ESG Due Diligence in Mergers and Acquisitions in India

Kiran Malik

24 Mar, 2023

Mergers and acquisitions (M&A) have long been a popular strategy for companies looking to expand their operations or enter new markets. In recent years, however, there has been a growing awareness of the importance of environmental, social, and governance (ESG) factors in the M&A process. ESG refers to a set of non-financial criteria that are increasingly being used to evaluate a company’s overall sustainability and societal impact. Due diligence is a critical part of the M&A process, involving a thorough assessment of the target company’s financial, legal, and operational performance. It takes this process one step further by examining a company’s ESG practices and identifying any potential risks or opportunities.
In this blog post, we will explore the importance of ESG due diligence in the context of M&A in India. We will discuss the key ESG factors that should be considered in due diligence, the legal framework for ESG due diligence in India, and the process for conducting effective ESG due diligence. We will also look at case studies of successful and unsuccessful ESG due diligence in Indian M&A, and consider the broader implications of ESG for the M&A landscape in India.

ESG Factors in Due Diligence

It involves assessing a target company’s environmental, social, and governance practices. Here’s a closer look at each of these factors:

1. Environmental factors: Environmental factors refer to a company’s impact on the natural environment, including its carbon footprint, waste management practices, and resource consumption. Environmental due diligence might involve examining a company’s compliance with environmental regulations, as well as its track record of environmental stewardship. Key areas to consider might include:
   • Climate change risks: Assessing a company’s exposure to physical risks (e.g., extreme weather events) and transition risks (e.g., policy changes or market shifts related to climate change).
   • Energy and water use: Examining a company’s consumption of energy and water, and identifying opportunities for efficiency improvements.
   • Pollution and waste: Assessing a company’s environmental impact, including its emissions, waste generation, and disposal practices.
   • Environmental management systems: Reviewing a company’s policies and procedures for managing environmental risks, including risk assessments, monitoring programs, and emergency response plans.
2. Social factors: Social factors refer to a company’s impact on society, including its relationships with employees, customers, suppliers, and local communities. Social due diligence might involve examining a company’s labor practices, human rights record, and community engagement efforts. Key areas to consider might include:
   • Labor practices: Examining a company’s policies and practices related to wages, working conditions, and employee rights.
   • Human rights: Assessing a company’s record on human rights, including its approach to responsible sourcing and potential exposure to human rights violations in its supply chain.
   • Community engagement: Examining a company’s relationships with local communities, including its approach to community investment, philanthropy, and stakeholder engagement.
   • Customer and supplier relationships: Reviewing a company’s policies and procedures for managing relationships with customers and suppliers, including any potential risks related to supply chain management.
3. Governance factors: Governance factors refer to a company’s systems and structures for decision-making, accountability, and oversight. Governance due diligence might involve examining a company’s board structure, executive compensation practices, and risk management systems. Key areas to consider might include:
   • Board structure and composition: Examining a company’s board of directors, including its composition, independence, and oversight practices.
   • Executive compensation: Assessing a company’s executive compensation practices, including the alignment of compensation with performance and the use of performance metrics.
   • Risk management: Reviewing a company’s risk management systems, including its approach to identifying, assessing, and mitigating risks.
   • Corporate culture: Examining a company’s culture and values, and assessing the alignment between these values and its actions and outcomes.

Legal Framework for ESG Due Diligence in India

India has a number of laws and regulations that require companies to consider ESG factors in their operations, and that apply to the due diligence process in M&A transactions. Here’s an overview of the key legal frameworks for ESG due diligence in India:

1. Indian Companies Act 2013: The Indian Companies Act 2013^[1] requires companies to report on their social and environmental impact, and to establish a corporate social responsibility (CSR) committee to oversee their CSR initiatives. The CSR committee is responsible for developing a CSR policy, and ensuring that the company spends at least 2% of its average net profits on CSR activities each year. Companies are required to report on their CSR activities in their annual reports, and failure to comply with the CSR requirements can result in penalties.
2. SEBI Listing Regulations: The Securities and Exchange Board of India (SEBI) Listing Regulations require listed companies to report on their ESG performance, and to disclose any material ESG risks that could affect their operations or financial performance. The regulations require listed companies to report on a range of ESG factors, including environmental impact, labor practices, and corporate governance. The regulations also require companies to establish a mechanism for shareholders to vote on significant ESG-related matters, such as environmental and social policy.
3. Other relevant regulations: In addition to the Companies Act and SEBI Listing Regulations, there are a number of other laws and regulations in India that require companies to consider ESG factors in their operations. For example:
   • The Indian Forest Act and the Wildlife Protection Act regulate companies’ use of natural resources and protection of biodiversity.
   • The Water (Prevention and Control of Pollution) Act and the Air (Prevention and Control of Pollution) Act require companies to manage their environmental impact and comply with pollution control regulations.
   • The Right to Information Act gives citizens the right to access information about a company’s operations, including information related to environmental and social impact.

These and other regulations in India establish a legal framework for ESG due diligence in M&A transactions. Companies conducting due diligence in India must be aware of these regulations and ensure that their due diligence process incorporates ESG factors in a way that is compliant with these requirements.

ESG Due Diligence Process in M&A

The ESG due diligence process in M&A involves conducting a comprehensive assessment of the target company’s ESG performance, and identifying any risks and opportunities that may affect the deal. Here’s an overview of the key steps involved in this process:

1. Conducting the due diligence: The first step in this process is to conduct a thorough assessment of the target company’s ESG performance. This may involve reviewing the company’s policies, procedures, and reports, as well as conducting site visits and interviews with key stakeholders.
2. Identifying ESG risks and opportunities: Once the due diligence is complete, the next step is to identify any ESG risks and opportunities that may impact the deal. This may involve analyzing the company’s environmental impact, labor practices, and governance structure, as well as assessing the potential financial impact of any ESG risks or opportunities.
3. Mitigating ESG risks: If any significant ESG risks are identified, the next step is to develop a plan for mitigating those risks. This may involve negotiating specific ESG-related contractual terms with the target company, or developing a post-merger integration plan that addresses any ESG-related issues.
4. Maximizing ESG opportunities: In addition to mitigating ESG risks, companies may also seek to maximize ESG opportunities that are identified during the due diligence process. For example, if the target company has strong environmental or social policies, the acquiring company may seek to leverage those policies to enhance its own ESG performance.

Overall, the due diligence process in M&A is an important step in ensuring that companies are aware of and prepared to manage any ESG-related risks or opportunities associated with a deal. By incorporating ESG factors into the due diligence process, companies can better understand the potential impact of a deal, and develop strategies for managing ESG-related issues post-merger.

Case Studies

ESG due diligence has become an important consideration for companies engaging in M&A transactions in India. Here are some examples of successful and unsuccessful ESG due diligence in Indian M&A:

1. Successful ESG due diligence: In 2018, Hindustan Unilever Limited (HUL) acquired the health and nutrition business of GlaxoSmithKline (GSK) in India. As part of the due diligence process, HUL conducted a comprehensive assessment of GSK’s ESG performance, including its environmental impact, labor practices, and supply chain management. Based on this assessment, HUL was able to identify and mitigate several ESG risks associated with the acquisition, including issues related to water use and waste management. As a result, HUL was able to successfully integrate the GSK business into its operations, and has since been recognized for its strong ESG performance.
2. Unsuccessful due diligence: In 2017, Vedanta Resources acquired Electrosteel Steels, a steel company based in India. Prior to the acquisition, Vedanta conducted limited ESG due diligence, which failed to identify significant environmental and social risks associated with the Electrosteel business. Following the acquisition, Vedanta faced a number of challenges related to environmental and social impact, including protests by local communities over pollution from the company’s operations. The company has since faced legal and regulatory action related to these issues, and has been criticized for its poor ESG performance.

These examples highlight the importance of conducting thorough due diligence in M&A transactions in India. Companies that prioritize ESG considerations in their due diligence process are more likely to identify and manage potential risks and opportunities associated with a deal, and are better positioned to achieve long-term success post-merger. On the other hand, companies that neglect to consider ESG factors may face significant challenges related to environmental, social, and governance issues, which can lead to reputational damage, legal and regulatory action, and financial losses.

Conclusion

It has become an increasingly important consideration for companies engaging in M&A transactions in India. By incorporating ESG factors into the due diligence process, companies can better understand the potential impact of a deal on the environment, society, and governance, and can develop strategies for managing ESG-related risks and opportunities post-merger.

While some companies in India have already adopted due diligence as a best practice, there is still a need for more widespread adoption of this approach. As investors and stakeholders increasingly prioritize ESG considerations, companies that neglect to consider these factors in their due diligence process may face significant risks and challenges.

Therefore, it is important for companies to prioritize ESG considerations in their M&A strategies, and to conduct thorough due diligence in all M&A transactions. By doing so, companies can mitigate potential ESG-related risks, maximize opportunities, and build a reputation as responsible and sustainable businesses in the eyes of investors, customers, and other stakeholders.

Also Read:
ESG and Due Diligence – An Overview
Role of ESG in Mergers and Acquisitions: Opportunities and Risks