Justin Bharucha and Vandana Pai examine how due diligence can be used to identify and address risks of non-compliance with ESG regulations
Investors the world over are increasingly structuring investments with lower environmental, social and governance (ESG) risks. One of the reasons for this is the growing regulatory scrutiny on ESG-related non-compliance. For instance, recently, the Securities and Exchange Commission fined BNY Mellon Investment Adviser for claiming that it had met all compliance requirements despite having failed to undertake an ESG quality review.
ESG is not an entirely new concept in India. There have been statutes on the books and bodies regulating ESG issues in India for decades – for instance, various environmental regulations, labour codes, corporate social responsibility (CSR) rules implemented in 20141 and quasi-judicial authorities like the National Green Tribunal.
Even the 2021 business responsibility and sustainability reporting (BRSR) issued by the Securities and Exchange Board of India (SEBI), India’s securities market regulator, is based on the principles set out in the National Voluntary Guidelines on Social, Environmental and Economic Responsibilities of Business issued by the Ministry of Corporate Affairs (MCA) in 2011 (and updated in 2019), and has replaced the business responsibility report first introduced by the SEBI in 2012.
In the past, Indian regulators have taken enforcement action against companies for failing to comply with regulatory ESG requirements. For instance, the National Green Tribunal, by its order dated 10 September 2020, directed the Central Pollution Control Board to undertake an environmental audit of Amazon Retail India Private Ltd due to its excessive use of plastic as packaging material.
Similar scrutiny may also be expected from other Indian regulators in the coming years given India’s target of net zero greenhouse gas emissions by 2070.
ESG reporting metrics and scope of diligence
In India, ESG reporting is neither objective nor standardised. As of 1 April 2023, the SEBI’s BRSR requires the top 1,000 listed companies by market capitalisation to make ESG-related disclosures in their annual reports against nine principles, including accountability and transparency, provision of sustainable goods and services, and responsiveness to stakeholders. However, BRSR compliance is not mandated for unlisted entities or smaller listed companies, and there is no format for ESG reporting in India for such entities. The only guidance available is the BRSR lite version of the reporting format suggested by the MCA in the Report of the Committee on Business Responsibility Reporting, which recommended changes to the MCA’s National Voluntary Guidelines on Social, Environmental and Economic Responsibilities of Business.
Given the above, diligence undertaken by the investors becomes a key measure to evaluate target companies’ ESG compliance and commitment. Akin to a legal due diligence, an ESG due diligence should be structured based on the sector in which the target is engaged, and involves the assessment of compliance and liability. For instance, a plastics manufacturer would be more susceptible to risks associated with waste management, as opposed to a target in the IT/ITES sector where risks pertaining to data protection norms may be more relevant. Additionally, the ESG due diligence may also take into account: (i) whether the target has a dedicated ESG policy; (ii) how the target chooses to respond to ESG-related risks; (iii) the target’s governance structure, including decision making at the board and shareholder levels; (iv) oversight models adopted by the target; (v) evaluation of the target’s supply chain, and, to the extent possible, whether the target’s suppliers are compliant with ESG requirements; and (vi) the energy sources used by the target.
Mitigating ESG risks and next steps
Fundamental ESG risks identified through due diligence must be addressed either through pre-closing conditions or conditions subsequent. ESG compliance is increasingly likely to be an extremely important issue that may impact whether a transaction will actually progress.
Investors may also consider including tailored representations and warranties in the transaction documents. These may include representations and warranties pertaining to compliance with regulatory disclosure requirements – including compliance by the target’s suppliers, maintaining adequate sectoral licences, and incorporating a defined metric to measure future ESG goals. To address the adverse impact of issues such as greenwashing and social-washing (essentially, artificially inflating ESG compliance or portraying a higher level of compliance), investors may consider building specific indemnities into the deal documentation. To that end, market practice has been to either negotiate to hold back a portion of the investment amount – which can then be set off against any losses arising from known ESG risks – or deferring that portion of the payment until ESG compliance requirements have been met.
Globally, insurance providers are coming up with assessment tools for ESG risks that can measure a target’s ESG performance in accordance with internationally recognised methodologies and provide a score based on 18 ESG themes. Essentially, these ESG scores allow underwriters to make decisions on whether there can be any incentives or dynamic pricing on insurance products, depending upon contingent events, for eg, installation of solar energy panels. Once these products and services – tailored to the nine principles under the BRSR and the MCA’s guidelines – are available in India, investors may opt for the same to measure the target’s ESG performance and manage risks2.
Post closing, investors may require the target to build and follow voluntary industry group standards and best practices, undergo voluntary social audits and assurance from time to time, and benchmark its ESG performance against its competitors.
Given the rise in ESG concerns and the lack of objective regulations, ESG-based due diligence has become an essential tool for investors to unlock value and protect themselves against potential risks. Targets that embrace regular ESG due diligence and take proactive initiatives are better positioned to build trust with their potential investors and adapt to the expectations of sustainability.
- India was the first country to legislate mandatory CSR requirements and compliance, and penalties for failure to comply. A company that fails to make the mandatory CSR contribution is liable to a penalty of twice the amount that was not contributed for CSR purposes, and its officers in default are liable to a penalty of one tenth of the CSR amount that was not contributed or INR 10m, whichever is lower.
- Although ESG ratings services are available in India, the ratings are usually restricted to entities whose securities are listed on a stock exchange as the ratings providers rely on publicly available information to evaluate these entities.
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