Growing investments in sustainability
Interest in sustainable investing has grown significantly over the last 7 years, totalling $13.3 trillion in 2012 and more than doubling to $30.7 trillion by 2018. Over the next 15 years this number is expected to reach over $150 trillion.1
Once considered a niche of the investment world and at times labelled as philanthropy, investors worldwide have come to realise the value – morally and financially – of incorporating ESG (Environment, Social and Governance) considerations into their investment decisions. Venture capital, as much as any other asset class, is one field where this interest for ‘responsible investment’ has gained momentum. To achieve sustainable development at scale, it will be key for early stage investors to channel the right amount of capital to the future ‘green swans’2 that will leapfrog market constraints and scale solutions to age old problems.
Leading this momentum are large funds such as the newly launched Climate Pledge Fund (launched by Amazon in 2020), that aims to invest in sustainable technologies across various industries:
“The Climate Pledge Fund will look to invest in the visionary entrepreneurs and innovators who are building products and services to help companies reduce their carbon impact and operate more sustainably,” Amazon CEO Jeff Bezos said in a statement. “Companies from around the world […] will be judged on [their] potential to accelerate the path to zero carbon and help protect the planet for future generations.” 3
However, as the famous adage goes: “not everything that counts can be counted and not everything that can be counted counts”. While identifying future unicorns is a key challenge in the venture capital industry, judging a company’s “potential to accelerate the path to zero carbon” adds an additional layer of complexity.
In other words, investors are facing the following puzzle: how can they ensure that the companies they invest in can deliver on their sustainability claims without causing other negative social or environmental impacts? Our answer: this can be achieved through the expansion of the typical due diligence process and continuous monitoring by the right experts.
Expanding due diligence
A due diligence process for early stage investments typically involves a screening due diligence (i.e. does the investment fit the fund’s mandate criteria, what problem is it addressing and what is the proposed solution); a business due diligence (i.e. product market fit, financial history, business model, and track record of the founders), a technical due diligence (i.e. viability, feasibility and reliability of a product) and a legal due diligence, before moving onto a financial valuation exercise. The aim of this process is for the investor to assess the probability of a desired return on investment.
Investing in sustainable early stage companies, however, brings another element that requires investigation into the picture – sustainability claims. This is often one of the most challenging aspects of a startup to assess as investors often lack the expertise required to thoroughly test assumptions and do in-depth technical analyses of innovative technologies. Furthermore, the startups themselves often lack the necessary insight needed to truly understand the impacts of their technologies or business models.
This is where it becomes useful to involve sustainability experts in the due diligence process. Not only do they understand environmental and social impacts and how these can genuinely be addressed, but they also often have a good understanding of the markets in which these companies operate.
The process outlined below has been tailored for cleantech companies aiming to help mitigate climate change but could also be adapted and applied to companies addressing other environmental or social problems.
Step 1 – Preliminary screening
As argued previously, the basis of any due diligence process requires a basic understanding of the company, the market in which it operates, the technology it is developing as well as its competitive landscape. Additionally, from a sustainability perspective, it is important to assess what technologies or business models the company is competing with or hoping to replace and what the claimed impact of this will be. Any sustainability claims should be assessed according to:
- Reliability – how reliably can it be proven that this claim is always the case?
- Relevance – is the claim relevant to a genuine issue?
- Clarity – is it clear what problem is being addressed?
- Transparency – how easy is it to assess the truthfulness of the claim?
Furthermore, all risks related to the company and product should be identified and assessed – technical hurdles related to scaling-up, market adoption, and regulatory and legal risks are some examples.
Step 2 – Impact assessment
This is one of the most important steps in assessing the true impact of the company’s product or business model. In this case, the aim is to carefully assess the impact on carbon emissions as a direct result of the company in question. For example, a company might claim that their diesel made out of recycled plastic reduces CO2 emissions per litre by 2kg. To check this claim, a lifecycle emissions assessment is carried out, in accordance with the GHG Protocol Product Life Cycle standard4, to determine the amount of CO2 released during the production and use of this fuel. This can then be compared to the emissions associated with normal fossil-fuel derived diesel.
This allows us to calculate the Emissions Reduction Potential (ERP) of the fuel in question. This value might differ according to the regions it is sold into due to differences in production processes, transport, use of biodiesel, etc. so it is important to also consider the potential market(s) that the company plans to enter and calculate different ERPs for each region.
Once the ERP has been calculated it is possible to determine the Potential Climate Return on Investment (pCROI) that the investor might realise from their investment. This figure indicates the emissions reduction (or sequestration) from their investment in the company, in other words CO2 mitigated per € invested.
Step 3 – Monitoring and Auditing
Due diligence should not stop once the investment has been made. Continuous monitoring allows investors to gauge the impact of their investments and whether they are living up to their claims and ambitions.
To achieve this, we offer an investment dashboard which provides up to date KPIs, such as climate return on investment and cumulative reduction in emissions, for all the investments within a certain fund.
Data is collected directly from the investee and any changes to the technology, production process, business model, etc. is considered and the ERP recalibrated when necessary. Access to this information and expertise is not only beneficial to the investor but also to the startup who might lack the ability to accurately assess the impact of their strategic decisions.
The increasing threat of climate change and other sustainability issues facing our society has created business opportunities for some of the most innovative entrepreneurs around the world. Recent research has shown that Cleantech startups, for example, have, on average, higher technological capabilities compared with all other startups5.
Investors have been quick to identify this field as an attractive investment opportunity not only financially but also from a moral standpoint, which has created a need to also innovate the way due diligence is typically conducted.
With the involvement of the right experts, investors can ensure that these investments create the positive impact that they are promising while also providing an attractive financial return. In doing so, capital and resources will flow to the business models and technologies that have the most potential to help transition us to a better future.
- Elkington, j. (2020). Green Swans, The Coming Boom in Regenerative Capitalism. Fast Company Press.