What is ESG Due Diligence?

ESG diligence is the process of identifying and remedying environmental, social, and governance (ESG) risks. The intent is to understand the target's risk profile and risk exposure. This could include, for example, where the company operates, which sector the company belongs to and the company's business partners and customers. Any red flags should also be identified. Usually, an investor performs due diligence from a financial, operational, tax, legal and now-a-days technology point of view. In today's scenario where ESG has made its importance acknowledged globally, it is imperative that ESG due diligence becomes very much a part of the diligence exercise conducted before the investment. An ESG framework can well satisfy the expectations of the investors while fundraising.

Purpose of an ESG Due Diligence

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. 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.

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 focus 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.

Furthermore, preventive measures in the target should be identified and assessed, including whether the company itself has good procedures and routines in place for preventing violations of relevant laws and regulations. This will then provide a basis for assessing the "residual" risk in the company and whether there is a level of risk that is acceptable to the buyer or whether there are issues that should be rectified before completing the transaction.

Benefits of ESG Due diligence:

The investor gets the values and attitude towards non-commercial factors aligned to his perspectives. Along with the financial and commercial evaluations, the investment is also sought to be clear from an ESG point of view.

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 environmental concerns, social red flags, and governance issues that can depreciate the value of an investment.

How is ESG due diligence conducted?

With the objective to ascertain whether the investment is being made in an entity that values the ethos of Environment, Social and Governance, the due diligence is targeted to obtain answers which would allow the investor to take a well-informed call along with the commercial factors of investment. An ESG due diligence shall include, not exhaustively, checks around the following aspects of the business:

Environmental: 

Environmental policy, environmental permits, utilization of scarce resources, waste management and recycling impacts on ecosystems, environment and biodiversity by deforestation, use of chemicals, hazardous substances, pollution, etc, energy efficiency strategy and carbon management, and procurement practices of the company.

Social:

Health & safety policy, anti-discrimination and diversity policies, data privacy and security human rights risks - labor standards and child labor, community welfare strength of relationships with workers and communities, worker safety, accidents, Product Safety, diversity, inclusiveness and equal opportunities.

Governance:

Ethics & code of conduct policies, whistle-blowing, enterprise risk management framework audit committee and board composition, adherence to global accounting and auditing standards, succession planning, political connections and contributions, compensation to management breaches and enforcements.