In both the public and private sectors, there has been a growing interest in environmental, social and governance (ESG) matters. This article examines how ESG developments may affect M&A and identifies the changes that may need to be made.
 
What are ESG Investing and Sustainability Disclosure Standards?

Following the COP26 meeting in November 2021, both public and private sector players set out to implement plans to cut CO2 emissions to limit global temperature rises to 1.5°C above pre-industrial levels. With this goal firmly in mind, the establishment of the International Sustainability Standards Board (ISSB) was announced at COP26 to “deliver a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions.”
 
To set about this task, the ISSB has developed the IFRS Sustainability Disclosure Standards. The Sustainability Disclosure Standards provide global standard disclosures on sustainable ESG matters, akin to the existing IFRS accounting standards for financial metric disclosures.
 
The ISSB will focus on climate disclosures first and has committed to publish the first Sustainability Disclosure Standards on climate some time in 2022 (at the earliest). Until such standards are launched, the prevalent ESG reporting frameworks are currently those issued by the Global Reporting Initiative, Integrated Reporting, the Principles for Responsible Investment, the Task Force on Climate-related Financial Disclosures and the Sustainability Accounting Standards Board. Some governments, including, the EU, Australia, New Zealand, the UK, France and the US, have already developed their own version of mandatory/voluntary climate related disclosures for certain organizations.
 
In addition to these ESG disclosure regimes, rating providers such as S&P Global, MSCI, Sustainalytics and CDP have developed methodologies to rate the ESG performance of entities. Such ratings should help investors better understand the ESG disclosures of companies and make an assessment of their ESG level.
 
Certain financial institutions are already mandated to increase their investment in sustainable products and disclose their level of “green” investments.  These developments, driven by a strong push from investors to build greener and more socially-impactful portfolios, are evidence of a major trend toward environmentally and socially responsible and sustainable investment (commonly referred to as ESG Investing or Impact Investing).
 
How will ESG Investing and Sustainability Disclosure Standards affect the way we do M&A?
 
Due Diligence
 
Given these developments, assessment of the value and risk profile of a target is likely to go beyond traditional financial, legal, tax and technical due diligence and extend to an examination of the ESG risks and management processes of the target.  How important this is will be likely to depend on the nature of the target and the acquirer. Depending on the facts, a target’s ESG performance could increasingly become one of the factors in whether or not (and in what form) a deal goes ahead.
 
The employment of an ESG compliance expert in addition to traditional advisers in the due diligence and deal making process is likely to be increasingly common on some deals. The question is, what are the key issues that such an expert would examine?
 
Key Issues for ESG Compliance
 
The Recommendations of the Task Force on Climate-related Financial Disclosures provides guidance on how the Sustainability Disclosure Standards on climate will be determined. The recommendations suggest that the Sustainability Disclosure Standard on Climate may include, amongst others, disclosures on:
  1. The organization’s governance around climate-related risks and opportunities; 
  2. material information on actual and potential impacts of climate-related risk and opportunities on the organization’s business, strategy, and financial planning; 
  3. how the organization identifies, assesses and manages climate-related risks; and 
  4. the material metrics and targets used to assess and manage relevant climate-related risks and opportunities.
Following the launch of the Sustainability Disclosure Standards on climate, the ISSB will then undertake further work to produce similar Sustainability Disclosure Standards on social and governance matters. Based on the topics as set out by the Sustainability Accounting Standards Board1, it is anticipated that these may include:
  1. Social Aspects: Human Rights & Community Relations, Customer Privacy, Data Security, Access & Affordability, Product Quality & Safety, Customer Welfare, Selling Practices & Product Labeling, Labor Practices, Employee Health & Safety and Employee Engagement, Diversity & Inclusion; and
  2. Governance Aspects: Product Design & Lifecycle Management, Business Model Resilience, Supply Chain Management, Materials Sourcing & Efficiency, Physical Impacts of Climate Change, Business Ethics, Competitive Behaviour, Management of the Legal & Regulatory Environment, Critical Incident Risk Management and Systemic Risk Management.
These new standards will require sellers and potential targets to “look ahead” to consider to what extent their companies comply with current (as applicable) and future ESG sustainability disclosure standards.
 
Buyers may seek to determine a target’s ESG compliance. Again, how important this will be is likely to be fact-specific. This will include:

 

  • Whether the target has an ESG policy in place and, if so, its content; 
  • requesting a description of how ESG risks are monitored and managed; 
  • whether the target’s supply chain has any adverse ESG impacts; 
  • the ESG training used within the target and the effectiveness of such training;
  • a description of how the target’s environmental performance has improved; 
  • whether the target monitors its carbon emissions; 
  • whether the target has effective employment, diversity, engagement and inclusion policies; and
  • whether the target has procedures in place to protect itself against illegal situations, such as the prevention of human trafficking and human rights violations.

The recently published EU Directive on Corporate Sustainability Due Diligence highlights the potential direction of travel in this respect. The Directive will complement the current Non-Financial Reporting Directive and its proposed amendments (implemented through the Corporate Sustainability Reporting Directive) by adding a substantive corporate duty for some companies to perform due diligence to identify, prevent, mitigate and account for external harm resulting from adverse human rights and environmental impacts in the company’s own operations, its subsidiaries and in the value chain.

Transaction Documents

Following the due diligence, a buyer will have to decide whether the transaction documents include a set of ESG targeted representations and warranties which adequately cover ESG compliance to minimize litigation and reputational risks to the target. In such a case, sellers should be advised to: (i) comply with reasonable requests for information from the buyer; and (ii) ensure their ESG commitments are sufficient but not excessively burdensome.

ESG warranties can be broadly drafted to cover areas such as confirmation that the target has adequate ESG policies in place and that there have been no ESG incidents within a given past period. These broad warranties may overlap with the existing traditional warranties such as those relating to legal and tax compliance, anti-bribery and anti-money laundering, data privacy, environmental and safety matters. If a buyer has any particular sensitivity on certain ESG issues such as workplace harassment, supply chain sustainability or community engagement, then, more specific warranties can be crafted to target those specific issues.

Although environmental W&I insurance is now standard, social and governance W&I insurance is not yet common. However, over time, it may be that social and governance W&I insurance grows. What is not yet clear is how and to what insurers will underwrite the risk and they will need more than a detailed and comprehensive ESG due diligence report.

Post-closing action plans may also be helpful to improve the target’s ESG standards. Specific ESG indemnities may also be required to rectify any areas of ESG non-compliance. However, as not all ESG matters can be financially quantifiable, it may be challenging for a buyer to be fully or properly compensated in the event of non-compliance. Therefore, buyers should put more focus on conducting a proper ESG due diligence and ensuring that issues are dealt with at an early stage and potentially prior to acquisition.
 
In the years ahead we expect to see increased interest from buyers and sellers in assessing and mitigating targets’ ESG risks, and this area of due diligence, as well as ESG specific deal-protection provisions, is expected to increase in importance on transactions.



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