Startups have caught everyone’s fancy. But why they are lagging on ESG parameters?

Over the past few years, India’s startup ecosystem has grown by leaps and bounds. Startups have raised millions of dollars in funding from venture capital investors, with almost 100 companies attaining the status of a ‘unicorn’ that has a valuation of at least $1 billion. To be sure, funding has slowed in recent months and many startups are laying off staff to cut costs. Still, one aspect that has largely been given short shrift by investors backing startups and small businesses relates to ‘environment, social and governance’, or ESG. 

Although ESG as a concept has been talked about for a few decades by now, it has traditionally been more of an after-thought as investors tend mostly to focus on the economically more important aspects of the deal.

But that seems to be changing as venture capital firms are now seriously looking at impact investing especially in the tech space. 

But before we delve deeper into the topic, what does ESG even mean for startups? Should such fledgling companies even be bothered about such aspects as ESG when they are still in survival mode? Conversely, can they afford to ignore ESG in a world that is conscious of the perils of climate change? And more importantly, what role, if any, do other stakeholders have to play when it comes to responsible impact investing?

The global picture

Well, if a recent survey conducted by the World Economic Forum (WEF) is anything to go by, respondents say that ESG should not be approached as a standalone topic and instead should be “embedded into key corporate strategies and decision-making, ideally from the beginning so that it scales with a company.”

In fact, at a global level, WEF found that 68% of the startups that were surveyed “integrated ESG into their business strategy from the beginning, before most even had a viable product, complete C-suite, or office space.”

Startups also want friendly metrics when it comes to implementing ESG norms and measuring performance. The fact remains that when it comes to concretely measuring ESG performance, there is still a lack of methodologies as to how start-ups could practically approach ESG. The current standards in the market (such as Sustainability Accounting Standards Board) are mainly focused on corporate houses that can dedicate resources into thoroughly tracking all required metrics.

Interestingly, and perhaps reassuringly, the WEF survey found that customers and employees are the key stakeholders demanding ESG advancement. 

Little wonder, then, that the assets under management (AUM) under impact-oriented funds have been ballooning both globally as well as in India. 

As startup-focussed news website Inc42 noted in a recent article, the global impact AUM crossed $1 trillion across asset classes in 2022. This impact AUM is managed by 3,349 organisations, where fund managers account for the majority of them. Concurrently, the startup sector observed $134 billion invested in 5,200 startups since 2014 in India and a $2.5 trillion in over 100,000 startups worldwide.

Moreover, as the same article noted, a new set of impact startups challenging the traditional impact business models also emerged during the last few years, piggybacking on disruptive innovation, an often quoted and generally accepted investment driver in the mainstream startup sector. 

And as investors increasingly began to become more interested in the impact theme, a few of them also joined the tech bandwagon. 

The India picture

To be sure though, as far as India goes, the numbers remain relatively small. A country of more than 140 crore people has only about 107 unicorns, or startups that have a valuation of $1 billion or higher. Of these 107, only 11 are impact unicorns. Moreover, for a country, two-thirds of whose population is still dependent on agriculture, India has no agritech unicorn that can qualify as an impact unicorn. 

This compares poorly with the global scenario in which 40% of the world’s 1,200 unicorns can be classified as impact-focused startups. 

Dig deeper, and we begin to see that the recent data around impact investing in India shows a mixed bag of sorts. Since 2016, commitments by asset managers have fuelled an 11% growth in the impact AUM deployed. Yet, this figure dwarfed the growth in private markets AUM, which went up from $5.2 trillion in 2016 to $9.8 trillion in 2021 during the same period at a CAGR of 16%, according to a Mckinsey report.

Moreover, as Inc42 notes, the gap widens when we consider that the $4.2 trillion funding required to achieve 17 Sustainable Development Goals by 2030 is just 1.1% of assets held by financial institutions. 

In fact, if these figures are looked at in light of a survey by JP Morgan and Global Impact Investing Network (GIIN), which found that more than 55% of impact funds deliver at least market rate returns, as well as a study by MSCI, Inc. which said that companies with higher ESG ratings have higher profitability, lower systematic risk and lower tail risk, India’s numbers begin to look even more dismal. 

In addition, as a report in The Economic Times pointed out, a recent study done by CFA Society India and CFA Institute on Indian ESG funds suggests that the ESG integration practices are understandably in relative infancy, and wide variability exists across ESG funds with respect to their investment approaches, ESG scoring methodology and outcomes. For example, the number of stocks in these funds ranged between 23 and 54, and many funds held a significant portion of assets outside their benchmark universe as of November 2021. They also had varying exposure to carbon intensive sectors like oil and gas, with some funds exceeding the exposure vis-à-vis their benchmark.

Some greenshoots

Yet, some greenshoots seem to be emerging when it comes to ESG investing in India. 

In September last year, the country’s first ESG focussed startup venture program—ONE in India—was launched by the women founders of Germany-based JUST DAMN RIGHT, Nadine Bruder, and of India-based The Public Policy Advocates (PeoPLe) & Advocate & Founder - Cornellia Chambers, Pritika Kumar. 

ONE in India bills itself as an early stage “ESG-focused startup venture program to support impact-driven founders who blend sustainability, disruptive technologies, and game-changing solutions to help solve India's most pressing challenges.”

“Empowering young entrepreneurs locally and collaborating internationally for zero-emission, circular and inclusive economies, that's what we hope to also inspire in others through our program," Kumar, Advocate and Founder PeoPLe, said while launching ONE in India. The orgnisation aims to back companies in domains such as climate technology, fintech/finance, circular economy, food and agritech, legaltech, affordable housing, digital health and education. 

Other venture capital and private equity funds that have ESG-focussed vehicles include Avendus, which manages the Avendus India ESG Fund, a category III alternative investment fund, and the Neev Fund, which focuses on clean energy and early-stage VC Infuse Ventures. 

In fact, even private equity funds seem to have warmed up to the idea of impact investing. 

A June report by Bain & Co said that AUM of ESG-focussed PE funds more than doubled in India in 2021 to $650 million. It said adoption of ESG mandates will also influence the pace of global private capital’s investment decision making in India.

The report—India Private Equity Report for 2022—said India-focused funds expect ESG considerations over their PE AUM assets under consideration to grow to 90% over five years from now, up from only 39% five years ago, indicating a significant acceleration in ESG adoption across the sector.

“The global acceleration toward ESG adoption has reached the Indian shores, as many India-focused funds are increasingly looking for ways to embed ESG norms into their firms and portfolios,” Bain said. “ESG is getting recognised as an opportunity for value creation and should be viewed as a differentiated driver of value across the full investing value chain,” it said. 

The consulting firm said, “As funds explore how to raise better, invest better, own better, and exit better, they have an opportunity to emerge as leaders capturing outsized value from their initiatives. Firms have unlocked 3–5% points of EBITDA from ESG levers, and this value is expected to grow.”

"There was an expansion in buyouts deal value by 5x to over $16 billion in 2021, and the average value of deals tripled since 2016. A massive increase in VC and growth equity expanding to $38.5 billion, in almost a 4x jump from 2020, that took its share of overall investments to greater than 50%,” Bain said.

But challenges remain

A recent study done by CFA Society India and CFA Institute on Indian ESG funds suggest that the ESG integration practices are understandably in relative infancy, and wide variability exists across ESG funds with respect to their investment approaches, ESG scoring methodology and outcomes.

Moreover, there is variability in the ESG ratings by various agencies. These ratings disagreements reflect the heterogeneous views among market practitioners about which factors are important in assessing the ESG performance of a company.

Further there are also challenges with respect to issuer level disclosures. SEBI’s business responsibility and sustainability reporting (BRSR) mandates companies to produce an array of metrics, but there are definitional issues which makes comparisons difficult.

In addition to BRSR, SEBI has proposed a number of ESG rules recently, relating to the improvement of ESG integration practices, ESG rating providers, firm level policies, and disclosures by ESG funds in India.

“To generate and sustain the growth of ESG investing, there is a need for focused investor education. Investment advisors should work with investors to identify their ESG and financial preferences when recommending ESG products. Investors should do their own research and understand the investment objectives and features when investing in such products,” said ESG experts Sivananth Ramachandran and Mohan Kumar Prabhu, in a recent article.