The Rising Importance of ESG Due Diligence

Due to the ever-expanding scope of reporting obligations and the ambitious targets set by companies to align with global trends and stay competitive, companies have long been required to conduct due diligence (“DD”) to assess and advance their compliance with Environmental, Social and Governance (“ESG”) concerns in their internal operations and activities. While some health, safety, and environmental aspects have been part of DD for about two decades, scrutiny of ESG factors took off only recently. This shift is driven by higher customer expectations, concerns about the environment and resource costs.

As this trend continues to grow, companies are increasingly seeking high ESG sensitivity in their investment decisions and commercial relationships with customers, business partners, and associates. This has undoubtedly had a significant and rapid impact on due diligence processes used to enumerate the potential risks of an investment or business relationship.

It should be noted that, each industry presents its own array of environmental impact and stakeholder interaction that must be considered. Hence, ESG criteria to be evaluated need to be selected from a bouquet of key performance indicators (KPIs) taking industry-transaction-target specific factors into account. Among the ESG factors, the scope and impact of environmental risks to be found after the DD process remain paramount, however, social and governance factors are also gaining prominence.

As with any DD, the aim will be to determine whether the transaction price is fair and to assess the degree and extent of risks that may arise if the transaction proceeds. Thus, it is evident that ESG-based evaluations will become significant not only in mergers and acquisitions but also in simple bilateral relationships. All of this necessitates the inclusion of ESG assessments in traditional due diligence processes.

Although it is not common for companies to conduct a thorough DD on other companies with which they wish to establish commercial relationships when there is no share transfer involved, the introduction of reporting obligations, particularly the Corporate Sustainability Due Diligence Directive (CSDDD) and Germany’s Supply Chain Due Diligence Act (LkSG), has changed this dynamic. As these regulations extend their impact beyond individual entities to multiple legal entities working together within a commercial chain, future reporting requirements will likely constitute a form of mini-DD or a Know Your Customer (KYC) practice between parties entering new commercial relationships.

As a result, the ESG due diligence (“ESG DD”) shall: (i) grasp the risks associated with the counterparty, essentially by understanding its ESG risks, (ii) catch any warning signs tied to issues found during the DD process, (iii) spot, study and if convenient, address the measures to lessen these risks, (iv) figure out the "how" and "when" of lessening these risks and, if possible, insuring the ones that cannot be eliminated.

The possible outcome and the opportunities that an ESG DD may create can be listed as such:

-       Valuation Scale:

When ESG due diligence results demonstrate strong ESG performance, this is often factored into the counterparties or the subject of the transactions’ valuation. Particularly in the context of sustainability, since reporting and relevant sanctions often lag behind what they should be, it results in actions and inactions being valued either higher or lower than their actual worth by the parties involved in the transaction. In this regard, companies that take the initiative beyond existing ESG obligations, especially if they are in a position of transferring shares or providing services in a commercial relationship, tend to demand a higher price for shares or services than their actual value. Conversely, companies with high ESG sensitivity, despite the counterparty adhering to the current standards, are inclined to set a lower price than the actual value when they are in the position of acquiring shares or receiving services.

-       Avoiding Reputational Effects:

ESG and human rights concerns have the potential to greatly influence a company's image, influencing its appeal to investors, customers, and other involved parties. It should not be overlooked that prominent M&A transactions or collaborations encounter heightened public examination and possible negative reactions due to worries about environmental harm, violations of human rights (especially related to labor conditions in less developed nations), or inadequate corporate oversight. This highlights the importance of managing the process in the marketing context by identifying risks upfront or at the end, results in the transaction to not proceed.

-       Liquidity Opportunity:

Companies with a favorable ESG narrative find themselves in a stronger position to attract investments. A transaction focused on achieving sustainable development goals is often more attractive to banks for financing and may also benefit from incentives and other advantages. The due diligence process plays a crucial role in shaping the legal framework of the transaction, thus helps to obtain better financing and result in preserving the liquidity of the parties involved.

As with all negative outcomes from DD reviews, identified ESG risks can lead to legal consequences, financial penalties, and reduced investment returns. However, it is particularly important to emphasize that with the prevailing sustainable transformation mindset, findings related to ESG sensitivities are more likely to result in reputational damage rather than financial burdens. This surely is the reflection of the "double materiality approach," requiring companies to evaluate both how external factors (such as trade tensions and supply chain dynamics) affect their financial value and the broader impact of their operations on the environment and society.

Our series, which outlines the ESG concept and provides a legal perspective, can be viewed from the "Journal" section of our website (https://ege-law.com/wp-content/uploads/Toplu-ESG.pdf).