How ESG is Transforming the Corporate Landscape

Accelerating awareness of the threat of climate change combined with pressure from activists, consumers and investors has pushed environmental, social and governance (“ESG”) matters up the agenda, presenting a key consideration amongst stakeholders with regards to both business operations and corporate finance activities.

Responsible investing is widely understood as the integration of ESG factors into investment processes and decision-making. ESG metrics include a variety of factors, which traditionally are not part of financial analysis, yet may have financial relevance. Typical ESG metrics include the measures in place to reduce carbon emissions, whether efficient water and waste management controls are in place, the effectiveness of health and safety policies in protecting against accidents and the extent to which staff welfare and healthy corporate cultures are promoted.

The first challenge is recognising how ESG translates into financial success. Perhaps the most prominent link comes from employee management. Employees working within a healthy ESG environment are typically more focused on teamwork and productivity. There are also cost benefits to be realised from having a stable workforce and better employee retention.

Consumers are also paying more attention to environmentally friendly and ethically sourced products. In this highly connected global market, brand reputation is emerging as a key factor in consumers’ purchasing decisions. Consumers do not shy away from endorsing their favourite products or berating them on social media platforms.

There is also a rational connection between ESG and a company’s overall maturity. A company that has sustainability measures and solid governance policies is likely to have optimised its operations to reduce costs. It will also likely have stronger community and government relations to bolster its reputation. Therefore, identifying a target’s ESG becomes a valuable tool and risk management strategy for Acquirers whilst preserving value for shareholders.

The impact of the growth in ESG disclosures on mergers and acquisitions (“M&A”) cannot be underestimated. In the near-term, ESG performance will be incorporated into company valuations and risk assessments, and Acquirers and Targets will be expected to consider ESG performance when evaluating the impact of potential transactions. All aspects of M&A will be affected.

ESG will continue to be an increasing concern in transaction due diligence. Notably, risks relating to corrupt business practices, privacy and data security, climate change, greenhouse gas emissions and employee diversity policies are already being evaluated in the context of M&A due diligence. The potential impact of an acquisition on the reputation, culture and integration of the combined company will be a key consideration for Acquirers.

Lenders have already experienced the impact of significant ESG risks on the creditworthiness of businesses and industries (such as the dry up of investment and lending into the coal industry). Over time, companies may find their cost and access to capital becomes increasingly linked to ESG performance. There is recognition that not all ESG metrics will have the same (or any) impact on borrowing rates, but widespread availability of comparable data will allow lenders to determine over time which metric is most likely to be material.

The disparity between larger and smaller companies’ disclosure of basic ESG metrics is striking. Even in developed markets, ESG disclosure levels can be patchy. These large gaps demonstrate the need to gain further sources of ESG information, and more importantly, to meet with corporate boards and management teams to clarify governance and management of important environmental and social risks. It will be interesting to see how the audit profession builds this into their reviews and opinions and consultancy businesses generate transformation plans for their clients.

The lack of readily available ESG information in the small/mid-cap segment is a key theme going into the early 2020’s, with ESG’s prominence and importance in the large cap world already trickling down into SME M&A activities. Companies undertaking an active approach in updating and developing their ESG framework will find themselves in good stead when embarking on corporate finance activities including fundraising going forward, ESG is here to stay.

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