change their purchase preferences based on social responsibility, inclusiveness, or environmental impact. In the same survey, 86 percent of the Indian respondents said buying sustainable products makes them happy and nearly 88% of consumers in India were willing to purchase a more sustainable product once they were made aware of the sustainability issues.

The numbers are even higher when we factor in the responses given by the younger generations— Millennials and GenZ, who are more concerned about ESG issues. According to the 2022 Oracle ESG Global ‘No Planet B’ study, of the 1,000 Indian respondents, 93 percent believed that it’s not enough for companies to declare their ESG priorities, and they want to see actions taken.

Companies recognise the necessity to respond to this shift in consumer behaviour to stay viable in the long term. Anirban Ghosh, Chief Sustainability Officer, Mahindra & Mahindra, which has a $600-million green product portfolio across its businesses, from electric mobility to green buildings, says, “Practice of ESG helps reduce cost, gives new sources of revenue and access to new talent, and brings new consumers. It is another quiver for companies to become more resilient.”

As India is a key global manufacturing and services hub catering to multinational buyers, the ESG policies adopted by global companies is leading to a change in the ways in which Indian companies think about their sustainability efforts. To stay competitive globally, Indian firms are seeing the necessity to examine their own value chains, due to the significant role that supply chains play in climate action and emissions.

Preeti Gandhi, Head of Sustainability Marketing at TCS, says, “We are seeing a lot of our stakeholder groups, including our clients, partners, and employees, choosing us because of our strategic focus on sustainability and our ability to help them meet their targets.”

Except a handful of firms, most venture capital (VC) firms have watched these developments from the sidelines. With more focus on scaling startups and generating strong returns, VC firms have been slow to adopt ESG processes in making investments.

But this is quickly changing. In the 2021 PWC Responsible Investment Survey, 64 percent of the 70 VC firms that were surveyed said that their LPs have expectations regarding ESG risk management. VC firms are also recognising the important role they can play in advancing a startup’s ESG journey and setting it up for long-term success.

For startups in India, this is a great time to look closely at their approach to ESG. There are several advantages of being ahead of the curve.

Here are some guidelines that our investee companies have found useful.

• Investing time to understand the ESG criteria and its implications for the company

• Identifying how the company’s products and services can create a positive impact on the society; for instance, by aligning them with the UN SDGs (https://sdgs.un.org/goals).

• Identifying meaningful ESG metrics: For most Indian companies, their current operating metrics have significant value in highlighting the ESG impact. For instance, for a lending company, it is not that difficult to cull out the number of women borrowers, first-time borrowers or borrowers below a certain income bracket. For a SaaS company with technology for healthcare, keeping track of rural and urban patients serviced and access to specialists for customers in tier-2 towns could be a start.

• Getting the management team to lead from the front on core aspects of diversity, equal opportunity, fair wages, and other aspects of a socially responsible organisation

• Setting in place clear and formal policies around ethics, worker harassment, and other governance requirements

• Communicating the company’s ESG belief system to employees: Employees, like consumers, are now drawn to organisations with green and socially responsible credentials. This could be the X factor in being the employer of choice.

A meaningful ESG strategy and progress towards ESG goals can be a big differentiator for many startups in attracting a large set of deep-pocketed investors in their journey to build a strong and successful company.