At the beginning of ‘Godfather III’, Corleone’s daughter gives $100m to the Catholic Church to ‘resurrect Sicily’ in the name of the family foundation. ‘Every family has bad memories’, she explains, but the right mind and big gifts can make up for murder and generations of a mafia existence. Or can they?
Would the Corleone family today talk about their practice as ESG – or possibly even focus on the positive impact their activities produced? Would they be accused of ESG-or impact-washing, trying to resurrect their image, without really changing the ‘core business’?
Since the 1990s when the third part of Godfather was released, the language around philanthropy, charity, CSR, impact and ESG has changed significantly. But misunderstandings and myths prevail. Let’s focus on even just one term, ESG, and this becomes clear quickly.
Over the last years, ESG has seen a lot of opinion pieces and critiques from all sides. ESG has made it into big American politics, too. At least two candidates for the upcoming presidential election, Flo. Governor Ron DeSantis and Vivek Ramaswamy, are running on an anti-ESG or what they call ‘anti-woke capitalism’ platform. As we argued before, this movement doesn’t get ESG right at all. But they are not alone in that.
In our work both as researchers and practitioners working with venture capital investors and their limited partners at VentureESG, we continuously encounter confusions. If you don’t get the definitions right, ESG washing is just one step away. Conversely, not seeing ESG for what it is also prevents potentially well-intentioned investors from driving real change and action.
We want to take on six of the most common myths and misunderstandings we encounter on a day to day basis. The hope: if we clear up the fog, much wind will in fact be taken out of the sails of the anti-ESG warriors. And the big belief: that is for the good of everyone. So let’s dive in:
- Myth 1: ESG and impact are basically the same. Simply speaking, impact is about outcomes and ESG is about process. A carbon removal startup has a positive environmental impact that increases in lockstep with company growth; but that doesn’t mean that the company is also ‘managed well.’
Integrating ESG principles would make sure that the company’s employees are well treated and its supply chain doesn’t violate human rights among other things. Because the two are not congruent, Tesla can be thrown out of an ESG index while (arguably) being impactful. The seeming tension makes analytical sense and the analysis helps us to clearly distinguish who does what. The differentiation is the first key step towards preventing impact- and ESG-washing – hence we bang on about it so much.
- Myth 2: ESG is all about reporting and disclosure. While European regulation such as SFDR (for investors) and CSRD (forthcoming for companies) focuses on disclosure of KPIs, that is only one part of how ESG works. ESG is a Full-Body-Workout which touches on all parts of a company or investor practice; it is not an add-on but involves changing existing processes (unlike philanthropy).
For a VC fund or a startup company, for instance, ESG disclosures (e.g. carbon accounting, and diversity, equity and inclusion metrics) are one part of ESG integration; but the disclosures need to lead to change over time in the company’s or investor’s processes and structures (e.g. carbon footprint reduction, increased board diversity). Disclosures without change are meaningless.
- Myth 3: ESG is all about measuring and quantitative data. The maxim ‘measure what you can’ has also taken hold of many ESG conversations, mistakenly. The process-focused ESG integration requires as much measurement as it does qualitative data, judgment and changing practice. Having an ESG Policy is only the start; how does a company or investor put it into practice? Knowing a company’s diversity statistics is only as good as understanding the measures it takes to make hiring and decision making more inclusive.
Some of the most important LPs in VC for instance take the due diligence conversations with VCs as seriously as they do the reporting of KPIs (see KfW Capital’s white paper). Would we want a VC investor to ever make an investment decision solely based on a business plan or pitch deck without in-depth conversations with the founders? It doesn’t make sense to limit ESG in this way either. To prevent the aggregate confusion the public market rating agencies are producing to infect the private markets, ESG needs to be both quantitative and qualitative.
- Myth 4: ESG is not relevant for early-stage companies and their VC investors. The widespread ESG frameworks – from the PRI and SASB/ISSB to SFDR – are indeed not (yet) fit for purpose for VC. VC-specific tools are needed both for measuring and for wider integration into VC and startup processes. The work which for instance ESG_VC or us at VentureESG have started in this direction is only the beginning of creating the necessary tools asset class by asset class. It will be on ecosystem participants – the anchor LPs and influential GPs – to come up with the right tools as the regulation will very likely never be VC-specific and for many of the standard setters, VCs is too small a fish to fry.
- Myth 5: ESG is just a long list of irrelevant issues. Public market ESG rating agencies and even existing ESG questionnaires for VC often consist of dozens if not hundreds of questions. Not all questions are relevant for every company, especially when looking at early stage startups. The universe of possible ESG issues needs to be filtered – with a lens which is widely called materiality. The task of a materiality lens fulfills is simple: it helps us to decide which ESG issues are having a financial impact given the company sector and stage. Again, it is the industry’s job to conduct the materiality analysis to make the ESG analysis relevant.
- Myth 6: ESG is not enough. When we take the difference between ESG and impact seriously, the limits of the former are very quickly apparent. ESG doesn’t help us to focus on solving problems or having a positive impact; it is a tool to incorporate risk factors into investment decision making and company processes but doesn’t contribute much to the company’s outcomes.
So yes, I agree with impact-supporters, such as Cohen or the Impact Weighted Account’s Serafeim, that we ultimately don’t only need to run our companies and investment firms more responsibly and with multiple stakeholders in mind we also need to focus on the right problems to solve. Climate change (Climate50) and economic inequality (Predistribution Initiative) should likely be very high up that list.
Being precise about the differences and understanding the limits of ESG is a crucial condition for implementing it in a beneficial way. As a matter of fact, even American regulators are of exactly the same opinion; not only is the SEC currently investigating various VCs around their governance duty in the FTX case. They are also looking into the ‘unprofessional nature’ of some private equity firms’ communication and deal making (e.g. using WhatsApp).
Overall, we believe that VC and other investors – including their portfolio companies – wouldn’t suffer from the rigorous implementation of some more professional standards and ‘good definitions’; let’s start with ESG and while we’re at it let’s learn from the mistakes made in the public markets.
Johannes Lenhard is co-director of VentureESG and researcher affiliate at the Minderoo Centre for Technology and Democracy at the University of Cambridge.
Hannah Leach is a partner at Houghton Street Ventures and co-founder at VentureESG.