Environmental, social and governance (ESG) considerations are not new, but their importance has increased dramatically in recent years driven by climate change, the impact of the Covid-19 pandemic and social justice movements. Globally the world is moving towards reaching ‘net zero’ emissions and reducing carbon footprints. Australia has committed to an interim emissions reduction target of at least 43% below 2005 levels by 2030.1
This means mergers and acquisitions (M&A) are about to get greener and ESG considerations will become increasingly important throughout the M&A lifecycle from target selection, due diligence, post-merger integration and ultimately in an exit. The Australian Securities & Investments Commission (ASIC) is taking note of the importance of ESG, with ‘greenwashing’ becoming one of its top priorities. This, combined with the proposed mandatory climate reporting for certain entities being phased in as of 1 January 2025 by the Treasury Laws Amendment (Financial Market Infrastructure and Other Measures) Bill 2024 (Cth) (this date is dependent on the commencement date), has pushed ESG higher on investor’s radars and as a result, ESG is sure to play an increasingly important role in any M&A process.
It is therefore imperative that ESG is no longer a ‘buzzword’, no longer a snapshot slide in a glossy brochure and no longer a ‘nice to have’, but that businesses understand the importance of ESG considerations, not only in their day-to-day operations but also in how it will affect a sale process.
Recent ESG developments that could impact M&A
The Treasury Laws Amendment (Financial Market Infrastructure and Other Measures) Bill 2024
The difficulty for businesses in navigating ESG considerations is amplified by Australia’s fragmented collection of laws in relation to ESG, making it difficult for businesses to ensure compliance and to stay on top of the ever changing regulatory landscape.
Recently Australia has followed the EU’s implementation of the Corporate Sustainability Reporting Directive which came into force on 5 January 2023 in the EU (which introduced reporting on ESG risks for relevant entities) in the biggest reshape of reporting for a generation in Australia. The Treasury Laws Amendment (Financial Market Infrastructure and Other Measures) Bill 2024 (TLA Bill) was introduced on 12 January 2024 and as early as 1 January 2025, it is proposed that climate related financial disclosures will become mandatory for entities that are required to lodge financial reports under Chapter 2M of the Corporations Act 2001 (Cth). The TLA Bill is currently before the Senate.
The TLA Bill proposes to amend the Corporations Act 2001 (Cth) (and various other acts). The amendments introduce a new annual ‘sustainability report’ that entities will need to prepare, in addition to their financial reports. An annual sustainability report consists of a climate statement which requires details of governance, strategy, risk management, emissions and climate related metrics and targets. The report must also contain a director’s declaration about these statements.2
Greenwashing
Businesses need to be sure they can back up their ESG claims, whether made as part of an M&A process or otherwise, not least because greenwashing has become a top priority for ASIC who are now leading the way globally as one of the leading financial regulators taking enforcement action to combat greenwashing.
ASIC considers greenwashing to be ‘the practice of misrepresenting the extent to which a financial product or investment strategy is environmentally friendly, sustainable or ethical.’3 The main types of conduct that have caused ASIC to intervene include net zero statements made without a reasonable basis or being factually incorrect and using terms such as ‘carbon neutral’ when such terms are not founded on reasonable grounds.
To date, ASIC have issued 17 infringement notices totalling more than $230,000 and have successfully pursued legal action against Vanguard Investments Australia Ltd, LGSS Pty Ltd as trustee of the superannuation fund known now as Active Super and against Mercer Superannuation (Australia) Limited.
The ACCC have also followed suit and in April 2024 commenced greenwashing enforcement proceedings in the Federal Court against Clorox Australia Pty Ltd for allegedly false claims about refuse bags being made from recycled ocean plastic.4
Why is ESG relevant in M&A?
ESG is relevant for every business and in every aspect of business. Every business is affected by and has an impact on the environment, every business operates within a broader society and every business has policies and procedures to govern itself. Purchasers will consider ESG considerations in target selection, ESG will form part of the due diligence process and ESG considerations can also impact the transaction documents, as we consider further below.
ESG in due diligence
Given the regulatory landscape, ESG considerations will form an increasingly important part of the due diligence process. ESG considerations are already at the forefront of transactions involving banks and financial sponsors.
Conducting effective ESG due diligence will enable investors to identify risks and liabilities associated with a target’s ESG profile, highlight opportunities to improve ESG credentials and provide insight into stakeholder relationships. Investors will want to see effective processes and procedures in place to manage ESG risk. If robust processes are in place, then the risk profile of the business may be lower and this could potentially lead to a higher valuation of a target. Having effective procedures in place can also ensure better post-merger integration for both the purchaser and target.
The nature of ESG due diligence largely depends on the nature and type of business. ESG will be more relevant for certain industries including agribusiness, energy, healthcare and manufacturing. ESG influences every aspect of a business and as such ESG considerations in due diligence cover a vast array of areas including:
- environmental impact assessments;
- environmental permits;
- pollution;
- energy use;
- regulatory compliance;
- employee relations;
- corporate governance (including corporate disclosure obligations that apply to listed entities in the Corporations Act 2001 (Cth));
- director duties, which are likely extend to a duty to ensure that corporations assess and make appropriate disclosure about material ESG risks;
- labour and supply chain practices;
- diversity and inclusion;
- human rights;
- data privacy; and
- anti-bribery and corruption.
Investors may also review a target’s ESG score in their due diligence. ESG scores measure how a business addresses ESG risks and concerns in day-to-day operations. However, the accuracy and impact of such scores is debatable as typically rating agencies will look at financial performance as opposed to the environmental impact of a business. Further, what ESG factors are important to one business can differ significantly to what factors are important to another business.
Lenders are also increasingly incorporating ESG disclosure obligations as conditions to financing agreements, which is a further incentive to manage and monitor ESG risks in debt funded M&A transactions.
By planning ahead, a business could maximise deal value and ensure a more efficient sale process. A business can prepare by reviewing:
- ESG progress and compliance with ESG objectives to address risks;
- energy use to consider reductions in energy;
- operating procedures to consider efficiencies;
- supply chains to consider efficiencies and compliance with laws;
- labour standards in the workplace and supply chain;
- all permits/authorisations/licences to ensure the business maintains those that are required;
- corporate governance guidelines;
- data privacy procedures and risk assessments;
- employee relations;
- employment and diversity policies;
- anti bribery and corruption policies;
- insurance policies to ensure adequate coverage to cover risks appropriate to the business; and
- how a target interacts with its wider stakeholders.
ESG due diligence is therefore crucial for identifying ESG risks and the consequent protections that will be required in the transaction documents, or to be adopted in the post-merger integration.
ESG in transaction documents
Failure to address ESG risks and compliance issues could result in regulatory action, reputational damage and adverse financial consequences. Navigating the ESG landscape is therefore increasingly important not only from a value perspective, but also from a reputational viewpoint.
The difficulty in addressing ESG comes with quantifying ESG risks, as it may be challenging to compensate a purchaser for non-compliance depending on the nature of the ESG risks. This highlights the difficulty in ensuring sufficient protections where warranties and indemnities may not be suitable and the purchaser may consider alternatives such as a purchase price reduction, escrow or requiring remedy of the specific concern by including a condition precedent or condition subsequent.
There are various areas in transaction documents where ESG may be addressed:
- Conditions Precedents (CPs) – the purchaser may require certain CPs be completed prior to completion of a transaction, for example adopting ESG compliant policies and procedures, obtaining environmental permits or undertaking remediation works.
- Post-completion remedy of identified risks – the purchaser may also require that certain risks be remedied post-completion of a transaction, for example updating diversity and inclusion policies or revising the corporate governance strategy.
- Warranties and indemnities – purchasers can negotiate specific warranties in relation to ESG matters as well as specific indemnities in relation to known risks. The difficulty that comes with warranties and indemnities is in relation to quantifying the risk. Nevertheless, warranties can play an important role in covering the bases of ESG concerns and in drawing out disclosures.
Whilst a standard suite of warranties includes compliance with laws and depending on the business, environmental warranties, it is becoming more prudent for specific ESG related warranties to cover the following:
| Area | Warranties |
| Environmental |
|
| Social |
|
| Governance |
|
We should expect to see some standardisation of warranties in transaction documentation in the near future as ESG considerations become a customary feature of the M&A process.
- Escrow – purchasers may hold back a portion of consideration as security for any potential ESG liabilities.
- Price adjustment – if material ESG risks are identified in due diligence, then the purchaser may consider a reduction in the purchase price.
- Post-merger integration – to ensure an easier integration into the purchaser’s business, targets may be required to implement the purchaser’s group policies and procedures. Purchasers will be interested in making the post-merger process as seamless as possible, they will want the ESG standards to measure up to their own standards for example in employee relationships, corporate culture, social responsibility, governance policies, environmental impact and supply chain. Typically, the transition will be set out in the ‘100 day plan’ and depending on the compatibility of the purchaser and the target in these areas, the post-merger integration could become a cumbersome process if the entities do not have similar ESG standards.
Take action and prioritise ESG in your M&A strategy
Investors, employees, regulators and consumers are increasingly demanding greater transparency and accountability regarding ESG practices. As ESG considerations and regulatory developments continue to reshape the landscape for businesses, any party embarking on acquisition should closely consider ESG issues. In the near future, we expect to see a rise in ESG considerations during due diligence and in transaction documents, including the standardisation of ESG warranties. Depending on the nature of the business and associated ESG risks, transactions could become structured around managing ESG risks and compliance.
It is important to take proactive steps now to ensure your M&A processes are ESG-compliant and value-driven. For more information, contact Peter Williams or Rachael McGurgan to learn how we can assist you in navigating ESG considerations in your next transaction.
1https://www.climatechangeauthority.gov.au/2035-emissions-reduction-targets
2https://treasury.gov.au/sites/default/files/2024-01/c2024-466491-exposure-draft-em.pdf
3https://asic.gov.au/about-asic/news-centre/speeches/asic-and-greenwashing-antidotes/
4https://www.accc.gov.au/media-release/glad-bags-manufacturer-in-court-for-50-ocean-plastic-claims
