Where other asset classes have blazed the trail towards the integration of impact considerations on the environment and society, Venture Capital seems to be lagging behind.

However, startup failure stories together with creeping ESG regulation signal that VC is on a head-first trajectory towards the widespread adoption of ESG considerations. But what is most frequently left out of the conversation is the ever more evident responsibility the venture capital industry has in this transition and how ESG themes can be effectively integrated into all stages of the investment process.

On one hand, it should not come as a surprise that VC is ideally placed to instill the importance of ESG in the technology leaders of tomorrow. On the other, the question of how to properly tackle this matter is swiftly taking shape.

If venture capital managers still needed convincing that ESG should be a priority, 2021 has provided plenty of evidence to dispel any remaining doubts.

The experience of the food delivery company Deliveroo, which crashed at IPO after being shunned by a host of institutional investors over concerns about its treatment of workers and governance arrangements, showed that ESG considerations have a direct bearing on the valuation of portfolio companies. The shift in attitudes among investors is gathering pace: by 2025, half of all professionally managed assets are expected to be governed by an ESG mandate, compared to 26% in 2018.

ESG scrutiny is also becoming part of the regulatory system for private markets investors. In Europe, VCs now face requirements under recently-enacted European Commission regulation to disclose how they consider sustainability risk as part of their investment process.

The question the VC industry faces is not whether to adopt a more stringent ESG approach to investing, but how. Will managers see the need to account for the environmental, social and governance dimensions of each potential investment as a burdensome obligation? Or, as we would advocate, will they consider it an opportunity to improve how they invest and do more for their portfolio companies, LPs and the global community?

To reach a consensus regarding the industry’s approach to ESG, we should remind ourselves of the distinctive role that VC plays in markets and the economy. From the wiring of the global financial system to the future provision of healthcare and the emerging world of work, tomorrow’s economy is being engineered by technology companies – exactly the companies that VCs help support and grow.

It is VC investors who come in on the ground floor, sitting on the board, providing advice when a startup’s culture and practices are being formed, and helping set the standards that will accompany its growth at scale. This influence means few investors are better positioned than VCs to help implement the attitudes and structures that will shape a generation of socially and environmentally beneficial companies. As the US VC General Catalyst has argued in its manifesto for responsible innovation: “we can no longer engineer solely for growth; we must embrace the right constraints, transparency, and framework to engineer for growth and good. We also must set a new standard for what defines a successful company in the modern era.”

The potential role of VCs is also magnified by their reach across the start-up ecosystem. A VC’s ability to share insight and cross-pollinate best practices across their portfolio is already one of their most important roles. This same network effect means they are equally well placed to be a catalyst for effective ESG practices: sharing what works and providing advice based on proven experience.

How might this work in practice? It must begin at the due diligence stage, where ESG needs to be a key area rather than an afterthought, and investors should not spare the expense of employing external advisors to help them understand specific areas of risk. VCs need a systematic way of capturing relevant data and assessing the materiality of ESG factors to current and future financial performance. While there are no certainties in startup investing, VCs must be as thorough as possible in identifying ESG risks or shortcomings that will need to be corrected. A good benchmark is to consider how rigorous they are about modelling financial prospects, and apply the same standards to ESG.

VCs must then bring forward the same attitude with the companies they decide to invest in. It is not enough simply to be a watchdog at the decision stage of an investment. ESG is a broad spectrum encompassing a range of complex issues, including but not limited to, employment quality and conditions, racial and gender equity, privacy and ethical use of data, cybersecurity and energy management.

Scrutinising every aspect of their ESG footprint and scanning the horizon for risks is a challenge for any business, and especially for startups that are working around the clock to establish awareness and market share. That is where a responsible investor will roll up their sleeves: asking the right questions, helping young companies to access the resources and expertise they may need in specialist areas, and ensuring that ESG benchmarks are tracked with the same care as financial equivalents.

The responsibility of VCs as investors in this area is therefore twofold: to ensure that they do not support companies with evident ESG flaws to begin with, and that they work with their portfolio companies on an ongoing basis to ensure they meet the highest possible standards.

This work is badly needed, with the industry’s acceptance of the need for rigour around ESG still at an early stage. As a report for the Harvard Kennedy School observed last year, “venture capital has lagged behind other asset classes, with no systematic approach to screening, managing or reporting ESG performance or other societal considerations specific to frontier technologies.”

As this suggests, VC has some catching up to do. But as an industry, we can also recognise and grasp the opportunity to lead on ESG. No other part of the investing world has the same power to influence and guide companies that are developing the technologies and platforms of the future. It is time that the industry’s practice around ESG stepped up to unlock this promise.