• EU pushes for increased corporate responsibility for climate change, human rights
• ESG due diligence to become increasingly important for sponsors as rules tighten
• Although Europe is leading the way, greater accountability is a global trend

European companies that fail to take emergent environmental, social and governance (ESG) rules as seriously as their peers will find their access to capital begins to suffer as a result in the months and years ahead, experts said.

“Businesses deemed to have negative ESG impact will find it increasingly difficult to access capital, both debt and equity,” said James Hilburn, sustainability and climate leader for Deloitte’s Financial Advisory business.

Patrick Harris, associate director at Calash, said incoming rules will be a “game-changer” for dealmakers. “Neglecting this area could impact access to funding, including working capital, because the ability to have accounts qualified will be dependent on ESG-baseline compliance.”

Although access to capital for laggards isn’t necessarily an issue now, it will become increasingly crucial as new rules come into force, Natalie Stafford, head of ESG and sustainability at S-RM, said. “The direction of travel is clear.”

The EU is pushing for greater corporate responsibility for climate change and human rights, with measures including environmental reporting, carbon taxes and a deeper understanding of supply chains.

The European Corporate Sustainability Reporting Directive (CSRD) came into force on 5 January. It modernises and strengthens reporting rules on the environmental and social impact of businesses; and the first set of companies with businesses in the EU will have to apply the rules in 2024 and report results in 2025.

Meanwhile, the EU’s Carbon Border Adjustment Mechanism (CBAM) will apply definitively from 2026, with a transitional phase between 2023 and 2026, and will ensure that a fair price has been paid for embedded carbon emissions produced with the bloc.

Looking further ahead, the Corporate Sustainability Due Diligence Directive (CSDDD) will establish a duty for companies to identify and tackle environmental and human rights issues throughout their supply chains. Once the proposal is accepted by the European Parliament and the Council of the EU, member states will have two years to transpose the directive into national law. Germany has been leading the way on this front with its own supply-chain law, as reported.

On the horizon

Private equity (PE) firms will have to think particularly hard about the changes due to their long investment horizons, experts said.

“Private equity firms tend to be under-prepared when it comes to the increasing focus on ESG due diligence,” S-RM’s Stafford said. “More scrutiny is coming, and anyone who is under-prepared is making a big mistake.”

As a rule, ESG teams in the PE world tend to be too small and too junior, Stafford said. “ESG shouldn’t be pigeonholed,” she said, adding that general partners (GPs) need to increase budgets and recruit more ESG professionals. They also need to give the team a seat at the table and a mandate to think strategically, she added.

“When the real scrutiny starts, being able to demonstrate that you have the right processes in place is a must,” she said, adding that it is important to stress-test any ESG processes.

However, some PE firms are already grappling with translating multiple impacts into deal pricing, Deloitte’s Hilburn said. ESG due diligence needs to translate the risks into financial terms so sponsors can decide whether or not to proceed, he added.

Limited partners have been pushing GPs to take these issues seriously, Hilburn said. “PEs have been faster out of the blocks than corporates.”

PE firms need to think about exits as they invest, which means that sponsors will have to take a view on how regulations will change, Harris of Calash said. “Failing to plan ahead could make it harder to grow new investments, and compromise exits,” he said.

Investing is often not about picking the winners but avoiding the losers, according to Tauni Lanier, co-director, sustainability & ESG hub at BDO UK.

The “investability” of companies should include avoiding value erosion as well as thinking about value creation, Lanier said. “So-called ‘dirtier’ industries are more likely to land on the side of value erosion and are not set up to be future-proof, with little clear growth and value possibilities.”

Risks galore

Some late adaptors to incoming rules can already see an impact on their operating costs, Hilburn said. ESG laggards will have higher carbon emissions than peers, which can lead to carbon taxes, hurting pricing, he said.

“We work with companies to help them be more resource efficient,” Hilburn said. “By not doing this, you’re becoming a high-cost producer in your value chain.”

Meanwhile, deal practitioners need to continually monitor change-of-law clauses in sale contracts to keep up with fast-changing environmental regulations, according to Peter Bird, managing director at BRG. “Post-deal disputes arising from environmental legislation are becoming increasingly common.”

Some of the risks might be hard to spot using conventional tools. “Qualitative due diligence –speaking to people and stakeholders – is becoming absolutely critical, particularly for social and governance issues,” James Kirby, senior associate, Calash said.

It is too soon to say what the standard ESG due diligence package will end up looking like, Harris of Calash said. However, it will become “a basic part of the dealmaking process” as the new regulations gain force, rather than a premium feature as it is currently, he added.

Global trend

Although Europe is leading the way in ESG, other parts of the world are also moving in a similar direction, albeit at a slower pace.

For example, the International Sustainability Standards Board (ISSB) is developing global standards for sustainability disclosures as part of the International Financial Reporting Standards (IFRS). The first iteration of the rules, known as IFRS-S1 – S standing for sustainability – is effective from 1 January.

Differing rates of implementation will lead to opportunities as well as risks, Calash’s Harris said. “Private capital, for example from family offices in the Middle East or Asia, could step into the breach. Gaining access to capital could be a catalyst for moves to redomicile, or for cross-border M&A.”

However, sovereign wealth funds (SWFs) from the Middle East are increasingly thinking about ESG issues, according to Deloitte’s Hilburn. Energy-transition plays are an attractive asset class, he said, adding that SWFs are competing with the most mature investors in the world for the same infrastructure assets.

There are also political risks to sustainable finance, particularly in the US, BDO’s Lanier said. ESG has become politicised in the US, she noted.

Even so, sustainable finance is likely to grow fast in the years ahead, Lanier said. She cited research showing that the field was valued at USD 4.2tn in 2022, which could increase more than 7x to USD 30.9tn by 2032.

Companies seeking to maintain the status quo will still be able to find financing in the years ahead, Lanier said. However, their cost of capital is likely to go up as increasing numbers of institutional investors use ESG data as a fundamental screening criterion, she added.