As stakeholders and governing bodies coalesce behind the understanding that Environmental, Social, and Governance (ESG) considerations carry significant financial risk, ESG due diligence is set to become a standard aspect of doing business.
Here’s a look at what’s coming in terms of regulations, and the role ESG due diligence plays in ensuring your business isn’t carrying – or taking on – undue financial risk.
Environmental, Social, and Governance Factors: A Quick Review
Before we dig into the news of the day, let’s examine what ESG means for your organization.
An evaluation of environmental, social, and governance factors is considered to determine the long-term health and prosperity of an organization. These areas are of the utmost importance to those in the financial sector who seek to make sound investments in organizations that are unencumbered by risk.
Environmental factors include carbon emissions, soil and groundwater pollution, waste disposal, material sourcing, biodiversity impact, and regulatory history.
Environmental factors are currently leading the way in terms of global awareness. The United Nations COP26 Climate Change Conference sparked a very real sense of urgency among governments and businesses to mitigate climate change, as both a matter of ethics and finance.
Social factors include human capital management and relationships.
This covers how your company manages people within your organization and handles relationships with customers, employees, suppliers, partners, and communities.
On the employer side, social factors include pay and benefits packages, DEI (diversity, equity, and inclusion), and employee well-being.
For your broader social impact, factors include customer protections, contractor relationships, human rights and fair labor practices of suppliers and partners, and your social impact within your community.
Governance comes down to how the board of directors runs your organization, including management of environmental and social issues.
This factor examines incentives and compensation for stakeholders and executives, as well as other forms of financial compensation. Conflict of interest, cyber security/data privacy, auditing, risk management, and issues of corruption fall under this umbrella as well.
Significant Changes Will Impact How Organizations View ESG Due Diligence
Due Diligence has traditionally been focused on downside risks in four areas: subsurface issues, contaminated infrastructure, operational compliance, and business risks. ESG has been added over the recent years as one of the key business risks, being demanded by stakeholders as an important factor in determining responsible investing. In other words, verifying that the target for due diligence is not encumbered with negative ESG factors that would jeopardize their investment.
Up until recently, stakeholders largely drove the need for ESG due diligence; however, regulations are now starting to play a significant role. New regulations and standards have been drafted that will set benchmarks for ESG disclosure requirements and accountability, particularly with publicly traded companies.
Proposed Regulations and Standards Set Benchmarks for Change
In March of 2022, the United States Security and Exchange Commission (SEC) released their proposed climate disclosure rules, detailing the metrics companies would need to disclose regarding Scope 1, 2, and in some cases Scope 3 greenhouse gas (GHG) emissions. If approved, these regulations would govern all publicly traded companies in the United States.
SEC Chair Gary Gensler said in a statement about the proposed regulations, "I am pleased to support today’s proposal because, if adopted, it would provide investors with consistent, comparable, and decision-useful information for making their investment decisions, and it would provide consistent and clear reporting obligations for issuers."
The SEC draft publication was followed closely by the International Financial Reporting Standards Foundation’s (IFRS) release of their International Sustainability Standards Board’s (ISSB) proposed standards for corporate climate-related sustainability disclosures.
As opposed to the SEC, the IFRS is not an official governing body, though their draft statement noted, “The ISSB is working closely with other international organizations and jurisdictions to support the inclusion of the global baseline into jurisdictional requirements.”
The Broad Reach of Reporting Requirements
These proposals signal a significant step toward environmental accountability for industries across the globe. While the SEC regulations only directly impact publicly traded companies within the United States, the inclusion of Scope 3 reporting for some organizations will have a ripple effect on companies within their value chain.
Scope 3 Emissions are those emissions that fall outside of the reporting organization’s responsibility under Scope 1 and Scope 2, but within their value chain. Taken a step further, the ISSB standards include Scope 3 emissions for all companies, which means that adoption of these standards in any jurisdiction could induce smaller companies to take a look at conducting their own ESG assessment to establish their value as a low-risk partner.
ESG Due Diligence as a Proactive Measure
Two aspects of ESG due diligence should come into play in your valuation process when considering a target on the buy side: (1) potential risks associated with an ESG-encumbered target; and, (2) value creation, post-acquisition. Both are equally important to your investors and stakeholders.
On the sell side, understanding the buy side intentions should cause you to take a proactive approach before entering into a sale of your business.
Benefits of an ESG Assessment
- Demonstrate to your shareholders, investors, or other stakeholders that you are making a responsible investment with third party due diligence reports;
- Through your due diligence, tangibly demonstrate to your investors how you will build value in the investment during your hold period; and,
- Ensure you are prepared for pending regulatory requirements once they come into play in your jurisdiction, post-acquisition (e.g., Scope 3 reporting requirements, SEC Climate Change disclosure requirements, etc.).
- Build trust in your negotiations with buyers through transparency and disclosure around ESG topics;
- Gather and align existing data and company metrics with ESG concerns; and,
- Secure your place in the value chain of potential buyers that must meet existing or pending regulatory reporting requirements;
ESG Assessments Make Good Financial Sense
Investors are seeing remarkable returns when they choose organizations with strong ESG factors. A comprehensive study by Morningstar Investments found that “77% of ESG funds that existed 10 years ago have survived, compared with 46% of traditional funds.”
Additional studies support these findings. A report by Fidelity International stated that “not only were returns for high-ESG portfolios greater in 8 of the study’s 12 industries, the ESG portfolios also displayed lower volatility across the board when compared to industry peers.”
Even though the proposed SEC regulations only apply to publicly traded companies, private equity firms are also paying attention to ESG. Sixty-six percent of respondents to a survey by PwC reported that value creation was the key driver for their ESG activity, outranking the previous leaving driver, risk management, by 26 percentage points.
ESG Due Diligence Is a Smart Move
As more jurisdictions around the world turn an eye toward ESG reporting requirements, including ESG in your due diligence is a must.
Knowing where your target (buy side) or organization (sell side) stands through data and in-depth due diligence reports gives you the ability to demonstrate wins via marketing programs aimed at consumers and investors alike.
For support on incorporating ESG into your due diligence reporting, reach out to our team of experts today.
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