ESG due diligence, or Environmental, Social, and Governance due diligence, is a comprehensive assessment process employed by investors, financial institutions, and other stakeholders to evaluate the non-financial aspects of a company. This evaluation is crucial for making informed investment decisions, as it considers the potential impact of a company’s practices on the environment, society, and its overall governance structure.
Environmental (E):
In the environmental dimension, the due diligence process delves into a company’s ecological footprint and its efforts to mitigate environmental impact. Key considerations include energy consumption, greenhouse gas emissions, water usage, waste management practices, and adherence to environmental regulations. Investors are increasingly concerned with how a company addresses climate change and other environmental challenges.
Social (S):
The social component assesses how a company manages its relationships with various stakeholders. This includes examining labor practices, diversity and inclusion policies, human rights safeguards, community engagement initiatives, and product safety standards. Investors are interested in understanding how a company contributes positively to the well-being of its employees, communities, and society at large.
Governance (G):
Governance focuses on the internal structures and processes that guide a company’s decision-making and operations. This includes scrutinizing the composition and effectiveness of the board of directors, executive compensation structures, shareholder rights, ethical business practices, and the overall transparency and accountability of the organization. Effective governance is viewed as essential for ensuring the long-term sustainability and ethical behavior of a company.
The ESG due diligence process involves a thorough examination of a company’s policies, practices, and performance metrics related to these ESG factors. Analysts may also evaluate the integration of ESG considerations into the company’s overall business strategy and assess the depth of its commitment to sustainable and responsible business practices.
ESG due diligence has gained prominence in recent years as investors recognize that ESG factors can significantly impact a company’s long-term value and reputation. Integrating ESG considerations into investment decisions is not only seen as a means of promoting sustainability but also as a way to manage risks associated with environmental and social issues. The transparency and ethical behavior assessed through ESG due diligence contribute to building trust among investors and stakeholders, fostering a more responsible and sustainable business environment.
Within the European Union (EU), the doctrine of due diligence has been enshrined in several legislations and directives, prominently featuring the Non-Financial Reporting Directive (“NFRD”), Corporate Sustainability Reporting Directive (“CSRD”) and the Corporate Sustainability Due Diligence Directive (“CSDDD”).
These legal frameworks mandate companies to disclose information concerning their environmental, social, and governance (ESG) impacts, along with any associated risks or adverse effects stemming from their operations or supply chains.
It is noteworthy that the scope of these regulations extends beyond EU borders; supply chains originating from any part of the world are subject to scrutiny. Particular emphasis is directed towards markets in Africa, Asia, and Latin America, regions historically characterized by a lack of traceability and transparency, especially in the initial and concluding stages of the supply chain, such as those involving smallholder farmers or informal waste collectors.
In addition to these pan-European regulations, each member state has established its own set of laws and requisites governing due diligence, which can vary based on the industry or sector within which a company operates. Notably, specific due diligence requirements are imposed on the mining and extractive industries under the EU Conflict Minerals Regulation.
To align with these legislative frameworks, companies are obliged to undertake comprehensive and continual due diligence. This entails identifying and evaluating potential risks and impacts associated with their operations, products, and supply chains. This comprehensive assessment encompasses an evaluation of the environmental and social ramifications of a company’s activities, as well as a scrutiny of potential human rights violations or instances of corruption within the supply chain.