In today's ever-changing landscape, ESG factors have become pivotal considerations for investors, stakeholders, and regulators alike. An undeniable increase in adverse environmental events such as drought, wildfire, and flood, as well as the economic hardship caused by a greater incidence of geopolitical conflict and civil strife, has seen corporates (and investors) the world over scramble to better understand how, if at all, the tangible effects of these events can be mitigated so as to protect the viability of their operations, revenue streams, investments, job security, and, ultimately, shareholder value.
In this context, ESG due diligence has emerged as a crucial tool for assessing risks, driving positive impact, and promoting sustainable growth. In a nutshell, it may be said to entail the systematic assessment of an entity’s performance across a number of environmental, social, and governance dimensions, so as to assess (i) that entity’s ability to withstand ‘sustainability risks’ (i.e., as defined under the EU’s Sustainable Finance Disclosure Regulation (SFDR), “environmental, social or governance event[s] or condition[s] that… could cause an actual or a potential material negative impact of the value of the investment [if they were to occur]”) and, on the flipside, (ii) that entity’s impact on ‘sustainability factors’ (i.e., as also defined under the SFDR, “environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters”).
This dichotomy reflects the principle of ‘double materiality’, which has become one of the main focus points for the European Commission in its crusade towards transitioning the bloc to a ‘greener’ future.
As alluded to in the explanation above, double materiality focuses on financial materiality (i.e., impact inwards – vide point (i) in the paragraph above) and impact materiality (i.e., impact outwards – vide point (ii) in the paragraph above), and therefore provides a 360-degree assessment of an entity’s prowess through an ESG lens. But, tangibly, what does this really mean, and what is the ultimate benefit of this exercise? Why are routine legal due diligences conducted in the course of M&A deals increasingly focusing (albeit to a limited degree) on ESG risks, and how, if at all, are target companies managing and mitigating the effects of these risks?
Intrinsically, it all boils down to one key word – value (or long-term value, to be precise). Those entities that are best placed to navigate the challenges of a ‘harsher’ world, including by limiting or outright eliminating their effect (and that of their supply chain) on any further environmental/societal decline, will benefit from this added resilience, be it in the context of long-term shareholder value or otherwise as a more attractive outfit for outside investment.
This article focuses on the salient aspects of ESG due diligence, including the associated challenges, best practices, and the evolving regulatory landscape in this respect. Some remarks will also be spared for Malta’s efforts on the ESG front, and how Maltese entities are addressing the risks and opportunities in this sector.
Key components of an ESG due diligence and best practices
An ESG due diligence typically focuses on three main areas:
Environmental factors – this aspect focuses on the evaluation of a company's impact on the environment, such as its carbon footprint, resource usage, pollution levels, and commitment to sustainability initiatives such as renewable energy adoption and waste management. This would, in itself, necessitate the collation of a significant amount of data – typically requiring the input of a number of experts and other stakeholders working in tandem with the company’s management team.
Social factors – this aspect would look into a company's relationship with its employees, and the wider community of which it forms part. Considerations that would typically be taken into account when focusing on social factors include labour practices, human rights policies, diversity and inclusion efforts, community engagement initiatives, and (crucially) adherence to ethical standards throughout that company’s supply chain.
Governance factors – this area consists of the wider examination of a company’s corporate governance structure, including its policies and disclosures, as well as general practices that govern a company's day-to-day operations. Key areas of scrutiny typically include board composition, management structure, executive compensation, transparency, risk management practices, compliance with regulations, and the existence of robust internal controls.
A comprehensive evaluation of all three factors should enable the company to better assess its viability and potential to create long-term value for its shareholders, while also providing much-needed insight into any ‘value gaps’ in the company’s operations, and other potential areas for improvement.
A number of best practices may be employed by companies seeking to carry out an ESG due diligence of their own operations, or, rather, to assess the ESG credentials of other entities that they intend to engage with. These include the following:
Use of data – a thorough and holistic assessment of the above-mentioned environmental, social, and governance factors will require the analysis of quantitative and qualitative metrics that are designed to enable a comprehensive understanding of a company's performance. Despite the challenges in this respect (as shall be tackled later in this article), the depth and quality of ESG data is undeniably on the rise – with the novelty of ESG having now worn off, and companies (particularly those that are subject to ESG regulation) having since expanded or redeployed their resources to meet this aim, be it internally or by engaging one or more of a number of data providers operating in the market.
Stakeholder engagement – it is necessary to engage with a wide range of stakeholders – including company management, employees, customers, suppliers, and local communities – to gather diverse perspectives and insights into ESG issues.
Use of frameworks and international standards – companies would be well advised to leverage internationally recognised frameworks and standards such as those developed by the Global Reporting Initiative, the Task Force on Climate-Related Financial Disclosures, and the Sustainability Accounting Standards Board to guide their ESG analysis.
Continuous monitoring and improvement – companies ought to establish mechanisms for ongoing monitoring and evaluation of their ESG performance, allowing for the identification of trends, risks, and opportunities, and encouraging and enabling continuous improvement over time.
A good ‘ESG score’ would give rise to a number of advantages for the company and its shareholders, including the following:
Risk mitigation – a business that is run in compliance with ESG considerations will be better equipped to mitigate the effects of major operational risks, including reputational risk and regulatory risk. With reference to the latter risk in particular, the global shift towards increased ESG regulation and supervisory scrutiny effectively means that those entities whose operations are in full compliance with ESG rules and regulations will be better placed to navigate ever-changing and complex regulatory landscapes.
Competitive advantages – incorporating ESG into one’s business culture may yield a much-needed competitive advantage over one’s peers in the industry, be it in the context of increased employee loyalty, customer retention, or increased investor interest. A growing inclination towards sustainable investing – from a purely conscientious point of view (particularly among a younger investor base) as well as from a regulatory perspective (with a number of entities seeking to diversify their portfolios by dipping into sustainable markets to consolidate their regulatory disclosures and increase their appeal among a wider investor base) – means that entities that harness, and operate in full accordance with, sustainability goals and standards will constitute an attractive investment opportunity for investors who are seeking to divert their monies towards ‘causes’ that ameliorate or, at the very least, do not harm sustainability factors. Indeed, even in the context of an M&A transaction, good ESG performance (as a telling sign of a target company’s resilience) may have a bearing on negotiations and, ultimately, the amount of consideration paid.
Challenges in ESG due diligence
Despite its importance, ESG due diligence is not without its challenges. Some of the more common hurdles in this space (which companies would be well advised to adequately cater for when planning their ESG strategy) include the following:
Data quality and reliability – access to reliable and standardised ESG data remains a significant challenge, making it difficult for companies to assess their ESG performance accurately, and for investors to compare companies in a like-for-like manner on the basis of their ESG credentials. With the coming into force of the EU’s Corporate Sustainability Reporting Directive (CSRD), however, many in the area are hopeful that the reporting requirements incumbent upon in-scope entities (including listed entities) will stimulate the proliferation of better-quality ESG data, which can be used to inform the website and pre-contractual disclosures of financial market participants and advisers within the context of the SFDR, for instance. This would kick-start a positive, ‘chain reaction’ effect in the ESG ecosystem, which would not only counter growing scepticism by a number of market players (which have become inclined to view ESG as a burden and an expense) but would also be of great help in eradicating unlawful greenwashing practices.
Lack of consistency and transparency – as alluded to above, there is a lack of consistency and transparency in ESG reporting practices, with companies often using different frameworks and metrics when drafting their disclosures, thus making it challenging for investors to make meaningful comparisons and evaluations. Within the EU, however, it is contended that, as the reporting culture grows, and in-scope entities converge towards regulatory standards that are informed by the union’s overarching Taxonomy Regulation, the consistency and credibility of data will grow year on year, to the ultimate benefit of the market at large.
Integration and materiality – integrating ESG considerations into investment decision-making processes and determining their materiality to financial performance remains a complex issue, requiring a nuanced understanding of the interplay between ESG factors and business outcomes. The narrative employed over the past couple of years – namely, that ESG and ESG investing will necessarily correlate with better short-term gains when compared with plain vanilla investing – has proven to be populist and misleading, and the time is ripe to move on to the second phase of our collective ESG maturity; i.e., looking at ESG as a value strategy for long-term growth.
The EU regulatory framework and where Malta factors in
The focus on ESG due diligence is by no means a recent trend or development, with the European Commission having realised (and acted upon) its importance as far back as the introduction of the Non-Financial Reporting Directive (NFRD), which, for the first time, required the disclosure of what was dubbed as ‘non-financial’ information by certain large undertakings and groups. As a minimum, this information (namely, environmental, social, and employee matters, respect for human rights, and anti-corruption and bribery matters) was to be disclosed under a number of reporting areas and categories, including within the context of a company’s due diligence processes.
The NFRD’s spiritual successor, the CSRD, has upped the ante, with in-scope entities expected to provide more comprehensive information concerning the due diligence process implemented with respect to sustainability matters, including the principal actual or potential adverse impacts connected with the undertaking’s operations and with its value chain, and the actions taken to identify, monitor, prevent, and mitigate the effects of those actual or potential adverse impacts.
Further to the above, a provisional agreement was reached towards the end of 2023 on what has been called the Corporate Sustainability Due Diligence Directive (CSDDD). Once (and if) approved, the CSDDD will set obligations for large companies regarding actual and potential adverse impacts on human rights and the environment, with respect to their own operations, those of their subsidiaries, and those carried out by their business partners.
The CSDDD purports to introduce a number of groundbreaking measures that are geared towards accelerating the implementation of corporate sustainability due diligence, such as including the introduction of punitive measures and civil liability, as well as the re-evaluation of directors’ duties to consider the consequences of their decisions for sustainability matters – including, where applicable, human rights, climate change, and environmental consequences, in the short, medium, and long term – and to oversee due diligence actions.
Given its scope (which some commentators have viewed as overbearing), the CSDDD proposal has not been without its controversies. In fact, at the time of writing, the CSDDD proposal has failed to achieve final approval by the European Council following objections from a number of member states. It will therefore be interesting to see how this space develops in the medium to long term.
Malta has been closely following the developments on the sustainability front recently, with the Malta Financial Services Authority (MFSA) identifying sustainable finance as one of its supervisory priorities for the past two years. In-scope financial market participants and advisers have been hard at work to comply with their obligations pursuant to the Taxonomy Regulation and the SFDR, and the demand for ESG training (and ESG accreditation) remains on the rise.
The MFSA has also committed to increase its supervisory work in the area, including via the carrying out of desk-based reviews and compliance inspections of Maltese regulated entities and their ESG efforts and disclosures.
Meanwhile, in the run-up to the full implementation of the CSRD for listed SMEs, in-scope Maltese undertakings have started to make the necessary preparations to ensure that all the data required for reporting purposes is collated and interpreted in good time prior to the preparation of the first management report in accordance with the European Sustainability Reporting Standards.
Concluding remarks
ESG due diligence is fast becoming the new norm for corporates seeking to maximise the value of their business, while having due regard for the environment and society at large.
Despite the influx of pan-European rules and regulations that have undoubtedly accelerated this shift towards a more sustainable future, the author hopes that this article has shown that ESG (and the carrying out of ESG due diligence) transcends regulatory expectation, and should be treated as a ‘need to have’ for the continued success of one’s business, and, just as importantly, that of the environment in which it operates.
