How to Resolve the Conflict Between Long-Term ESG Benefits and Short-Lived Start-ups

Reporting on ESG metrics is a common practice among companies today. On the one hand, it may simply be necessary to meet regulatory standards. On the other hand, companies measure their ESG performance to meet their own ethical standards, win customers who prioritize sustainability, and attract investors who consider ESG in their investment decisions (Amel-Zadeh et al., 2018).

This semester, I studied how startups and small and medium enterprises (SMEs) could drive a sustainable transition as part of the SIRI Practicum course at Columbia University. Start-ups and SMEs often depend on venture capital, which raised a central question: how can investment for ESG-positive companies be incentivized?

While studies show that 75% of investors take ESG metrics into account when building their portfolios, most investors still prioritize financial returns above all else (Edmans et al., 2024). A founder’s business idea may be highly beneficial to society, but without competitive financial returns, they may not receive the necessary funding.

At first glance, it may appear to be 'bad news' that a recent study found no evidence that high-sustainability funds outperform low-sustainability funds (Pástor, 2019). If there is no higher profitability, then the 75% of investors who prioritize financial returns may not invest, meaning that startups and SMEs lack the capital they need. However, that study had a critical limitation: it only considered developments of U.S. funds between March 2016 and January 2017 - a very short-term window. Most high-sustainability businesses achieve their benefits over the long term.

This principle is already understood among long-term investors: “Long term institutional investors tilt their portfolios towards firms with better ESG profiles” (Starks et al., 2017). Real societal and transformative change does not come from investments that optimize short-term profit. It comes from investments with long-term targets that transform systems and sectors (Schol et al., 2019).

This, however, stands in conflict with the nature of venture capital. Start-ups rise and fall quickly, so long-term investments are not the norm. Start-ups and SMEs are under pressure to generate high returns for investors who typically seek rapid turnover.

This raises an important question: How can investors be convinced of the superiority of long-term ESG benefits over the short-term profits of low-sustainability projects?

Part of the answer comes from Pástor et al. (2022): green bonds tend to outperform brown bonds in periods when climate concerns intensify. The more society becomes aware of climate change risks, the more people are driven toward sustainable investments. In other words, when people perceive climate change as a present and immediate issue rather than a far-off threat, they are more willing to invest in green bonds.

Based on this, I propose two solutions to unlocking venture capital for ESG-positive start-ups.

First, climate risks and environmental damage must become more salient in public consciousness. This requires participation from media, policymakers, researchers, and educators who communicate the impacts that unsustainable behavior already has on modern society. When people see and understand climate threats - as they did during the 2019 Amazon forest fires - ESG investments will follow more naturally.

Second, there must be a financial mechanism that aligns the ESG goals of long-term investors with the short-lived nature of start-ups and SMEs. The risk of startup failure is too high for traditional long-term investors, creating a structural conflict. A dedicated pool of capital is needed - one that prioritizes long-term ESG benefits generated through startups and SMEs, absorbs the risk of some firms failing, and captures the value of system-wide transformation. Blended finance between the public and private sectors will be essential to de-risk these investments and incentivize the innovation needed for systemic change.

References

Edmans, A., Gosling, T., & Jenter, D. (2024). Sustainable Investing: Evidence From the Field. https://doi.org/10.2139/ssrn.4963062

Amel-Zadeh, A., & Serafeim, G. (2018). Why and How Investors Use ESG Information: Evidence from a Global Survey. Financial Analysts Journal, 74(3), 87–103.

Hartzmark, S., & Sussman, A. (2019). Do Investors Value Sustainability? The Journal of Finance, 74(6), 2789–2837.

Pástor, Ľ., Stambaugh, R. F., & Taylor, L. A. (2022). Dissecting Green Returns. Journal of Financial Economics, 146(2), 403–424.

Starks, L. T., Venkat, P., & Zhu, Q. (2017). Corporate ESG Profiles and Investor Horizons.