ESG due diligence in M&A: the new frontier in dealmaking

Answer

The legal landscape has shifted in recent years, pushing environmental, social and governance (ESG) due diligence higher up the mergers and acquisitions (M&A) agenda. Now something of a buzzword in corporate spaces, ESG encompasses a broad range of considerations: the ‘E’ covering environmental matters (eg, climate change, fossil fuels and renewables), the ‘S’ covering social issues (eg, diversity and inclusion, gender pay gap and human rights) and the ‘G’ covering corporate governance problems (eg, anti-money laundering, cyber security and corruption). The importance of ESG is growing exponentially for both customers and investors, with companies either aiming to snag more attractive valuation creation opportunities or being forced to incorporate ESG strategies in order to remain competitive.

A company that’s ahead on the sustainability curve is more likely to attract acquirers seeking to strengthen their ESG scorecards. M&A activity is strong in sectors naturally aligned with sustainability, such as recycling, a crucial component of the circular economy. Dealmakers know that the demand for recycled material will continue. Despite it being cheaper to produce virgin material than source recycled material, the cost difference is predicted to reduce or disappear over time, especially as legal and regulatory developments begin to mandate minimum recycled-content requirements for manufacturers. This broader shift is reflected in investor behaviour: assets under management in ESG-focused funds surpassed $1 trillion globally in 2020 and the growth of impact investing has led to UK investors turning away from sectors such as tobacco, gambling and fossil fuels.

High-profile ESG shocks illustrate the financial consequences of weak sustainability practices. In 2020, Boohoo's share price fell sharply following allegations of modern slavery linked to the ill-treatment of staff in its Leicester supply chain. Institutional investor Aberdeen Standard Investments sold the majority of its shares following the incident, and retailers such as Amazon, ASOS and Next removed Boohoo stock from their platforms. As a result, M&A dealmakers are increasingly focused on protecting value from reputational risk and therefore ESG due diligence plays a role even in transactions not explicitly driven by sustainability objectives. So, is ESG in M&A a passing trend or a lasting shift?

Why ESG due diligence is rising up the M&A agenda

Accounting firm KPMG surveyed more than 600 dealmakers and conducted 50 in-depth interviews in its Global ESG due diligence+ study 2024 and found that four out of five dealmakers globally indicated that ESG considerations were on their M&A due diligence agenda. ESG-focused due diligence is conducted based on the belief in the monetary value of identifying sustainability-related risks and opportunities early on in the transaction process. If these factors are identified at the pre-signing stage, they can be factored into valuation. If investment is required to bring the target up to scratch, these costs can be understood before a purchase price is settled upon. Many studies have demonstrated a positive correlation between ESG and financial performance. However, due to methodological challenges, establishing a causal link remains difficult. Despite this, around two-thirds of KMPG respondents said they were willing to pay a premium for assets with high ESG maturity.

In the UK, the ESG lens has also been propelled by regulatory momentum. Aiming to build from the global Task Force on Climate-related Financial Disclosures currently required by law in 10 countries, the UK government's Transition Plan Taskforce Disclosure Framework will require certain financial institutions and listed companies to publish transition plans detailing how they’ll decarbonise as the UK moves towards a net-zero economy by 2050. Moreover, under section 172 of the Companies Act 2006, UK directors must act in a way that they consider, in good faith, would be most likely to promote the success of a company, having regard to, among other things, the impact of the company's operations on the community and the environment.

Demystifying ESG due diligence: what it actually looks like in practice

The due diligence process is an integral component of M&A, providing the buyer a chance to uncover any actual or contingent liabilities that may affect the value of the target company or assets to be acquired. A typical due diligence exercise requires the corporate legal team to prepare detailed due diligence questionnaires, review the seller's disclosures in a virtual data room and liaise with specialist teams across tax, employment, environment, finance, regulation, commercial contracts, operations and intellectual property. This builds a picture of the target's risk profile.

ESG-focused due diligence is now a more common feature of M&A transactions, with buyers looking into sustainability, human rights, governance standards and climate-related risks. In terms of environmental factors, climate due diligence once focused primarily on physical risks, such as exposure to floods, droughts and climate resilience adaptation. Additional risks have now emerged as we transition into a low carbon economy, such as regulatory and technological shifts, and market dynamics. On the social and governance side, M&A due diligence regularly encompasses workplace culture and composition, sexual harassment, and misconduct red flags.

Greenwashing and bluewashing present another modern dilemma: 'carbon neutrality' has become somewhat of an overused buzzword, so buyer due diligence will sometimes verify the target's marketing materials and public claims relating to environmental and social credentials. Companies exaggerating ESG qualifications face litigation risk under the Financial Services and Markets Act 2000 for publishing misleading information, as well as claims for misrepresentation and breach of warranty.

KMPG recommends that firms commission a dedicated climate or ESG-focused workstream. However, efforts should target areas that are material to the deal. This expanded scope may necessitate alterations to information request lists, additions to questionnaires, more extensive research in the public domain, and will likely involve multiple advisers and advisory firms. This expansion will increase transaction costs for the buyer but could ultimately achieve lower integration costs and higher valuations on exit.

The challenges: data, scope and quantification

In KPMG's 2024 study, three key challenges were identified. Firstly, it’s difficult to gauge what to actually look at, and to choose a scope that’s both meaningful and practical. This adds complexity to an already complex process. Although, this hurdle is lowering as it’s becomes clearer which ESG topics genuinely matter most to acquisitive buyers. Secondly, target companies often don’t provide high-quality ESG data and information. A potential solution here is for sellers to prepare better ESG documentation in advance, such as vendor ESG reports, which could consequentially increase the value of the business being sold. Finally, it’s difficult to measure the impact of due diligence findings, and quantify ESG risks and opportunities. Modelling the financial impact of social issues such as diversity, equity and inclusion is complicated, and challenges are particularly salient in the human rights context, due to the broad and global nature of human rights due diligence laws and complex supply chains.

Despite a growing body of evidence supporting the importance of ESG, budgets for ESG due diligence remain low compared to the traditional workstreams. This limits ESG specialists' ability to undertake in-depth analysis. Low budgets could be explained in part by the fact that only 44% of KPMG's 2024 global respondents consider ESG due diligence to be ‘very important’ or ‘absolutely critical’, compared to 94% for financial due diligence, 91% for legal due diligence and 85% for commercial due diligence. Will we see this outlook evolve in the future?

How ESG is shaping transaction documentation

ESG's growing participation in due diligence is also beginning to leak into other aspects of M&A dealmaking: transaction documentation and planning. ESG is expected to become more central to the negotiation of share purchase agreements and asset purchase agreements, particularly relating to warranties and covenants. This mirrors the approach taken in anti-money laundering processes.

The broad warranties typically included in M&A documentation often capture some ESG issues. However, additional risk allocation through the refinement of warranties can catch other ESG matters that’d otherwise slip through the cracks. We could, therefore, expect to see ESG addressed in a more tailored manner, for example through warranties covering general compliance with ESG, adequacy of ESG policies and buyer-specific investment strategy focus areas, such as the gender pay gap, supply chain sustainability and diversity.

ESG is also dealt with in M&A planning mechanisms. If a problematic, but curable, ESG red flag is discovered, the buyer can insist on rectification as a closing condition. In addition, if an issue is non-curable, a specific indemnity can be sought. However, proving and measuring reputational damage for indemnity may be cumbersome, and monetary value may not cover the full financial and reputational cost to the buyer in the event of an ESG disaster. Therefore, remediation pre-closing is likely the easier option. In extreme contexts, toxic assets (eg, heavily polluting factories) can be ring‑fenced by excluding them from the transaction or segregating them structurally into a non-acquired entity, purchase prices can be reduced to reflect the cost of remediation or deals can be abandoned.

ESG as a dealmaker or deal-breaker: is ESG here to stay in M&A?

ESG due diligence has real-world consequences and the trends explored in this article indicate that it’s rapidly becoming a standard feature of M&A transactions. Globally, 57% of dealmakers expect to conduct ESG due diligence on most of their deals within the next two years. ESG is emerging as a differentiator in value, competitiveness, buyer appetite and regulatory compliance, with many dealmakers reporting stronger returns where robust ESG practices are in place.

Strong ESG performers benefit from fewer red flags, lower integration costs and, ultimately, higher valuations. Conversely, poor ESG performance can trigger price reductions, heightened contractual protections or even the collapse of a deal altogether. As buyers become more attuned to sustainability risks, ESG considerations are capable of making or breaking a transaction long before any documentation is signed.

For lawyers, this shift underscores the growing importance of interdisciplinary coordination, rigorous due‑diligence processes and precise contractual risk allocation. As ESG continues to reshape the dealmaking landscape, effective legal support will require both technical expertise and a holistic understanding of the ESG‑related risks and opportunities that now lie at the heart of modern M&A.

Danielle Norris is a trainee solicitor at Womble Bond Dickinson.