The growing importance of ESG due diligence

By Michelle Bennett, Dora Banyasz, Emily Turnbull, Kye-Ren Cheong
Environment, Social, Governance Mergers & Acquisitions Risk & Compliance

Relevant to acquisitions, investments and business opportunities 4 min read

Environmental, social and governance (ESG) issues are a major focus for many companies, their stakeholders and regulators. Companies are exploring how to embrace the opportunities that may arise from a well-executed ESG strategy and navigate the risks that ESG issues present, particularly in a period of evolving laws and standards, stakeholder expectations and shareholder activism.

A key step that companies can take to identify and assess ESG issues is to conduct due diligence that focusses on ESG matters. This is particularly relevant if you are assessing potential investment, acquisition or expansion opportunities (such as entering a new market, sector or jurisdiction).

This Insight, along with the accompanying video, considers the importance of ESG due diligence and outlines the key elements for you to consider.

Key takeaways

If you are considering potential acquisition, investment or expansion opportunities, ESG issues should form part of your due diligence exercise. We suggest you:

  • assess an organisation's structure, strategy and operations for ESG risks and compliance;
  • think beyond the transaction and consider the ESG issues facing the purchaser and the target post-transaction, including the country or sector in which they will operate or the ESG impact of a new product; and
  • utilise the right tools and experts to conduct ESG due diligence effectively.

Why is ESG due diligence important?

While not a new phenomenon, ESG issues are becoming more prominent and influential in decision making, from board level and down across a range of sectors and industries. Pressure is emerging from multiple angles – regulation, investors and communities – to have a proactive approach to these issues.

In addition, a company's ESG credentials are becoming increasingly relevant. They can have an impact on a range of factors, such as a company's growth opportunities, outcome of project bids, ability to attract finance, employee satisfaction and morale, and customer retention and growth.

Shareholder activism focused on both environmental and social issues is also on the rise. We have previously reported on the shift in investor sentiment towards ESG issues and the potential for ESG-related litigation to rise in Australia.

Consequently, assessing an organisation's ESG performance and identifying current and potential risks and opportunities is an important step in ensuring you are making well-informed investment and strategic decisions.

Moreover, financiers are also increasing their focus on ESG issues. We expect that financiers may specifically require purchasers to have conducted ESG due diligence before providing financing. Similarly, this may become an area of greater focus for W&I insurers when issuing insurance for M&A transactions.

ESG due diligence from an M&A perspective

ESG due diligence is no longer restricted to 'traditional' assessments of hard law compliance issues. It can be more effective and valuable when a broader approach is adopted that considers both:

  • legal and regulatory compliance; and
  • the commitments a company has made and the international policy positions it has adopted (where relevant).

icons-esg-disputes_3_disclose.pngLegal and regulatory compliance

For example, ESG due diligence might cover issues such as human rights (eg risks of modern slavery or forced labour in operations or supply chains, or indigenous engagement, including whether or not free, prior and informed consent has been achieved when required), net zero transition risks, impact on the environment, employment arrangements and whistleblowing, anti-bribery and corruption, anti-money laundering and sanctions, together with assessing the company's policies systems and procedures to identify and manage these ESG issues.

icons-esg-disputes_2_duties-of-care.pngA company's commitments

Taking the net zero transition as an example, it might be relevant to assess any climate-related commitments made by the target company and the plan to achieve these commitments, together with the implications the climate target may have on any existing commitments the purchaser may have made (ie will buying this target company make achieving those commitments more likely or more challenging, and what steps might need to be taken to address this?).

In the case of a potential acquisition, the key steps in an ESG due diligence may involve:

number_blue-50x50px-1.pngan assessment of the target's material ESG risks, depending on the target's industry and business;

number_blue-50x50px-2.pngbenchmarking the target's ESG policies and procedures against peers and sector best practice to identify gaps and opportunities for improvement;

number_blue-50x50px-3.pngassessing the target's compliance with regulations, soft law and voluntary commitments, including reviewing the target's existing corporate policies and governance structures; and

number_blue-50x50px-4.pngconsidering the alignment of the target's commitments, policies and structures with those of the purchaser and the implications of any key areas of difference.

ESG due diligence in other contexts

Due diligence in other contexts, such as before engaging with a new third party, entering a new country or issuing a new product, is key to mitigate potential legal, financial and reputational risks and leverage any ESG related opportunities. ESG due diligence is a risk-based exercise and may include the following considerations:

  • reviewing the ESG rules and regulations of the target country, including both hard and soft law standards;
  • conducting ESG risk assessments of potential business partners and third parties;
  • considering the ESG impact and risks of a new product or service (such as climate change risk and labelling and responsible marketing); and
  • assessing alignment with relevant international and soft law standards (such as the Paris Agreement on climate change).

The focus of such due diligence steps will depend on the circumstances – in some situations it may be necessary to look broadly across all issues that fall within ESG, while in others the due diligence may be more focused on particular environmental or social issues.

Practical due diligence tools like checklists can be valuable in assessing, and generating evidence of, a company's compliance with ESG standards.

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