ESG due diligence - How it's done & why
ESG due diligence - How it's done & why
Investing in today’s corporate environment is more challenging than ever. Issues such as carbon emissions, human rights violations, and corrupt governance create complex risks that can cripple investments while increased regulations and market volatility complicate these issues even further.
To navigate these concerns and mitigate risks, both investors and stakeholders are focused on aligning investments with ESG (Environmental, Social, Governance) principles. A recent Fidelity International study found a strong linear relationship between high ESG ratings and portfolio performance. Companies with strong ESG ratings are outperforming their non-ESG focused competitors. In fact, non-ESG compliant businesses are now perceived as riskier investments.
The way a company handles ESG issues can affect its long-term performance and valuation. Because of this, more investors are insisting that ESG factors are specifically included in the due diligence process to better manage risk and enhance performance.
What is ESG due diligence & why is it important?
In short, ESG due diligence should provide data and insights into the success and value of a company’s ESG performance and policies. Many investors are beginning to require ESG due diligence reports, which include differentiation between each of the ESG criteria.
For example, environmental issues can include pollution, exposure to extreme weather, carbon management, and use of scarce resources. Social issues can include product safety, human rights, worker safety, customer data protection, and diversity & inclusion. Governance issues can include factors such as accounting standards compliance, succession planning, anti-competitive behavior, and a strong ESG management process.
ESG due diligence sheds light on a company's controversial or illegal behaviors while providing insight into positive ESG actions and programs. These reports and data help investors make sound, ethical investment decisions that support the primary purpose of all due diligence: risk mitigation.
The ESG due diligence process helps investors mitigate risk by better understanding the acquisition’s risk profile and risk exposure. For example, engaging with a company where human rights violations in the workplace have been discovered can damage the company’s reputation and impact returns.
The due diligence process helps investors identify red flags before a transaction occurs. This process also helps identify if the company has solidified routines and procedures that help prevent violations or relevant laws and regulations.
Investors should keep in mind that there’s no one-size-fits-all approach to ESG due diligence since standards vary widely from sector to sector. For example, ESG due diligence for an oil and gas company might report on their environmental impact in greater detail, while a company in the financial industry may place greater emphasis on social and governance factors. ESG standards should be measured by sector, tailored to individual companies, and take geographic regions and business models into account.
How does the ESG due diligence process work?
The ESG due diligence process should start early, ideally at the same time as other due diligence processes. Since ESG due diligence can uncover deal breaker issues, such as child labor, it’s best to uncover those issues as soon as possible. Delaying the process means considerable risks and opportunities for improvement might be missed or discovered too late.
To begin, create a checklist and template that guides decision making and identifies KPIs (Key Performance Indicators). This framework helps steer implementation and will shed light on all the ESG issues to consider. All parties involved should agree on a common ESG strategy, policy, and execution.
When establishing consensus on ESG principles, here are some steps to follow:
- Begin with a desk review by collecting, organizing and merging all key documentation
- Interview company stakeholders such as employees, board members, and C-suite executives
- Run background checks on key personnel to uncover current or previous corruption
- Consider conducting an accounting analysis or transaction testing
- Perform on-site visits of existing facilities or new project sites if relevant
- Conduct an ESG risk assessment
After this is completed, firms can generate an analysis and make recommendations. At the end of the ESG due diligence process everyone should have a clear understanding of the company’s operations, business plan, along with ESG impacts and risks and how management plans to address or capitalize on those issues.
ESG due diligence best practices
While standards and regulations around ESG remain unstructured and due diligence must be tailored by industry and sector, there are some best practices emerging within the private equity industry.
Create a formal ESG policy
Developing an ESG policy provides documentation that can be shared with stakeholders and offers a guideline for the due diligence process.
Concentrate on ESG materiality
Since all sectors and industries are different, not all ESG issues will apply to every company. Focusing only on the material ESG issues and risks relevant to the investment will ensure proper due diligence.
Focus on climate risk
Climate change is a major area of focus within ESG considerations. Of all ESG issues, climate risk is a factor that investors and regulators look for within every company, regardless of industry. Make sure climate risks and issues have been taken into account during the ESG due diligence process.
Gather & track data
Measurable ESG-related KPIs provide tangible data points by which investors can monitor and track ESG efforts. Identifying and tracking baseline efforts and analytics prior to acquisition ensures improvements, challenges, and opportunities can be identified and addressed.
Beware the clock
Due diligence takes time, especially when ESG considerations are added on. When running up against limited time and competition, some firms may try to cut the process short, which has the potential to wind up hurting the investment. Incorporating ESG considerations into the due diligence process early on supports stronger time management and ensures a better investment outcome.
The beneficial outcome
ESG management principles provide a foundation for alignment and consensus between investor and manager interests while supporting responsible, sustainable investment decisions. The inclusion of an ESG due diligence process produces a greater return on investment for portfolios, investors, and society as a whole.
Ultimately, ESG due diligence protects against the environmental concerns, social red flags, and governance issues that can depreciate the value of an investment. The benefits of risk awareness and mitigation far outweigh the investment of time and resources spent through a thoughtful diligence process.