ESG - from the wings to centre-stage
Environmental, social and governance issues are now firmly in the spotlight in transactions and increasingly sparking litigation. Yet many companies underestimate the detailed analysis they need to do on the climate, cultural and human rights impacts of deals.
In the last two decades environmental, social and governance (ESG) issues have been steadily climbing up the boardroom agenda for large companies and financial institutions.
Yet awareness has grown in fits and starts.
The corporate social responsibility (CSR) movement – which saw many organisations start to report on their environmental and social impacts in the late 1990s – was, in truth, half-hearted for many and often little more than a ‘nice-to-have’. Activists regularly dismissed CSR reporting as ‘greenwashing’.
In a second wave, and perhaps partly in response to those accusations, we saw an increasing number of organisations embrace a more thorough form of sustainability reporting. The most serious, eager to prove that they had embedded sustainability into their day-to-day operations, began measuring progress using key performance indicators (KPIs) and other verifiable metrics as rigorous as those used to assess financial performance.
While these efforts were genuine, they remained vulnerable to changing investor priorities and market conditions. In the wake of the global financial crisis, for instance, ESG issues onceagain took a back seat as companies and investors focused on the business of surviving the ensuing downturn.
It was only after the financial crisis subsided that ESG issues once again edged back into the limelight, with climate and aspects of governance, notably anti-bribery and corruption, becoming a particular focus in the due diligence carried out around M&A transactions and project financing.
But now we are seeing a more significant sea change.
ESG issues are increasingly a hot topic for corporate players, lenders and financial investors, and a key topic at the deal table as acquirers seek to finance and execute transactions. Yet many companies continue to underestimate the level of scrutiny they will be put under and the growing level of legal risk attached to ESG issues.
Although the term ESG covers a wide range of issues, many of which are already part of the standard due diligence package, a number of developments are driving change in this area, none more so than expanding regulation and the increased risk of litigation.
In addition, we are seeing a far greater focus on ESG issues in the financial services sector, which, given the pivotal role it plays in the financing of transactions, is inevitably spilling into other sectors of the economy. This trend has been further accelerated by a number of central banks, including the Bank of England, now identifying climate as posing a systemic risk to the banking system, an edict likely to drive further regulatory and behavioural change.
Where climate is concerned, investors, lenders, insurance underwriters and acquirers are now routinely looking at assets from a climate resilience point of view, identifying climate-related risks (and/or opportunities) and assessing their likely impact on a company’s future financial position. This reflects the evolving debate over climate. Few now question the science of climate change or the fact that humans are responsible for at least a portion of it. Indeed many are now focused on specific real economic and business threats that could ensue, such as food and water shortages, droughts, coastal flooding and social instability.
Shareholder activism is also playing a significant role. NGOs are either buying shares in companies or getting other investors to buy them on their behalf so that they can bring pressure to bear on boards on ESG governance and disclosure issues or even challenge acquisitions or investment decisions in CO2 heavy projects. We are also seeing climate and ESG-themed shareholder resolutions being submitted by investor-led groups such as Climate Action 100+.
Pressure is coming from another direction as well. The signing of international agreements, such as the Paris Agreement, has emboldened countries, states and municipalities to take action on carbon reduction and renewable energy.
In addition we are seeing an increase in litigation, particularly around deals that have a negative environmental impact. Although we have yet to see many claims resulting in damages, companies are increasingly realising they may be forced to defend themselves, with claimants demanding additional discovery around climate impacts and courts in many jurisdictions willing to see such impacts as causation.
It all adds up to something of a perfect storm and we are seeing similar developments beginning to play out where human rights and social engagement issues are concerned. Here, international commitments, such as the UN’s Guiding Principles on Human Rights, are cascading into regulation at the EU level and within individual states and provoking an increase in litigation.
This is most obvious in the growing pressure on states to place a duty of care obligation on companies not just domestically, but wherever in the world they have subsidiary operations or interests.
France has taken a lead here, bringing forward a very strenuous due diligence law that has a “plan de vigilance” obligation at its heart. A similar proposal is now being debated in the UK, with the Labour Party under pressure to commit to such an approach and with a House of Commons committee also pushing the case. This would go further than the existing requirements under the UK Modern Slavery Act, which was recently the subject of an independent review.
Litigation risk is rising here too, and increasingly the risk has an extra-territorial reach affecting both corporate players and multilateral lenders.
The UK Supreme Court, for example, recently ruled that nearly 2,000 Zambian villagers, affected by the discharge of toxic waste from a copper mine, could bring action in the UK courts against the mine’s ultimate owner, Vedanta Resources, underlining its duty of care for its overseas impacts. Vedanta had argued the case should be heard in Zambia alone. The U.S. Supreme Court recently issued a similar ruling affirming the viability of a claim by a non-U.S. community group against a U.S.-based multilateral institution – that had consented to a loan to a local coal-fired plant –seeking recovery for environmental damages linked to the plant’s poor environmental performance, and analogous cases are pending in the U.S., Canada and elsewhere.
Diligence and disclosure dilemas
In this increasingly complex environment, companies, lenders and financial investors find themselves facing a range of dilemmas around disclosure and due diligence and, in the absence of globally accepted standards and further regulation, many are finding themselves on treacherous terrain. Investors in particular are concerned that the data being made available by companies on various ESG issues are not good enough to enable them to make a proper risk assessment.
Although some new standards and forms of guidance are emerging, for instance from the Organisation for Economic Co-operation and Development (OECD) and the Task Force on Climate-related Financial Disclosures (TCFD), dealmakers are still feeling their way with little to guide them.
How do you make a financial disclosure about the risks of climate change or human rights issues? How do you identify the real risks and quantify them? When doing due diligence within your own company, what metrics do you use? How can you be sure, in making an acquisition, that all legacy issues acquired with the asset that might lead to future claims have been identified?
The pressure to be more transparent and to disclose areas of risk is undoubtedly intensifying. But as laws and regulations crystallise around these issues it leaves organisations in a considerable bind. They are effectively being encouraged to disclose more issues that, increasingly, have a legal risk attached to them. That leaves companies having to think very carefully about what facts are material and what to disclose without exposing themselves to greater, or even unforeseen, risk.
Meanwhile, the demands being placed on borrowers, especially by multilateral lenders, are now routinely quite onerous, with loan covenants demanding that borrowers both comply with all applicable local and international laws but also take responsibility for protecting and preserving human rights and cultural heritage.
Such demands can be difficult for borrowers to satisfy, but we believe they will only become more common in the years ahead.
In the deal environment, there are natural limits to the depth of diligence that can be done. Inevitably, the level of scrutiny undertaken is dictated by a number of factors, including, among other things, deal timing and pace, the parties’ relative leverage and sophistication, the parties’ willingness to devote financial and personnel resources to conduct due diligence, and the availability of digestible, meaningful information. In a competitive auction, those constraints can be even tighter.
Even where circumstances would permit adequate due diligence to be conducted, dealmakers often forego this opportunity because they underestimate the potential risks at stake or the degree of detail or rigour required to adequately assess such risks.
As acquirers think about the issues that need to be addressed in the standard due diligence process, their horizons need to be set much wider than in the past with a longer list of topics that need to be covered.
Increasingly they also have to take a much more sophisticated approach to ESG issues than has previously been the case. Where necessary that might mean involving technical consultants in their team of advisers, such as experts able to model the physical and financial impact of climate on assets.
They will also increasingly need to report on ESG and financial issues in an integrated way, paying careful attention to whether disclosures made in their CSR and sustainability reports match what they are saying publicly elsewhere (for instance, in filings to stock exchanges or to the Securities Exchange Commission). This includes the need to accurately incorporate ESG data about a newly acquired business into the acquiring entity’s overall disclosures.
The tide has once again risen on ESG issues, but this time it has risen higher than ever before and shows no signs of receding.
Companies and financial institutions are beginning to realise that they need to take ESG reporting much more seriously and do it in a truly integrated way. Effective assessment, management, and disclosure of ESG issues will be an increasingly critical component of many organisations’ success in the years to come.