In any transaction, private or public, ESG issues now require the same detailed due diligence traditionally paid to financials. Increasingly, dealmakers recognise that almost any acquisition brings with it a series of ESG risks that are, at the same time, highly material, hard to quantify and subject to shifting goalposts.

Take environmental risk. Acquiring a company also means acquiring the future costs of its carbon emission, says Nicholas O’Donohoe, CEO of CDC Group. “If you don't factor the cost of those into your model,” he says, “you run the risk of having significantly lower financial returns than your model would otherwise suggest.”

With shareholders and regulators intensifying scrutiny of companies’ ESG practices, dealmakers are in a race against time to improve ESG diligence. From a buyer perspective, it is vital to avoid overpaying for targets, while sellers must identify and minimise their ESG risks in order to maximise value when exiting.

The many faces of ESG risk

ESG risk takes different forms. Failure to disclose an environmental, social or other issue, or a gulf between ESG commitment and action, creates a risk of litigation post-transaction. Such risks may be intensified within going public transactions, given rising ESG disclosure requirements in many markets.

Identifying risk becomes more complex as guidelines, such as those being prepared by the Task Force on Climate-Related Financial Disclosures (TCFD), demand risk visibility throughout companies’ supply chains. John Cullen, Chairman of Aon’s EMEA M&A Advisory Board, advises potential sellers to get a handle on this well before they start thinking about exit: “Your tier-two suppliers and their network will start to drive the ratings you get … If you haven't thought about it by the time you come to exit, you could be saddled with a supplier’s environmental issue.”

ESG, of course, refers to more than climate change. The pandemic-related emphasis on human-capital issues has thrust the social component of ESG to the fore. Issues such as employee engagement, loyalty and wellbeing, corporate purpose and overall workforce resilience all play a part in the social component and should be part of M&A due diligence.

The requirements for disclosure of social practices are currently less well defined than they are for environmental practices. “In our research, we found that the social element of ESG disclosure requires further attention from issuers,” says Claire Dorrian, Head of Sustainable Finance, Capital Markets, at the London Stock Exchange Group (LSEG). “In some cases,” she says, “companies with a good level of basic social policies in place may not disclose them, because it’s assumed that investors are taking them into account already.”

Social due diligence should, at a minimum, seek visibility in areas such as wage rates, avoidance of child or forced labour, or a company’s health and safety track record.

The risk of litigation involving ESG comes into play not only with failure to disclose, but also when a gulf comes to light between disclosure, intention and action. According to Meredith Jones, Aon’s Global Head of ESG, “If management says they’re going to increase the diversity of their workforce by a certain percentage and they don't do it, that can cause litigation. If they say they’re going to get to net zero but don't do anything about it, that can cause litigation.”

The quest for clarity

Due diligence into ESG practices is additionally complicated by confusion about how their impacts are defined and measured. This lack of clarity can result in deal parties misunderstanding the risks that exist and/or underestimating the value-creation opportunities a company’s ESG practices offer. “Everyone is thrashing around trying to work out what is material, what is reasonable, what is commercially sensitive or what is commercially effective,” says Adam Young, Head of Equity Advisory at Rothschild.

When it comes to PE firms, Carlisle White, ESG Manager at Copenhagen Infrastructure Partners (CIP), holds a similar view: “The concept of ESG is not sufficiently defined in the industry just yet. One of the biggest areas of confusion is how exactly ESG creates value. This is still an abstract concept for a lot of people.”

A first step to gaining clarity is to start thinking about ESG in terms of materiality: that is, the impact those practices have on the company’s financial condition. “There are many corporates and PE firms that still confuse ESG with ‘being nice’, when they should think of it more from the standpoint of enterprise risk management and potential value creation,” says Meredith Jones.

A way of doing this, and thereby reducing confusion around ESG practices, is to start thinking about them simply as good business practices. Caroline Cormier, Vice President of Corporate Strategy at Upfield, a producer of plant-based foods, believes that existing ESG labels make researching and monitoring ESG practices more complicated than necessary. “ESG targets should become as embedded in the business as financial targets,” she says. Cormier is hopeful that this will be the case in most businesses within five to ten years.

In Europe, at least, greater clarity around ESG is on the way. “The EU is defining sustainable investments on multiple levels,” says Carlisle White. “This includes the technical requirements, such as climate-based thresholds, as well as what social impacts are linked to that investment. That is a huge step forward.”

The ever deeper embedding of ESG in the DNA of businesses – and in investor considerations – bears comparison with the evolution of digital technology earlier this century. Once considered an add-on to business models, digital is now at the core of many, if not most. Deeper assessment of companies’ digital assets and practices is increasingly influential in investors’ valuation processes today, and cyber security is also highly material in an ESG risk context. The increasing thoroughness with which investors are now digging into digital credentials is perhaps a good indication of how ESG diligence must evolve.