By Madison Guerinot
How Will an Increased Focus on ESG by the SEC and Investors Impact Transactions? ESG Overview and Use in Investments
E
nvironmental, social, and governance (ESG) has become a hot topic for investors in recent years. For those not familiar, ESG proposes a set of nontraditional factors to identify risks and opportunities related to a given business. Each of the three main categories includes numerous subcategories, so any given company must tailor its focus to the ESG factors most relevant to its business. Environmental considerations range from physical risks from rising sea levels to carbon emissions. Social factors can mean anything from diversity and inclusion to the ethical sourcing of materials. The governance factors look to how ethically a company operates and how it incorporates environmental and social considerations into the business. ESG advocates argue that boards incorporating ESG into business decisions and investors using ESG to evaluate potential investments increase financial returns and reduce liabilities.1 For example, a company with robust anti-harassment practices is less likely to encounter costly litigation. On the environmental side, an investment fund considering the physical risks of its assets is likely to suffer fewer costly damages from hurricanes or flooding.
Consequently, ESG-related funds and a focus on ESG have proliferated in the M&A world.2 According to one study, 65% of M&A executives say their companies’ focus on ESG will increase over the next three years.3 Incorporating ESG into due diligence involves broadening traditional diligence considerations that are already geared toward evaluating potential litigation risks or future financial performance. In fact, many ESG factors, like safety and diversity, are already accounted for in EEOC and OSHA reporting requirements. Buyers are asking more ESG questions in the due diligence process, and sellers need to be prepared. As investors seek ESG investments, companies are reviewing their internal ESG metrics and seeking to provide reports to their shareholders and potential investors. However, the U.S. currently lacks an overarching ESG reporting standard. Companies attempting to incorporate ESG have wide latitude to choose a reporting standard (or not) in compiling any investor reports or public relations materials. The most used reporting standards include the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and the Task Force on Climate-Related Financial Disclosures (TCFD). Even after selecting a given framework, companies have further discretion on how to use the framework. For example, SASB includes 77 identified industries, each with different standards for evaluation.4 Thus, a company must select the most applicable industry (or combination) prior to evaluating its ESG metrics. Similarly, the TCFD includes 11 different categories of disclosure. For the fiscal year 2021, only 4% of companies using TCFD disclosed according to all 11 recommended disclosures and only 40% included at least five of 11 disclosures.5 While ESG reporting may provide investors and shareholders with more information, the lack of standardization makes it difficult to draw comparisons between companies, or even develop a full understanding of any individual company or