At least since BlackRock boss Larry Fink’s annual letter to CEOs in 2019, investing in ESG assets has become a major topic among both retail and institutional investors. In a new article, we address the question of how economically attractive investments in ESG-oriented startups are.
Net capital inflows into sustainability-oriented firms and funds are soaring, and so are the valuations of ESG assets. Yet, the economics of sustainable investing are controversial among practitioners and academics. While many industry reports point to the high net capital inflows and favorable valuations of sustainable assets, financial economists warn that ESG-investing hype could be driven by an unsustainable demand. The current focus on ESG could result in these assets underperforming once the high net-capital inflows begin to subside.
In line with the above skepticism, Schumpeterian economists argue that society will only transition to become more sustainable if new, more sustainable businesses disrupt incumbents via the dynamics of “creative destruction.” Thus, these economists argue that if society aims to achieve the United Nations’ Sustainability Development Goals, the focus needs to be on investing in ESG-oriented startups.
However, the same Schumpeterian economists have yet to answer the question of how to finance sustainability-oriented creative destruction. The problem at the core of the debate is that ESG-oriented startups face several additional constraints without being able to fully appropriate all the positive externalities from the good that they do. For example, a sustainable fishing startup incurs additional costs by getting certified and faces restrictions on where, when, and how to fish, yet it will not fully benefit from the long-term benefits of healthy oceans.
The example illustrates the core problem of ESG-oriented creative destruction: It may simply not be profitable in our capitalist society (at least as long as consumers and investors do not show a greater willingness to pay for more sustainable products). Therefore, large-scale government subsidies might be needed to effect sustainable change.
Our recent research addresses the question of how economically attractive startups are for entrepreneurs and investors. We looked at more than 1,000 crowdfunded projects that sold digital blockchain tokens to fund their ESG-oriented startups. This allowed us to obtain both valuation data during the crowdfunding and performance data after the crowdfunding (because tokens are typically traded in liquid markets). We also developed a machine-learning approach to measure the startups’ ESG properties (which is publicly available via an easy-to-use web app).
Our results reveal a pronounced valuation premium for startups with salient ESG goals. If a startup increases its “ESG-ness” by one standard deviation, it can raise 28 percent more financing. The result is important insofar as it implies that entrepreneurs have a strong economic incentive to adopt ESG goals in the first place, which is consistent with the Schumpeterian view.
Given that investing in sustainable companies is attractive for the average entrepreneur in our sample, the question is whether it is also financially attractive for investors to finance sustainable startups. The answer is: no.
Our study suggests that the more pronounced a startup’s sustainability orientation, the lower the investor returns after the crowdfunding event. Yet, despite the underperformance of ESG-oriented startups, investors still fund them. In fact, our analyses suggest investors are willing to accept financial losses of 16–31 percent per standard-deviation increase in sustainability orientation.
Overall, our study paints a relatively optimistic picture. Although sustainable entrepreneurship leads to relative financial losses for investors, investors are willing to accept underperformance to a certain extent and still reward ESG-oriented entrepreneurs with higher valuations, thus creating an incentive for entrepreneurs to adopt ESG goals in the first place. Therefore, assuming startup investors remain willing to pay for ESG, Schumpeterian dynamics of creative destruction may be a key catalyst for our society to transition to a more sustainable one.
The key take-away for policymakers is simple: ESG-oriented entrepreneurs will help make our society more sustainable for their own sake. If one wants to accelerate this evolution, the best way is through policies that encourage investments in startups.