Towards Effective ESG Integration: Redesigning Due Diligence in Project-Financed M&A

Introduction

The previous ten years have seen a notable change in the execution and arrangement of mergers and acquisitions (M&A) transactions, as the increasing importance of environmental, social, and governance (ESG) factors introduces new dynamics in deal making. For corporate M&A attorneys working in key jurisdictions like the United States, European Union and United Kingdom,¹ the incorporation of ESG has transitioned from a simple compliance requirement to a strategic necessity that fundamentally influences legal, regulatory, and risk management systems, especially in the intricate field of project finance. Despite this increasing importance, a significant problem endures: a substantial gap exists in both legal research and market practices regarding the understanding and execution of effective ESG due diligence procedures² in project-financed M&A deals. Although policy frameworks and disclosure requirements are advancing, there is a lack of adequate practical guidance on the systematic identification, assessment, and response to ESG issues during the due diligence stage of intricate transactions. The lack of defined standards and best practices results in varied methods, possible neglect of significant ESG risks, and difficulties in securing contractual safeguards and maintaining compliance procedures. By highlighting and carefully analysing this crucial topic the integration of efficient, useful ESG due diligence into project finance M&A the paper seeks to provide crucial analytical and comparative viewpoints for academics and industry experts alike. In the end, closing this gap is essential to ensuring that ESG pledges produce notable outcomes in the planning, carrying out, and long-term success of M&A deals.

The gap: ESG due diligence as the weak link

(1) Lagging behind policy regulatory changes like the United States Securities and Exchange Commission’s (US SEC’s) guidelines³ on ESG disclosures, the European Union’s Sustainable Finance Disclosure Regulation (EU’s SFDR) and Taxonomy⁴, and the UK’s mandates aligned with Task Force on Climate-Related Financial Disclosures (TCFD)⁵ have surpassed the practical resources accessible to M&A dealmakers. Although policy establishes elevated benchmarks, the actual M&A transactions financed by projects often lack consistency in defining, gathering, and addressing significant ESG risks at the initial stages. In practice, ESG due diligence is frequently viewed as an additional assessment instead of being regarded as an essential element with specific goals. Numerous deal teams miss sector-specific ESG knowledge, heavily depending on generic checklists instead of assessments customised for their industry risks.

(2) Insufficient depth and breadth

The absence of clear instructions results in inconsistent and frequently shallow ESG due diligence procedures.⁶

(a) Environmental risks are occasionally confined to enumerations of permits and claimed compliance; cumulative impact evaluations, historical pollution, and transition risks (like decarbonisation exposures) might remain unnoticed.

(b) Social factors are often simplified to workforce statistics or current complaint systems, overlooking in-depth exploration of community rights, supply chain practices, or past violations.

(c) Governance concerns often emphasise Board Structure and regulations, rather than the strength of oversight or the reliability of internal probes.

(3) Legal uncertainty and deal vulnerability

In the absence of strong due diligence⁷ procedures, parties run the risk of falling short of future ESG reporting requirements, inheriting secret liabilities, and being sued after the sale. Due to this disparity, purchasers and lenders are subject to serious risks to their finances, operations and image.

Key drivers and challenges in robust ESG due diligence

(1) The nature of project finance transactions

Typically, project-financed M&A deals encompass large, capital-intensive assets that have been part of the infrastructure and energy sectors for over 20 years, and have a multidecade lifespan. Such transactions feature convoluted parties operating networks e.g. international project sponsors, community organisations, and government agencies besides human rights or social aspects. Furthermore, the involved parties may face such social and environmental risks that will not become apparent for a long-time and, therefore, the performance of due diligence with foresight into the future is imperative. Traditional M&A investigations, especially in non-Organisation for Economic Co-operation and Development (OECD)⁸ countries, often fail to recognise this multilayer complexity of rapidly changing ESG regulatory environments.

(2) Global regulatory divergence

In terms of mandatory ESG disclosures, acceptable diligence techniques, and recognised contractual procedures, the US, EU and UK have all adopted different stances, which is made worse by the lack of unified international standards on ESG due diligence. Although there are frameworks like Business Responsibility and Sustainability Reporting (BRSR), emerging nations like India have even more difficulties since there is a “compliance vacuum” in reality due to the lack of clear advice or enforcement on transactional ESG due diligence.

(3) Inadequate market practice and technical expertise

Even well-established financial institutions, private equity firms, and smaller acquirers might not have access to outside technical expertise or specialist ESG professionals. Although broad ESG “compliance” may be mentioned in legal papers, the measures, standards, or mitigation strategies are rarely specified.

Solutions: Measures to advance ESG due diligence in M&A project finance

In order to close the diligence gap, it is necessary to come up with a transaction-specific ESG due diligence framework that is formalised, shared and implemented.

One essential part of thorough scoping is the very early recognition of ESG risks and opportunities, which ensures that ESG due diligence is done along with financial and legal evaluations from the start of the transaction. Such a process requires a focused materiality assessment,⁹ which adjusts the diligence scope to ESG issues that are most relevant to the industry, location, and regulatory environment of the target. In addition, proper stakeholder mapping is very important, which means the prompt identification of all the major entities, such as staff, communities to be affected, regulators, and investors whose interests and views can not only change the level of risk of a transaction but also its overall success significantly.

Essentially, uniform criteria and metrics are the mainstay of efficient ESG due diligence. This means, the task has to be using checklists which are based on such international frameworks as the Equator Principles¹⁰, International Finance Corporation (IFC) Performance Standards¹¹, and relevant sector guidelines to form the basis for risk assessment. Besides, it is imperative to develop certain metrics targeted for the project, for example, emissions reduction goals, the risk of human rights, or board diversity criteria to both identify the most significant ESG factors and comprehensively cover them. Incorporating ESG factors into risk allocation frameworks means that explicit representations and warranties, indemnities, conditions precedent regarding ESG be integrated into the primary transaction agreements. Such material adverse change (MAC) clauses¹² need to specifically talk about the failure of support for essential ESG commitments, including climate goals or social responsibilities, as events leading to termination or remedies after closing. In addition, post-closing¹³ oversight with a solid structure should be there, requiring continuous reporting, regular audits, and independent external assessments in order to ensure that the specified ESG criteria are being adhered to at all times.

ESG due diligence in project-financed M&A has to be upgraded in a manner that reflects the reskilling of the employees and smart utilisation of technology. In order to achieve this, the deal teams must embed specialised knowledge across all stages by establishing cross-functional teams that comprise not only technical but also legal and community-oriented subject-matter experts, and at the same time providing continuous ESG training to their staff to be aware of the latest developments in standards. They can also leverage digital platforms and data analytics to improve diligence by automating the identification of risk and benchmarking, as well as assist in the development of current practices through the exchanging of anonymised data from previous transactions. Regulatory measures are vital, prompting US, EU and UK agencies to release comprehensive guidelines and template documents, while countries like India are urged to broaden BRSR¹⁴ requirements and establish frameworks for green financing. Self-regulation in the industry is significant, as legal and financial organisations ought to create specific benchmarks and certification programs for ESG advisors, enhancing both market trust and uniformity.

Case examples illustrating best practices

Recent transactions have highlighted emerging best practices in ESG due diligence, as demonstrated by significant examples in Europe and the United States. In securing European wind assets by a prominent multinational, the transaction included extensive environmental evaluations carried out by independent specialists and detailed social risk assessments via active community engagement, involving arrangements for long-term benefit sharing. ESG key performance indicators (KPIs) were incorporated into financing and acquisition agreements, backed by quarterly independent verification and escrowed environmental liabilities,¹⁵ along with customised MAC clauses and “step-in” rights to manage any shortfalls in achieving ESG objectives. This method enabled the early identification and proactive handling of ESG risks, fostering continuous compliance long after the closure. Likewise, a significant US public infrastructure acquisition implemented a comprehensive ESG diligence process in accordance with SEC and State regulations, including required environmental audits and detailed evaluations of social risks. The creation of an autonomous stakeholder board ensured ongoing supervision of ESG performance during the transition, supported by a specific claims reserve. Environmental liability assurances along with performance-based financial adjustments were among the explicitly stated provisions in deal documents, ensuring that future environmental standards would be met by legal requirements. These instances, taken together, indicate that comprehensive, integrated ESG due diligence not only feasible but also a positive impact on the complex project-financed¹⁶ M&A transactions.

Addressing persistent gaps: Towards a best-practice standard

Even with the rise of best practices, ongoing disparities in ESG integration remain. The problems mentioned above are the result of the unclear distribution of due diligence work among the legal, technical and financial terms, a lack of willingness to commit sufficient time and resources before closing, as well as little supervision of ongoing ESG compliance. These issues can obstruct proper risk management and can lead to a lack of reliability of corporate ESG promises.

To solve these problems. The following measures are recommended:

Efficient ESG due diligence is best supported through a partnership approach, which is initiated by the setting up of cross-jurisdictional working groups that comprise regulators, law firms, financial institutions, non-governmental organisations (NGOs), and standard setters who collectively draft adaptable guidelines for project-financed M&A. Such entities need to review criteria on a regular basis in order to reflect changes in risks and regulations while being able to provide easily understandable guidance and practical examples. Legal and market forces play a major role in shaping behaviour, among these forces are the promotion of insurance and guaranteed for ESG-related risk, as well as the offering of advantages such as better access to sustainable finance or more favourable capital requirements for buyers who demonstrate strong ESG diligence. Ultimately, the procedure has to incorporate stakeholder interaction which is active. This means understanding community involvement not just as something for the society but also as an indispensable tool for recognising both risks and opportunities. It also involves ensuring that there are clearly defined complaint handling and feedback mechanisms throughout the project period.

Conclusion

The evolving ESG landscape necessitates that dealmakers and lawyers not only adhere to the rules but also go deeper into the substance of the ESG reporting. Fixing the gaps in ESG due diligence for project-financed M&A deals is not merely about doing the right thing, it is very important in the protection of transactional value, the avoidance of legal disputes, and the guarantee of lasting project outcomes. By setting up rigorous, context-specific diligence frameworks, developing the relevant skills of the various disciplines and, among stakeholders, ensuring that they are motivated to act, the market can make a considerable move from ESG integration which is merely aspirational to those that are real, enforceable commitments in project finance M&A.