ESG considerations have moved from the periphery to central focus in recent years. As a result, getting ESG due diligence right is critical to managing risk and creating value.

Unlike traditional financial, legal and commercial analyses, the lack of a commonly accepted model for ESG due diligence means many organisations struggle with the best approach to take.

For some businesses or investors, ESG due diligence might be little more than a consistent 10-point checklist to demonstrate an awareness of some general ESG topics. For others, obtaining deep, accurate understanding and metrics on ESG issues could be fundamental to their ethos and define their whole approach to evaluating return on investment. Some will walk away from deals that do not meet their ESG principles.

Unsurprisingly given these variations, there is strong demand for a standardised approach to ESG due diligence that enables businesses to benchmark their approach against others in the market. But at the same time, procuring a standardised ESG due diligence service because that’s what other businesses are doing could lead to sub-optimal outcomes, particularly if it is not framed in the context of the overall strategic goals and the ESG journey of the investor. 

At KPMG, we have identified four key issues that investors (or businesses themselves) should consider when developing an ESG due diligence strategy.

1. How can you integrate ESG into the due diligence?

ESG is an incredibly broad topic and can mean different things in different markets and sectors. One of the first issues to consider, therefore, is what does ESG mean in the context of that business and its strategic objectives, and use that knowledge to define how to layer ESG factors into the due diligence process.

For example, if a business operates in multiple sectors and multiple countries, do you adopt one standard ESG approach for every country and every sector? Or do you customise it to different contexts? Are internationally recognised standards and frameworks to be applied, or do these need to be significantly tailored?  If so, how far does that customisation go?

Adopting a standardised approach provides the reassurance of consistency and transparency for both internal and external stakeholders, but it may not fully represent the realities of each context on the ground, or may be so generic that it doesn’t provide useful insights.

A more flexible approach, on the other hand, should be better able to reflect different ESG contexts, but that very flexibility means it will not provide the same degree of consistency, which may not suit all stakeholders. It runs the risk of manipulation of the approach to purposefully increase or decrease the likelihood of identifying challenges or deal-breakers.

This layering question is also key in determining where an ESG-focused approach might interact with work streams where there may be a much longer-standing consensus on the ‘standard’ house approach, such as financial and tax, commercial, technical, HR, IT and legal due diligence.

2. How will ESG due diligence findings shape decision-making?

There is a plethora of ESG standards and guidelines that could serve as an ESG due diligence framework. But who decides what is going to be prioritised and what decisions are made as a result of a nuanced finding?

Some investors may take an objective approach by using ESG indicators to screen transactions in or out. For example, many investors have taken firm stands to exclude entire sectors from their remit. Other investors take a case-by-case approach, where explicit ESG factors like community impacts and environmental incidents figure prominently. If an issue is flagged up, the agreed policy is not to invest. The decision can be justified as being part of the compliance process for whichever ESG framework is being applied.

Other organisations prefer a more subjective view, with all findings discussed internally and decisions taken according to the specific context. Rather than being a yes/no indicator, an ESG weakness or risk is seen an opportunity to create value by improving on that issue. In the short term, it might bring the business’s ESG credentials down, but in the longer term, it should strengthen them if the weakness can be turned around under their ownership.

Take a business with an all-male Board, for example. Do you refuse to invest because it goes against your ESG principles, or do you invest anyway with a view to creating a more diverse Board under your ownership?

A related question arises around jurisdictions. ESG regulations and stakeholder expectations vary significantly between different markets, even sectors. Are you going to tolerate these differences within a flexible ESG due diligence framework, or set a single, global set of standards that may mean some sectors and jurisdictions are off limits?

3. What’s your motivation?

The third key consideration is motivation. Is ESG being embedded in deal processes simply because customers, finance-providers or other stakeholders are expecting or even requiring it? Or is it about seeking a real opportunity to make bold improvements and become a leader in ESG?

If it’s the former, businesses are likely to implement something lower in ambition (and cost) than if they have a strong conviction that analysing ESG factors in depth will lead to increased financial returns.

This is not about making a value judgment on which approach is better, simply an observation that the motive should rightly inform the approach that is taken. A compliance approach, motivated by a desire to do what’s required to avoid embarrassment and demonstrate adherence to a set of external ESG standards, will be the right approach for some. Others may choose a deeper, more rigorous strategy, driven by a motivation to identify new opportunities to create value and build a greater legacy.

4. How flexible is your ESG due diligence strategy?

ESG considerations have been rising up the corporate agenda for some time, but ESG is a broad and rapidly evolving topic. In the past three years alone, there have been a number of high-profile social disruptions that have served to supercharge the interest in, and conversation around, a particular topic under the ESG umbrella. Examples include Greta Thunberg and global climate strikes, the #MeToo movement, and the death of George Floyd and its impact on the topic of diversity and inclusion in business and wider society.

Whatever ESG due diligence approach is taken, it needs to be flexible enough to respond and adapt to this changing ESG landscape. But at the same time, not so variable that the business is constantly racing to try and keep up with the latest trending topic.

The risk is that by being too responsive to current ESG trends, businesses will find themselves constantly changing their ESG due diligence strategy to reflect current expectations. At the same time, there does need to be some degree of flexibility to ensure the strategy evolves as societal and stakeholder expectations also evolve.

The path forward

The deals market is still a long way from having a widely agreed and recognised approach to ESG due diligence. Investors therefore need to define their own approach based on a full understanding and open discussion around the key issues outlined above.

There will inevitably be considerable differences in the approaches taken by different organisations. But those differences are to be expected, rather than accepting a one-size-fits-all approach that ultimately suits no-one.

Discussing these factors and reaching agreed positions can provide the confidence and reassurance that investors, businesses and finance-providers will need in the increasingly ESG-aware deals market.

To discuss any points raised in this article or if you need advice on your ESG due diligence strategy, please get in contact.