Environmental, social and governance considerations have moved centre stage in corporate finance. Tim Clare and Sarah Gilby of Anthesis Group explain what’s changed, including increased focus on climate change, diversity and inclusion, data and cyber security – and what’s coming next

Environmental, social and governance (ESG) was once a term only used in small sections of the finance community. Now, however, it is being used seemingly interchangeably with yet another commonly used abbreviation, corporate social responsibility (CSR), and sustainability.

ESG has become a financial performance and value consideration, and it’s a mainstream discussion topic at C-suite level across many industries. Yet it’s still, arguably, in its infancy and a constantly evolving concept, covering a wide and growing range of topics.

How much and how quickly the situation has changed can be seen by comparing information memorandums (IM) from now with those from only a year ago. An IM from early 2020 may or may not mention ESG. If it does, it will be towards the back of the document. More likely, there would be a page dedicated to health and safety or the implementation of some eco-efficiency initiatives. But now, there is a good chance of finding several dedicated pages on ESG topics. There will be a clear attempt to sell the ESG credentials of the business, likely starting in the introductory headlines.

Exactly what those credentials are has also changed. Now, there is a desire to tell not just the detail of the ESG controls and mitigations in place, but the business’s ESG narrative, too: how that business is fit for the future and the many societal transitions in motion, and how the business is an ‘ESG play’ – a company whose purpose is aligned, or will contribute to, those changes.

Collaboration

ESG due diligence is often carried out very closely with both the legal and IT (or perhaps dedicated cyber) due diligence workstreams, as ESG is intertwined across disciplines. Given the breadth of issues under the ESG umbrella, the starting point is an initial materiality assessment to evaluate what would typically be the most material issues associated with that business, based on what it does and where it does it. These identified issues then make up roughly half the assessment.

It’s also crucial to combine tools, such as the Sustainability Accounting Standards Board’s SASB Materiality Map®, which provides an industry-agreed set of aspects, with the experience of the advisory firm.

At Anthesis, we use RiskHorizon, a software tool that combines our experience with the SASB Materiality Map® to ensure consistency of opinion within the organisation. The end point of the process is a list of five to 10 topics to deep dive on.

However, materiality-driven assessment can fail when it ignores many of the core ESG requirements that good management in this area would need, even if the topic were not material. A business may not be a big emitter of greenhouse gases or be high risk around modern-day slavery or bribery and corruption, but a mature ESG-managing organisation should monitor and have controls on all risks. So, for this, a broader question list can be answered by the target’s management team, or it can be completed based on data room disclosures.

These two lines of questioning provide the bulk of understanding of how the target manages ESG issues. However, they do not necessarily reveal whether ESG is aligned with the purpose of the business and the value that will come from it. A big change has been the realisation that being ‘good’ at ESG can mean a stronger and more resilient business and a greater return on investment, which means it needs to go beyond a diligence process that only ticks boxes.

Ground shift

Throughout the COVID-19 pandemic and the events of last year, we’ve seen an increased focus on both climate change and diversity and inclusion (D&I). Many clients now include these two topics as standard across the board, for all asset classes, both during due diligence and ownership and exit phases.

Without a doubt, the pandemic woke up many businesses to the reality of the scale of economic disruption that can occur because of existential and systemic risks. Governments and individual companies have had a taste of what climate change might bring and have decided to act.

Alongside the voluntary or market-driven actions, businesses are increasingly focusing on climate change because of the Task Force on Climate-Related Financial Disclosures and related climate risk reporting requirements, notably for PRI (Principles for Responsible Investment) signatories. The EU Taxonomy and other European regulations will also drive transparency on performance.

Consequently, building some level of climate risk (and opportunity) assessment into the due diligence process has become a standard ask.

Regarding D&I, while the focus was on gender diversity 18 months ago, many companies are now interested in ethnicity and social mobility. Again, regulations have played their part, including the UK’s gender pay gap reporting requirements. However, companies are going beyond this, moving away from setting metrics and targets to ensuring that they move the dial on D&I rather than just reporting numbers. When helping companies with diligence on this topic, it’s noticeable that clients want to understand where businesses stand in this regard. That scrutiny covers the board and the wider leadership team, as well as the company as a whole.

The importance of cyber and data security is also rising, as are the risks and impact linked to them. As such, while it’s a standard ESG due diligence item, we expect to find it being a standalone workstream as well.

Win-win?

Clearer identification and understanding of company purpose and principles are needed. They can then be enhanced and woven through a company brand and identity. How a business’s activities fit into a sustainability trend, such as greenhouse gas emissions reduction, the circular economy, or the UN Sustainable Development Goals, is another area that interests organisations.

All this increased scrutiny has led to recent growth in requests for ESG vendor due diligence and exit preparation support for mainstream transactions, and especially pre-IPO, due to the enhanced ESG scrutiny of listed companies.

ESG is not just about meeting investor requirements – indeed, investors should be happiest when a business’s ESG management speaks to its wider stakeholders, especially its staff and customers. Good ESG management can also reduce risks and bring benefits in terms of staff attraction, retention and productivity. It can help maintain the existing customer base while attracting new customers with products and services that meet their changing needs and values, and possibly their own ESG requirements, too.

About the authors

Tim Clare, director of ESG advisory services at global sustainability strategy consultancy Anthesis Group, a member organisation of the Corporate Finance Faculty and a member of the British Private Equity & Venture Capital Association’s Responsible Investment Advisory Group.

Sarah Gilby, technical director in Anthesis Group’s UK strategy, brand and ESG team

Anthesis is a member firm of the Corporate Finance Faculty