Decoding ESG For Start-ups

Vikrant Rana And Anuradha Gandhi

5 Dec 2023 6:00 AM GMT

  • Decoding ESG For Start-ups
    Listen to this Article

    What is ESG?

    ESG are a set of standards that are used to evaluate an organization’s non-financial performance. The standards rest on three pillars, ‘E’ for Environmental, ‘S’ for Social and ‘G’ for Governance.

    According to the 2021-22 Economic Survey, India has the third largest startup ecosystem (over 100,000 startups) in the world following after US and China. However, only 7% of startups have a net zero (emission of greenhouse gases being balanced by removal) plan in place. Startups have always been known as the drivers of innovation and creation of novel products and processes and are thus being turned to as the drivers of sustainable development.

    Environment and the startup ecosystem

    The following key elements constitute the environmental pillar of ESG:

    • Climate Change
    • Natural Resources
    • Pollution and Waste
    • Renewable energy
    • Carbon footprint
    • Waste Management

    The environmental risks and opportunity will vary depending upon your organization’s objectives, business model, industry, and state of development, funding sources and various other factors. For instance, Reliance and Tata Consultancy Services although both being organizations that fall under SEBI’s list of top 1000 companies by market capitalization have completely different ESG material issues identified based on their unique business objectives and stakeholder engagement.

    To explore this further, let us say there is a startup that creates custom jewelry based on your astrological sign, environmental risks pertaining to this business model could look like packaging waste, the mining practices, raw material sourcing and the emissions in their delivery process. Failure to manage packaging waste could result in fines and penalties and supply chain disruptions, and result in reputational risk if biodiversity loss is caused in the mining process. Failure to comply with regulations or future proof in preparation for regulations could result in regulatory penalties and pose exposure risk that could be a massive cost and could potentially shut down a startup.

    Social Responsibility of startups

    ‘S’ in ESG is about an organization’s relationship with all its different stakeholders. It involves examining existing policies against the principle of business ethics and how its practices affect society at large.

    The following key elements constitute the social pillar of ESG:

    • Diversity and Inclusion
    • Community relations
    • Payment of fair wages
    • LGBTQIA+ rights
    • Sexual harassment policies
    • Employee working conditions

    An organization’s values and mission statement is a reflection of its business ethics and these are the values to which the organization’s business strategy is aligned. ‘S’ has been in the shadow of environmental and governance factors due to historical lack of regulation and encrypted data. Additionally, the impact of policies has been difficult to measure and quantify. However, with changing consumer preferences and employee attitudes, ‘S’ has gained prominence and is becoming a vital part of an organization’s sustainability strategy.

    Governance for startups

    The following key elements constitute the governance pillar of ESG:

    • Cybersecurity
    • Board members composition
    • Tax compliance
    • Corporate transparency

    S&P Global research found that organizations that rank lower than average on governance factors are unable to capitalize on business opportunities over time.

    The four pillars of corporate governance are transparency, accountability, honesty and responsibility are key to successful corporate culture and building a foundation of trust with key stakeholders. Effective ESG strategies are key to mitigating governance challenges mirrored by India’s lack of regulatory frameworks and institutional mechanisms and dearth of disclosure guidelines. In order for a startup to build its governing guidelines it must achieve a balance between implementing existing regulation whilst maintaining flexibility to adjust to evolving socio-political and cultural viewpoints. The Governance board must also consider its material risks to maximize shareholder value whilst creating conditions for long term investment to prosper.

    How ESG creates long-term value for startups

    1. ESG for investment:

    Foreign investment however plays a key role in funding India’s startup ecosystem accounting for more than 85% investments into the Indian startup ecosystem. Prior to investing in a startup, an institutional investor such as a venture capitalist typically conducts financial and legal due diligence risk assessments. In order to maintain a high valuation, the startups must ensure compliance with necessary laws from conception.

    Globally ESG investing has gained momentum post-pandemic with 90% of investors report giving greater importance an organization’s ESG performance and 86% investors considering decarbonisation efforts as key metric in their investment decisions as per an EY report

    ESG appears to be in its infancy in India, currently only 25 of 5180 investors headquartered in India have signed the UNPRI (United Nations Principles for Responsible Investing) additionally on 0.7 percent of bonds in the market are targeted at ESG companies and to top it all, these funds are focused on organizations tracking their environmental impact whilst leaving social and governance risks out of the picture. However, In line with India’s COP 27 target (reduce 45% of emissions per unit of GDP by 2030) SEBI introduced a number of mutual funds for ESG compliant companies to support the increasing need for green finance. In fact in 2020-21 investors poured over 500 million USD into Indian ESG mutual funds while the global whilst in 2018 the global ESG investment was 30 trillion USD with the potential to grow by a further 20 trillion over the next two decades.

    A 2021 PWC study found evidence of a link between investment and ESG strategies of a firm. It found that over 80% of investors surveyed reported that ESG was an important factor in their ESG decision making, 70% believed ESG factors should be incorporated into executive compensation, 50% were willing to divest from Companies that did not take sufficient ESG action. Although 75% of investors expressed that ESG factors were worth compromising short term profitability, 81% investors were not willing to accept more than 1% haircut of their investment returns. Investors also reported Scope 1 and Scope 2 emissions to be the most widely cited issue on the ESG horizon. Nearly 70% of venture investors and fund managers believe that ESG will matter more in 5 years.

    2. ESG for public funding:

    Government loan schemes are also an important source of funding for startups. SIDBI Fund of Funds launched a Green Finance Scheme for MSMEs covering sectors such as Renewable, Transport, Waste and Energy which had integrated ESG parameters. It achieved a 168% growth in outstanding green loans for the financial year 2022. SIDBI also has a risk sharing facility in place for energy efficiency projects, currently 13 Banks including SBI, HDFC, BOB and Canara bank have signed up as Participating Financial institutions.

    3. ESG stakeholder activism:

    Stakeholder activism is when a stakeholder (e.g.: Board of directors, customers, employees, local community, government) uses their equity stake in an organization to communicate a need for change. With the stakeholder view gaining prominence and increased demand for transparency and accountability. Increased ESG targets are changing the ways of corporate governance. Governance, rather than being dictated by a board of directors, is now considering views of its stakeholders from various backgrounds. Owing to the wide pool of stakeholders, a large number of KPIs and social and financial targets have been formulated to keep up with developing regulation. Additionally, Stakeholders are increasingly using social media to voice their issues and hold executives accountable which further drive coverage in traditional media. Meanwhile, Legal counsel is also moving beyond the traditional role of legal guidance and also leaning into managing stakeholder relations. Employees are also choosing their place of work based on the values and mission of the organization. In fact a study conducted by Marsh McLennan found that employers ranked high by employee satisfaction and attractiveness of talent had high ESG scores indicating that ESG can help attract and retain quality talent. This finding is in congruence with a study conducted by Mercer that found satisfied employees were more productive and the organization had a lower turnover rate. Demographic factors also play an important role in shaping the ESG landscape, Gen Z and Millennials are set to make up majority of the global workforce (72% by 2029), ESG efforts will become extremely important to attract and retain such talent.

    3. ESG long term pay offs:

    Analysis conducted by EY (Ernst & Young PVT Ltd.) Found a positive correlation of ESG factors with attractiveness to investors and financial performance. Due to there being a mismatch between the number of investors and attractive ESG investments, firms that implement robust ESG strategies will be able to secure a lower cost of capital.

    NYU Stern (New York University Business School) found that there is a positive correlation between ESG compliance and financial performance with 58% of its “corporate” studies reporting improved ROE (Return on Equity) and ROA (Return on Assets) in line with improved ESG performance. Additionally according to an analysis by EY Parthenon, sustainable companies exceeded their competitors on gross profit, EBIT (Earnings before interest and taxes), EBITDA (Earnings before interest, taxes, depreciation and amortization) and net profit.

    Additionally an Oxford metastudy: From the Stockholder to the Stakeholder found that ESG resulted in better operational performance in the case of 88% of the companies and had a positive influence on stock price performance in 80% of the cases.

    As stated by the evidence above, early ESG adoption can grant first mover advantage to organizations allowing them to capitalize on benefits such as better access to capital, subsidies, better relationship with external stakeholders and human capital ahead of their competitors.

    4. ESG product differentiation and brand equity:

    The FMCG sector in India is set to grow by a CAGR of 27.9% from 2021-2027 and be valued at 615.87 billion USD. With millions and billions of dollars being poured into this sector, it becomes a critical target for sustainability efforts.

    With increasing consumer awareness and demand for transparency, organizations are adjusting their value chains to integrate more ethical and sustainable practices ranging from ethical sourcing of raw material to using biodegradable packaging. The EY future Consumer Index found that consumers are demonstrating increased loyalty and affiliation towards brands that show a clear commitment towards integrating ESG into their business practices and purpose.

    5. Risk mitigation:

    ESG is essential for risk management as it allows organizations to plan for upcoming regulation, enhance voluntary disclosures as well as develop methodology to future proof their organizations against risk. Research suggests that organizations with severe or a high number of ESG incidents (incidents when ESG compliances are not adhered to) lose 6% of their market capitalization. Although startups do not face the same scrutiny as SEBI’s top 1000 companies by market capitalization, they are at a risk of exposure. Startups, without the safety net of major investors may not be able to recover from ESG exposure incidents.

    Is ESG feasible for startups?

    The chances of failure are very high for a startup owing to the significant pressure for economic survival. ESG implementation in India is still in its infancy being viewed more as a compliance than a strategic plan aimed at improving the organization’s performance. Nevertheless, SEBI’s latest mandate for ESG disclosures via BRSR (Business Responsibility and Sustainability Reporting) core calls to action the need for clearer ESG strategies.

    In order to implement an ESG strategy, any organization needs to conduct interviews, surveys and research to engage with stakeholders to identify ESG risks and opportunities, disclose KPIs, company performance. The following hurdles were identified with regards to adoption and integration of ESG strategies:

    1. Cost: The cost of reporting alone may see exorbitant, however with growing awareness of consumers and increasing regulation it may be more feasible to implement ESG practices and hire professionals while the regulations are relatively less stringent and the competition for ESG professionals is low.
    2. Many executives do not believe in carving out an ESG strategy as they believe that it has already been integrated into its DNA, however with rising claims of greenwashing having a quantifiable ESG strategy will be important for demonstrating ESG leadership and accountability. It will also help ensure stakeholders that ESG efforts are being incorporated into the organization’s business model.
    3. Lack of standards: Current ESG standards such as GRI (Global Reporting Initiative) or SASB (Sustainability Accounting Standards Board) are designed to suit corporates that are able to allocate resources for meticulous tracking standards. The highest priority for early startups is economic survival and attaining a product market fit. However there are certain standards that are better aligned towards the needs and resources of startups such as VentureESG or ESG_VC.

    Rather than companies worrying about striking the balance between gaining buy-in for their products and implementing ESG strategies, it was the organizations that had integrated ESG into their core practices that were able to scale and develop their ESG strategies as they grew. However, this should not deter startups from beginning their ESG journey, the sooner ESG strategies are integrated into the value chain, the easier and more effective ESG efforts become.

    Authors: Vikrant Rana, Managing Partner And Anuradha Gandhi, Managing Associate at S.S. Rana & Co.

    Celina Gandhi, Intern at S.S. Rana & Co has assisted in the research of this Article.


    Next Story