Integrating ESG Factors into Risk-Based Due Diligence

Abstract The incorporation of environmental, social, and governance (ESG) factors into a company’s business model has gone from the margins of corporate decision making to the core of corporate sustainability. The problem for organizations performing due diligence, particularly in a cross- border context, continues to be integrating ESG measurements into a conventional risk- based model. […]

Abstract
The incorporation of environmental, social, and governance (ESG) factors into a company’s business model has gone from the margins of corporate decision making to the core of corporate sustainability. The problem for organizations performing due diligence, particularly in a cross- border context, continues to be integrating ESG measurements into a conventional risk- based model. It must reconcile regulatory issues, policy making across borders, and the practicalities of counterparty assessments. This article adds to these conversations by critically examining methods to effectively incorporate ESG themes into the due diligence process. In particular we will highlight ways in which companies can comply with their legal obligations while simultaneously meeting sustainability goals and risking possible financial, legal, and reputational harms.

Keywords
ESG Integration, Risk-Based Due Diligence, Regulatory Compliance, Cross-Border Policy Alignment, Sustainability, Corporate Governance, Risk Management

Introduction
Historically, due diligence has emphasized financial, operational and legal analyses to catalogue and assess potential risks involved in an investment, merger, or cross-border transaction that could affect their viability. This has, in certain respects, transformed the paradigm of the limits of due diligence. Today, everyone from regulators to institutional investors are asking organizations to consider environmental, social, and governance (ESG) issues amongst other risk measurements . This is not only a question of corporate responsibility, but rather the tangible implication of why ESG factors’ performance relates to the generation of long-term value and risk exposure (Kotsantonis et al., 2016).
This change is reinforced by global trends in regulation. As a result, ESG has moved from being voluntary to being a compliance issue in a variety of relevant jurisdictions, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR), the SEC’s climate disclosure proposals, as well as other corporate governance reforms in multiple countries at the national level (Boffo & Patalano, 2020). As companies do business globally, they must contend with a fragmented web of ESG-related laws and regulations that all carry different disclosure and due diligence requirements.
The incorporation of ESG in due diligence for both small and large companies goes beyond a simple compliance measure, but is a necessary measure for understanding resilience in a world of climate risk and supply chain vulnerability, and higher social expectations. Risk-based due diligence, or RBDD, which has historically been rooted in the evaluation of corruption, fraud, and financial mismanagement, should also include ESG considerations as these are a fundamental part of the broader range of risks that can impact cross- border business success.

Evolving Frameworks for ESG Integration
A widely referenced set of guidance utilized for the incorporation of ESG into due diligence has been the OECD Guidelines for Multinational Enterprises, which outlines principles for responsible business in the areas of labor rights, human rights, and environmental stewardship (OECD, 2011) . Likewise, the United Nations Principles for Responsible Investment (PRI) promotes the consideration of ESG issues in investment decisions . These frames set expectations, but the integration of these into practical workflows of due diligence varies in consistency.
Risk-based due diligence provides a framework of sorts for that integration to occur. In making the connection between ESG and pre-existing categories of risk, such as financial, legal, and operational, companies can begin to understand how to recognize and measure ESG risks. Carbon footprint assessments and climate regulatory exposure risk are examples of environmental risk assessments, while assessments of labor conditions, diversity, or community impact could all fall under the umbrella of social due diligence. Various aspects of governance are evaluated, including the diversity of boards of directors, anti-corruption policies, and clarity and transparency of reports (Eccles & Klimenko, 2019).
The implementation of these frameworks in other jurisdictions is a struggle. Though in the EU, carbon disclosures and social responsibility may be raised, in other emerging markets, there may not even be an established report. For this reason, cross-border transactions need flexible arrangements that are able to cope with the differences in policy regimes but that can ensure uniformity in the risk assessment.

Regulatory Compliance and Cross-Border Alignment
At its essence, compliance with regulation is fundamental to ESG due diligence. Companies should avoid relying only on compliance to local ESG regulations, but also on an understanding of how these will evolve and will affect long-term sustainability. One example is the European Union Corporate Sustainability Due Diligence Directive (CSDDD), which requires companies to “identify, prevent, mitigate and account for adverse impacts on human rights and the environment in global value chains” . The costs to non-compliance are severe both in reputation and finances.
Policies across borders are especially difficult to coordinate in multi-region transactions. For example, a company doing its due diligence on a supplier in Asia would have to not only consider the labor and environmental laws of that local context, but also the disclosure expectations of investors and regulators in the U.S. or EU in terms of ESG considerations. Such an approach produces a “compliance environment” within which organizations are left to navigate multiple definitions and measures of compliance as well as differing approaches to ensuring compliance.
These gaps are now starting to be filled with technology-driven compliance tools. The use of enhanced data analytics and AI-based resources has the capability of tracking ESG risks continuously and at the jurisdictional level. New technologies have the ability to utilize natural language processing and scan like media and regulatory information around the world for potential ESG controversies to augment due diligence in near real-time.

Challenges in Integrating ESG Metrics
Despite the advancements that ESG has made, there are many complications with the manner in which ESG is incorporated into due-diligence processes.Problems arise, first of all, from the quality of ESG data. Most companies base their operations on voluntary disclosures which are mostly non-audited and not comparable across regions . So, even in areas with mandatory reporting, variations in methods make it challenging to find a point of reference for benchmarking purposes (Christensen et al., 2021).
Second, ESG risks tend to be also long-term and qualitative, thus more challenging to quantify than conventional financial risks. The exposure to climate regulation in the case of a company, for example, would not affect the current financial performance, but it could highly affect the valuation in the medium term. In the same way, concerns over reputational risk associated with violations of labor rights do not necessarily have an impact on the balance sheet but could jeopardize stakeholder confidence as well as access to markets.
Third, smaller businesses are affected more severely than larger businesses because less resources are available to them. Whereas large multinationals can afford to establish in-house compliance teams to tackle ESG, SMEs often find themselves incapable of navigating or complying with the due-diligence process because it can be so complex. Without standardization of the norms or availability of ESG metrics, these companies can be left out of global value chains.

Opportunities and Strategic Benefits
The incorporation of ESG into due diligence isn’t just about minimizing risk; it can also be about leveraging opportunities. “Companies that take a proactive approach to ESG are likely to be more attractive to potential investors, contract winners, and will build trust with stakeholders”. Strong ESG performance is increasingly seen by institutional investors as an indication of resilience and innovation and long-term profitability (Friede et al., 2015).
Moreover, organizations creating links between compliance and competitive advantage has the potential to create triage for non-traditional risk-based considerations while using ESG as a and ESG-based supply chain due diligence is an example of how uptake of renewable energy signals not only reduced regulatory risk, but signaled to the client and the end use, that the organization is leading the way towards sustainability over its counterparts, as well. In the same way, due diligence work emphasizing board diversity and transparency can be a positive driver of decision-making and confidence among stakeholders.
Instead of viewing ESG requirements as merely a check box, organizations can see the process of compliance as a foundation for building value.

Conclusion
One of the most significant shifts in how organizations assess counterparties and transaction assessments is the integration of risk-based due diligence, that is the application of ESG-based and risk-based vetting. This change is being driven by regulation and stakeholder expectations, but companies that transcend mere compliance will benefit in the long run from a strategic perspective. Barriers remain and include data quality and data standardization, as well as a lack of convergence across borders, but thanks to technological advancement and a movement towards globally harmonized regulation, the ESG space is on the cusp of growth.
The challenge for businesses is clear: due diligence is changing to account for the full spectrum of risks and the full range of opportunities affecting the global markets. But integrating ESG into a business is not just about preventing liability, it is about creating resilient and future-oriented and looking organizations that will thrive in a new era, an era of sustainability and accountability.

Author
Zita Agwunobi is a Legal Data Analyst, Technology Professional and Entrepreneur with over 15 years of experience.

References
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Eccles, R. G., & Klimenko, S. (2019). The investor revolution. Harvard Business Review, 97(3), 106–116.https://www.scirp.org/reference/referencespapers?referenceid=2755951

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Kotsantonis, S., Pinney, C., & Serafeim, G. (2016). ESG integration in investment management: Myths and realities. Journal of Applied Corporate Finance, 28(2), 10–16. https://www.hbs.edu/faculty/Pages/item.aspx?num=51511

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