[Few weeks ago, I wrote a blog titled Those Three Letter Words . This blog was a satire on the terms EIA and ESG. Many readers liked this blog.
Todays blog is on the 4 letter words that most investors use.]
Due Diligence (DD) is one of the important steps in lending or participating in equity or in merger and acquisition. DDs can result into “No No” or a “Yes” with a myriad of conditions, additionalities and covenants when approvals are given. Investment Committees (IC) at the investors generally carry out DDs on their own using their team of Investor Managers (IM).
Environmental considerations got introduced in the DDs and they focused on the required documentation (e.g. clearances, consents/permits etc.). Accordingly “undertaking” was asked to insulate from the risks of environmental, health and safety related non-compliance.
Earlier, in 1980s, lenders and investors in Americas and Europe had a bitter experience when the environmental assessment of sites was neglected. There were instances when collaterals that were taken on land assets turned into severe liabilities as the sites or the land parcels were found to be contaminated. Accordingly, the requirement of Phase-I and Phase-II environmental site assessments (ESAs) emerged. These ESA reports were included in the DD exercise. I remember when I was a member of the divesture commission, we had found that results of Phase-I and Phase-II reports influenced the decision on divesture.
In the last two decades apart from environment, health and safety; social due diligence got included in the DDs. The idea was to examine the social welfare related measures, policies and practices on gender sensitivity & diversity, stakeholder engagement plan and grievance redress mechanism. Soon, the social DD expanded to supply-chains and assessed whether environmental and social criteria were included in the vendor selection and management.
The investors started looking for a global framework that could be used to address environmental and social issues in a comprehensive manner covering many of the elements of the safeguards (e.g. biodiversity, culture heritage, community health & safety) that are followed by the big daddies like the World Bank, Asian Development Bank etc. International Finance Corporation’s (IFC)’s Performance Standards (PS) was one such global and commonly followed framework. Since environmental and social compliance requirements vary between countries (and even vary across the States/regions in a country), asking conformance with the IFC PS in addition to compliance, made a good sense. The two letter DD word got soon prefixed with E (Environmental) & S (Social) as the four letter word ESDD.
As the three letter word, ESG, emerged, some investors started asking for G (Governance) in addition to E&S, resulting into a five letter word – ESGDD. However, many investors realized that G was a different ball game altogether and had to be conducted separately using G specialists. IFC came up with the Corporate Governance (CG) guidelines for this purpose. So the four letter word ESDD remained in practice.
The investors did not have enough bandwidth to conduct ESDDs on their own. Besides ESDD being a specialized area, experts/consultants had to be hired who had a good experience in environmental and social domains and importantly were familiar with IFC PS. This led to some impact on the consulting organizations as they had to maintain environmental and social teams who not only were well versed with national E&S compliance, but also with IFC PS. These teams not only needed to know all expectations of all the 8 IFC PS but also be familiar with 600+ Guidance Notes (GN) that supported the PS. Since standards such as IFC PS are not taught in the academia, those desirous to do business or make a career in ESDD had to look for training programs or do self-learning on the job. Today most of the so called ESDD specialists at consulting organizations have learnt the “technique” of producing ESDD reports through templates and checklists.
Today, the “market size” of ESDD as a service is rapidly expanding. Most of the consulting companies are overstretched to conduct a quality ESDD and in time. While paucity of trained staff is one of the major reasons for poor quality, unrealistic expectations from Investor community on the delivery of ESDD reports is yet another reason. The Investor Managers ask for ESDD reports, generally when base DD work is done (with decisions almost reached!) and ESDD is asked only to meet the document requirements of the Limited Partners (LP). This often puts the ESDD consultant in a fix as the final report becomes more of a word play.
For financing intermediaries (FI), ESDDs are triggered through the Environmental and Social Management Systems (ESMS) – a yet another 4 letter word. ESMS guides whether ESDDs are required and if yes then at what level the ESDD should be conducted. One can question whether the ESDDs and the ESMS have been really effective on the ground and whether we can say that the investments made through ESMS/ESDD are truly responsible. But these 4 letter words, comfort the investors as they are intended to guard both financial and reputation risks. While I have umpteen examples where these mechanisms have remained rather perfunctory and have stayed only on paper, I am still not very pessimistic. Certainly, God has been kind to many investors as the “garbage” of non-compliance remains in the bin or gets buried not to cause a stink for quite long time.
I spoke about my observations and experience on ESDD and ESMS to my Professor Friend. As usual, he had another point of view.
He lighted his cigar.
“Dr Modak, DD is essentially a risk identification and management process. Addition of E&S expanded DD as ESDD. Unfortunately, the investor is still looking at ESDD only from risk perspective.”
I agreed. I said, “When you bring E&S elements together, we should not limit only to the risks but investigate opportunities – both financial and non-financial.”
Professor nodded and continued.
“One of the major outcomes of a ESDD is the Environmental and Social Action Plan (ESAP)”
He paused as he got up to bring the ash tray.
(I noticed that we were now talking of another investor’s 4 letter word)
“Dr Modak, imagine the ESAP was developed not only to close the gaps on compliance but also to improve resource efficiency, enhance circularity, address decarbonization targets, strategize CSR and increase stakeholder value? Won’t the investors, especially when taking stake on equity, find such kind of ESAP extremely useful? Won’t it help the investee to appreciate that while sustainability is a global good it is also immensely material to the business?”
I couldn’t disagree. Of course this would mean a total transformation on how ESDD should be – I was tempted to call this new approach as Environmental and Social Opportunity Assessment (ESOA). (As I wanted to stick to the family of 4 letter words in the interest of investors)
We spoke more and had an exciting conversation on how ESOA should be structured.
In closing, while extinguishing his cigar Professor said
“Dr Modak, all good – but the challenge is who will redraft those dreadful Terms of Reference (ToR) of ESDDs that are today blindly followed by the E&S specialists at the big daddies like the World Bank, IFC, Asian Development Bank etc. These folks will continue bullying the FIs and Investee companies and the ESDD consultants”
Professor was absolutely right.
I was happy that I could at least discover another 4 letter word – ESOA !
If you don’t change the upstream, nothing will change downstream!
(My company Environmental Management Centre Pvt Ltd has come up with a blended product of compliance and sustainability in the form of ESOAs to replace conventional ESDDs. Those interested to know more on this product, do contact me)
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