Last month I attended a breakfast conference looking at the influence of ESG (Environmental, Social, and Governance considerations) on M&A and private equity. The panel was varied and experienced and this certainly made for engaging discussion. In spite of the growing recognition that ESG is important for effective risk management, it was evident that some of the ideas around it continue to be in their infancy. I got a sense from the audience that there is a desire for:
• more information on how ESG due diligence is evolving; and
• guidance on how to adopt a more integrated approach

ESG: a dynamic concept

In the wake of the GFC the focus has shifted on the long term success of companies. ESG sits well with this renewed focus, and this has given ESG a more prominent role in M&A and other investment and transaction decisions. Panelist Jo Iwasaki commented that in today’s environment, in addition to a clear business plan it was increasingly important for companies to be seen as acceptable.

In reality, acceptance of the importance of considering environmental aspects has been longstanding However, Neal Barker from WSP also stressed that looking at, for example, the company culture, the OSH practices and the social risks in an M&A transaction should be seen as an opportunity to manage issues better and can in fact add value to a deal.

Mark Hughes from the European Bank for Reconstruction and Development (EBRD) also stated that the suite of issues that the EBRD was focusing on had changed. Because of shareholder governments the political agenda can change but since its inception in the early 1990s the organisation has had ESG frameworks in place. The focus has shifted from purely environmental to include social matters, such as cultural heritage, resettlement and indigenous peoples.

ESG in practice: setting expectations

Different approaches appear to be taken by different organisations. Tim Bescoby from RBS said the bank tends to look at ESG from the project side as opposed to the customer side, and that their approach has a number of key focuses such as sensitive sectors, including oil and gas and mining. Frameworks such as the UNPRI and the Equator Principles are also useful.
Peter Lane stated that to cater for ESG traditional due diligence mechanisms are being broadened out. According to him the process in itself is not all that different; what is important is that the right people are brought in to look at the right issues and having Q&A sessions with the relevant personnel.

Where ESG standards are found not to be up to scratch a solid action plan must be developed to address these shortcomings. Moreover, the criteria against which a portfolio or client will be assessed against will be need to be decided and incorporated into any agreement.

What happens once the money is out the door?

Post-investment monitoring is a real challenge, said panelists. Firstly, relationship teams need to be up to speed.

Written reports are often requested, the frequency of which will depend on the level of risk and if any new issues come to the fore, for instance in the media. Action plans will usually outline yearly objectives to be fulfilled over a period of 2-5 years. High risk clients will usually undergo annual reviews.

Audits were not extensively mentioned by the panel. I do however recall one of the panelists stating that high risk projects may demand getting on a plane and looking.

Are projects ever excluded on the basis of ESG concerns?

As a rule, panelists said that they will not usually exclude a project on the basis of an ESG risk. RBS and EBRD both stated that they tend to work with clients and mitigate risks through, for example, capacity building and transferring of know how. Working with clients to tackle these challenges in many instances can generate net value and lead to innovative solutions because you are supporting them to discharge of their ESG responsibility positively. Walking away is thus seen as less effective than working hard to make it work – it is generally worth engaging.

Nonetheless, sometimes saying ‘no’ and exiting on a deal is the only option. This might be the case where the ESG issue raised is highly emotive and the reputational risk is simply too significant. For example, projects where there is a risk of child labour occurring or which threaten the biodiversity of world heritage sights. The EBRD states that they said no from to outset to working on a transaction involving the state-run cotton industry in Uzbekistan, which is renowned for the prevalence of forced labour.

What role do NGOs have?

As expected, the mention of NGOs exposed mixed feelings on behalf of the panel. On the whole it was agreed that engaging with NGOs is both positive and necessary, particularly when operating at local level they have a very direct interest and understanding of ESG issues. In many cases, they actually assist in the risk management process by alerting banks and corporations of what issues might come to fruition and set off the internal escalation process.

One of the panelists spoke of an instant where banks got wind of grave labour issues in the prawn industry picked up by NGOs. This was treated as an opportunity to work with an Asian client, a prawn supplier, and build value. By looking at their supply chain in closer detail, demonstrating their ethical stamp and publicising their new frameworks, it lead to more business for the client.

To wrap up the discussion

Unsurprisingly, most panelists highlighted that effective communication with stakeholders should constitute a key component of any approach to ESG. ESG needs to be incorporated into the negotiation process from the outset and there needs to be clear expectations around it, too.
Overall, it was also apparent to me from the discussion that ESG risk management had come a long way – climate change continues to be on the agenda, and rightly so, but today there are a broader set of issues to consider.

WSP and ICAEW are in the process of developing a joint best practice guideline. The document is currently in its drafting stages but in addition to climate change it highlights the following two themes:
• resources scarcity
• human rights and social impacts
More to come on the draft guideline soon.