ESG due diligence is a term we increasingly hear when companies make investment and strategic decisions. But what does ESG due diligence really mean — and what should organizations be doing to ensure their due diligence is on point when it comes to ESG?
ESG Due Diligence Meaning
Due diligence, by definition, identifies risks in any corporate transactions, mergers or acquisitions, or investments in potential suppliers or projects. ESG due diligence is no different but focuses on risks brought about through an organization’s environmental, social and governance practices.
ESG due diligence comes into play in a few specific scenarios:
- In investment decisions
- In M&A decisions
- When working with third parties
Why Is ESG Due Diligence Important?
As ESG investing evolves from an ethically-sound approach to a strategy with proven business returns, investors seek out businesses with robust ESG rankings that can demonstrate sound metrics around sustainability, social responsibility and governance.
When companies are looking to merge or acquire other businesses, again, ESG due diligence comes to the fore. The importance of ESG due diligence is evident because, as the International Bar Association put it from a legal perspective, “Without a thorough risk assessment, buyers may acquire a non-compliant company that brings with it the risk of significant reputational damages, fines and lawsuits.”
ESG is also increasingly critical as a differentiator when candidates are shortlisting potential employers. A 2021 report by Washington State University found that, among Generation Z workers, 83% want to work for an organization where they can positively impact the world, with 70% wanting to work for a company whose values align with their own. Acquiring or investing in an organization that doesn’t meet these aspirations will make your talent attraction and retention far harder.
And it’s not just within your organization that ESG is important. Ethical and sustainable supply chains are an intrinsic part of the ESG discussion for businesses who want to ensure they are far removed from issues like modern-day slavery or poor ecological practices.
Carrying out the requisite ESG due diligence on your existing and potential suppliers will stand you in good stead.
But, as with any complex business strategy, there will be those who look for shortcuts and overstate their performance. Accusations of greenwashing have been rife, and although impartial ESG rankings are becoming more commonplace, there’s no substitute for also doing independent investigations into any company you are looking to acquire, invest in or partner with.
ESG Due Diligence in M&A
If your organization considers merging with or acquiring another, due diligence has long been part of the process. In the past, this would have confined itself to issues like the balance sheet, pensions commitments and similar financial considerations.
Today, any M&A activity brings with it the risk that you are aligning your company with one that doesn’t share your ethics. If a business has taken a less-than-rigorous attitude to environmental, social and governance issues, it can threaten your profitability, regulatory compliance and reputation.
Law firm Shearman & Sterling notes that “A company’s failure to understand and properly address key ESG factors in its business is increasingly viewed as a significant risk to the company’s long-term value.”
This isn’t a risk that any acquirer wants to take; what may have looked like an attractive opportunity to expand your business turns into a reputational and financial nightmare.
ESG Due Diligence in Investment Decisions
Today, investors want to be sure that the businesses they are investing in have ethical, sustainable, and well-governed policies.
Strong ESG performance can not only improve your balance sheet, but it can also make it easier and cheaper for you to borrow money. Some banks are linking interest rates on business loans to the company’s ESG standing, as ING did in a loan to Philips in 2017.
As potential investments, then, organizations that perform strongly on ESG metrics are more likely to be a good bet with investment returns growing and less volatile share prices. They’re also less likely to fail.
Carrying out meticulous ESG due diligence when making investment decisions is therefore non-negotiable, reducing your risks and potentially increasing the upsides of any investment.
ESG Due Diligence in Your Supply Chain
Looking outside your organization to companies you partner with and give business to should be a fundamental aspect of your ESG due diligence. Your suppliers and any organizations acting on your behalf are an extension of your business; if they fail on ESG, your name will also be tarnished.
Vetting suppliers and business partners on their environmental, social and governance strategies give you assurance that your buying decisions and strategic partnerships don’t pose an ESG risk to your organization.
Where Do I Start?
Making a start on ESG due diligence can seem overwhelming, with a plethora of considerations and possible criteria. Break it down into some simple steps, though, and the process becomes more manageable:
- Be clear on your ESG stance and priorities. ESG is a broad concept, covering everything from carbon footprints to board succession planning.
- Ask yourself some questions about your organization’s approach to ESG. What elements of ESG matter most to your organization? Which poses the most significant risk? Where are you trying to get to in the future on ESG? What would an acquisition target, investment or supplier need to look like to align with your answers? Then put in place an ESG due diligence checklist that reflects your priorities based on risk and opportunity.
- Utilize existing policy. It’s likely that you already have a due diligence checklist for corporate transactions, supplier onboarding or investment decisions. Your current due diligence processes should form the basis of your ESG due diligence; if you have a process that works, incorporate questions and data requests on ESG into that existing approach.
- Some organizations use a third party to carry out due diligence on their behalf, maybe their law firm or another advisor. If this is the case for you, ensure they are up to speed with your aims to expand your due diligence to cover ESG.
- Explore the potential of technology to support your ESG due diligence. This may be using metrics or outputs from an ESG governance solution that you already use to measure your efforts and inform your due diligence checklist. It may mean capturing this due diligence in a proprietary solution. However you make use of it, technology can make your ESG measurement and due diligence processes more failsafe, streamlined and effective.
The Role of an ESG Due Diligence Checklist
When putting in place an ESG due diligence framework, a checklist can help. An ESG due diligence checklist might include:
- Geographical information: Where does the company operate? What is the regulatory landscape in each geography?
- Sector information: What industry is the business in; what activities does it undertake? Does this have implications for ESG, with specific risks or requirements?
- Company structure: How complex is it? Does this have inherent risks for oversight of ESG? Does the company demonstrate an integrated approach to ESG risk across its entire footprint?
- Financial considerations: Who does the company owe money to? Are there ESG ramifications for any debts?
- Regulatory performance: How has the business performed on regulatory compliance? Are there any non-compliances you should be aware of?
- ESG rankings, ratings and disclosures: Does the company follow best practices when it comes to ESG disclosures or takes a tick-box approach to comply with mandatory reporting? How does it score against competitors on ESG performance measures?
- Reputation: Has the organization been the subject of adverse media reports, shareholder actions or other reputational issues? What results does a web search of the company name bring up?
- Questions like: How does the company manage ESG governance? What systems and solutions do they have in place to identify ESG risks, measure performance and identify mitigations?
Make the Right Decisions by Honing ESG Due Diligence
ESG due diligence is fast-becoming a non-negotiable element of any strategic decision. While it is complex and can seem daunting, for conscientious and risk-aware organizations, your existing due diligence processes are likely to give you a good foundation for any ESG due diligence you need to undertake. Use the checklist above to form the basis of the ESG questions you need to weave into your current approach.
Build Your ESG Expertise
There’s no doubt that ESG is enmeshed in business strategy and decisions — and rightly so when ESG performance can have such a quantifiable impact on performance. But its rapid ascent from nice-to-do to business imperative — and its multi-faceted nature — can make ESG a formidable challenge for corporate leaders.
Many feel under-prepared to tackle the growing criticality of ESG issues, particularly around climate change, where disclosure requirements, expectations and regulations are evolving fast. That’s why Diligent has launched the Climate Leadership Certificate Program.
The program prepares corporate leaders to oversee climate risk and identify how to create sustainable growth strategies for your company in a world of climate change. Offered in an interactive eLearning format, the program can be completed in as little as four weeks or 12 months, depending on your availability and preference. Find out more here.
You can also sign up for Diligent’s regular newsletter for updates on current environmental, social and governance challenges, new regulations and disclosure requirements (like the recent SEC announcement), and to hear from industry thought leaders. You’ll never receive spam, simply bi-weekly updates to help you implement ESG due diligence.