In recent years, stakeholders have started viewing ESG to be a value driver rather than just another compliance requirement. Consequently, there is greater attention to ESG considerations in M&A transactions. ESG – environmental, social, and governance – describe considerations that go beyond the traditional metrics of assessing a company’s performance and future value. Acquirers (especially non-resident) are increasingly leveraging ESG performance as an indicator of long-term value creation and resilience, thereby influencing deal decision-making and investment strategies. As stakeholders demand greater transparency, accountability, and responsible business conduct, ESG principles continue to shape the dynamics of M&A dealmaking in India. This article examines the practical aspects of navigating the ESG landscape through the acquisition process and offers insight into how acquirers can identify and address ESG risks in the Indian market.

Brief Overview of the ESG Framework in India

There is no consolidated legislation governing ESG in India. Instead, compliance requirements are dispersed across various statutes and sector-specific regulations with different ministries and regulators responsible for monitoring compliance.

Environmental Aspects: The Environment (Protection) Act, 1986 governs the ‘protection and improvement’ of the environment. Complementing this, the Water (Prevention and Control of Pollution) Act, 1974 and the Air (Prevention and Control of Pollution) Act, 1981 specifically address water and air pollution, respectively. These acts empower central and state pollution control boards to enact measures for prevention and control of pollution including categorisation of industries into Red/Orange/Green/White, based on the ‘level of relative pollution potential’. Industries in the red category are not permitted to operate in ecologically fragile areas.¹ Integrating into this framework are the Hazardous Waste and other Wastes (Management & Transboundary Movement) Rules, 2016, which outline procedures for the proper handling, transportation, and disposal of hazardous waste.

The environmental aspect is especially relevant in certain sectors such as manufacturing and energy. Environmental compliance involves securing consent to establish and other environmental permits. This initial approval mandates the submission of plans, manufacturing capacity details, and pollution load assessments. A consent to operate (“CTO”) is a pre-condition to commencing operations (except for industries categorised as ‘White’ for whom a notification to the concerned state pollution control board/ pollution control committee is sufficient) ² and thereafter the entity is required to adhere to the conditions specified in the consents and ensure ongoing compliance with environmental norms. Similarly, renewable energy projects (except those specifically exempted), must also undergo an environmental clearance process mandated by the Environment Impact Assessment Notification, 2006.³ Depending on the nature and scale of the project, different clearance requirements apply. For example, wind and solar projects, may require additional clearances based on ecological impact. The intention is to ensure that environmental concerns are adequately addressed in proportion to a project’s size and nature.

Social Considerations: The ‘social’ aspect in ESG focuses on a company’s interactions with employees, customers, vendors, local communities, and other stakeholders. It evaluates aspects like labour practices, marketing practices, human rights, community engagement, and diversity and inclusion.

Employers must comply with a comprehensive set of labour laws encompassing the rights of employees, including minimum wage, bonus, gratuity, social security benefits, and provisions for welfare activities, health, and safety. These aim for the protection and well-being of employees and fostering a conducive and lawful work environment. Special laws have also been enacted for recognition and protection of contract labourers, fixed- term employees, migrant workers and women employees.

Governance Framework: In India, the governance aspect focuses on transparency in decision-making processes, board independence, fostering ethical standards and anti-corruption policies, fulfilling corporate social responsibility obligations, and disclosing sustainability performance. Various provisions of the Companies Act, 2013 (“Companies Act”), regulations issued by the Securities and Exchange Board of India (“SEBI”) including the SEBI (Listing Obligations and Disclosure Requirements), 2015 (“LODR”), the Prevention of Money Laundering Act, 2002, and the Prevention of Corruption Act, 1988, cover these aspects. Under the Companies Act, directors have a duty to act in good faith in the best interest of the company, its employees, the shareholders, and for the protection of the environment.⁴ Qualifying companies are also mandated to establish a Corporate Social Responsibility committee and are obligated to allocate a minimum of 2% of their average net profits of the preceding 3 financial years towards social welfare projects, annually.⁵ In terms of ESG reporting, currently only the top 1000 listed companies by market capitalisation are required to comply with SEBI’s Business Responsibility and Sustainability Reporting under the LODR.⁶

ESG in M&A Due Diligence

The fragmented structure of the ESG framework often makes it challenging for acquirers to quantify ESG risks within the current regime. At the same time, acquirers are increasingly recognizing the long term financial and reputational impact that ESG risks potentially pose, for not just the target but also the acquirer group. Consequently, it is imperative for acquirers to conduct exhaustive ESG due diligence to not only assess the target’s compliance with diverse regulatory requirements but also to arrive at a suitable valuation and structure the purchase consideration based on the significance of identified ESG risks.

To identify potential risks in any diligence, acquirers should be able to access good quality data and information on the target. One way to achieve this is to ensure that the requisition list provided to the target’s team is customised to the target company’s sector and business operations. However, where ESG is concerned, in addition to review of documents and information provided, it is helpful (if not essential) to have a site visit conducted by independent experts to ensure the target’s compliance is not merely ‘on paper’.

This is especially true for targets in the manufacturing and energy sectors where environmental concerns and labour practices play an important role. For example, an expert conducting an environmental site assessment will be able to uncover potential issues with groundwater or soil contamination, use of plastic packaging, working conditions, adequate fire safety measures, etc. which may not be evident from a review of documents alone. Also, an expert on a site visit would be able to determine if the target is actually complying with the conditions of consents that it has obtained. For example, a manufacturing unit may have only one air emission stack listed in its CTO, but a site visit may lead to the discovery of numerous stacks across the facility constituting a violation of CTO terms. Similarly, issues with health and safety, working conditions, adequacy of fire safety measures or effluent discharge from nearby heavy polluting manufacturing units can only be properly assessed on site. However, while conducting such visits, acquirer representatives will need to be cognizant of seller sensitivities in relation to access, confidentiality and effect on transaction timelines. Thus, it is advisable that the parties discuss and document the effect of an in depth ESG diligence on transaction timelines and the exclusivity period at the term sheet stage.

Companies engaged in certain hazardous activities are subject to absolute liability and could be required to pay out significant compensation based on their size and revenue. Where a target is engaged in such activity and has not formulated an emergency response plan for events of spillage, leakage or mishandling of hazardous waste, the implementation of an emergency response plan (complaint with guidelines issued by the concerned pollution control board) should be incorporated as a pre-closing condition in the transaction documents.

Environmental due diligence should also assess the impact of climate change and emerging environmental risks on the target’s business operations and long-term sustainability. Environmental violations may attract penalties ranging from fines to closure orders, remediation costs, and legal proceedings. Worker safety violations, including failure to provide adequate safety equipment, training, or compensation, can lead to fines or imprisonment under statutes such as the Factories Act 1948, and have far reaching repercussions for business operations.

During the diligence process it is important to assess the target’s track record in implementing ESG initiatives, monitoring progress, and addressing stakeholder concerns to gauge its commitment to sustainability and responsible business practices. This is especially important to identify ‘greenwashing risks’ given that ESG reporting, or disclosure is a developing concept in India with different standards across sectors and also limited in its applicability. A typical diligence would have a look back period of 3 years for most areas; however, to get a better understanding of whether the target’s ESG credentials are reliable and consistent, it is advisable to consider a longer period for key areas.

For acquirers in the renewable sector where the target owns the underlying project land, it is important to assess that the acquisition has been done in a fair manner without destroying livelihoods of previous owners or communities dependent on the land. Thorough title due diligence of the land including independent searches, is advisable to mitigate risk of claims for compensation or subsequent issues with the local community (which may pose not just a monetary risk but also a reputational risk for the acquirer).

Greenwashing risks extend beyond the target company’s operations to its supply chain. Acquirers should also consider supply chain diligence for targets (especially those that are particularly labour intensive) to assess the integrity of the target’s supply chain, scrutinize supplier relationships, the sourcing practices, and adherence to ethical and sustainable standards. There may be potential risks that run through the supply chains for example where suppliers are engaging in child labour or high polluting activities which could have a significant negative impact on the target’s credentials.

Acquirers may also have to contend with certain sector specific issues. For instance, in parts of Gujarat and Rajasthan, considerations surrounding the valuation of targets must factor in litigation or regulatory measures aimed at safeguarding critically endangered species such as the Great Indian Bustard or Lesser Florican birds. These factors could result in project delays or cost overruns, necessitating careful evaluation and risk mitigation strategies during the acquisition process.

In certain sectors for example renewable energy, several Indian lenders (such as scheduled commercial banks, public sector banks, non-banking financial companies, etc.) require compliance with certain ESG or sustainability covenants tailored specifically to the targets project and in line with the lenders’ internal policies. These are typically monitored by techno economic viability consultants and independent engineers (“Consultants”) appointed by the lenders. As part of the due diligence process, acquirers could request access to the reports of Consultants to gauge the target’s compliance and mitigate potential default under the financing documents.

From a corporate governance perspective, the diligence exercise should extend to the analyses of internal management and decision-making processes of the target, incident management protocols, disclosure practices, engagement with related parties, and policy on anti-corruption and anti-bribery. Additionally, factors such as compliance with standards prevalent in relevant industry, data protection regulations, sanctions and insurance coverage for business associated risks should also be considered.

Addressing ESG concerns in the Transaction Documents

Acquirers are increasingly incorporating ESG specific representations and warranties in addition to the standard representation and warranties in the transaction documents. Depending on the sector of the target’s operations these are customised further to cover specific ESG risk that the target may be susceptible to in the sector. In certain sectors for example, manufacturing, which may have potentially greater environmental risk factors that may take longer to surface, acquirers should consider including environmental warranties as fundamental to benefit from a greater coverage.

In view of the dispersed compliance requirements in case of ESG, it is advisable that the acquirer requires the seller to rectify material ESG non-compliances as conditions precedent in the transaction documents. Sellers often resist inclusion of a particular item of rectification as a condition precedent, arguing that it will delay closing or that the cost of rectification is insignificant however the acquirer (especially one without a local presence or experience in the target’s jurisdiction) needs to consider not just the cost but also the potential effort involved for the acquirer in rectifying it post-closing. Further, in some cases a seemingly innocuous non-compliance may hide deeper issues that may be discovered only during rectification for example in case of renewal of certain licenses etc. Acquirers outside India may be required to comply with different standards in their home jurisdictions and such acquirers may require that their subsidiaries adhere to these standards even though these may not be mandated by local laws of the target. In such cases, acquirers may agree to bear certain additional costs of ‘clean up’ of the target to such standard as a pre completion item. Where the deal dynamics do not allow for these to be a pre completion item for the seller, the acquirer should clearly set these out in its integration plan and bind the sellers to assist the acquirer in achieving these standards as part of transitional arrangements.

However, not all ESG risks may be capable of remedy and even if remedied, past liabilities for non-compliances will need to be considered especially in cases of certain welfare statutes (labour legislation) where the courts are inclined to pardon delays in bringing claims. In such cases, the transaction documents should provide for acquirer protection in the form of specific indemnities, extended indemnity periods, uncapped or enhanced caps for ESG indemnities, holdbacks and adjustments to purchase price.

Warranty and Indemnity Insurance (“WI”) is a relatively new concept in India and WI insurers only provide coverage for unknown risks. Therefore, when considering WI, parties should weigh the cost of insurance against the exclusions outlined in the policy. Parties will also need to factor in the time taken for the insurer to complete its own diligence or verification of disclosures on the timelines for the transaction.

Conclusion

In conclusion, the intricate ESG framework in India, characterized by disparate regulations, varying regional cultural and business practices and the absence of a unified standard for ESG reporting, presents a significant challenge in assessing and mitigating ESG risks. However, with the growing recognition of the value of ESG- compliant businesses (particularly in the context of the race to address climate change), ESG considerations continue to gain prominence in M&A deal structures and processes. Engaging local expertise and conducting comprehensive due diligence covering all aspects of ESG performance is an essential tool for acquirers in understanding the unique ESG risks and identifying the long-term value drivers in Indian transactions. Incorporating mechanisms for acquirer protection in transaction documents, such as pre-closing remediation of significant ESG non-compliances, ESG-specific representations and warranties, extended indemnities, purchase price adjustments, holdbacks, and clearly delineated ESG compliance requirements in integration plans are ways in which acquirers could potentially mitigate these risks.

Authors: Rukmini Roychowdhury and Khushboo Bapna

Footnotes

1 Notification No. B-29012/ESS/(CPA)/2015-16/, Central Pollution Control Board, ‘Modified directions under Section 18(1)(b) of the Water (Prevention and Control of Pollution) Act, 1974 and the Air (Prevention and Control of Pollution) Act, 1981 regarding harmonisation of classification of industrial sectors under Red/Orange/Green/White industries’, 07 March                              2016, https://cpcb.nic.in/openpdffile.php?id=TGF0ZXN0RmlsZS9MYXRlc3RfMTE4X0ZpbmFsX0RpcmVjdGlvbnMucGRm.

2         ibid.

3        Notification        No.       S.O.1533,       Ministry        of        Environment        and                             Forests,                        14                   September                       2006, https://environmentclearance.nic.in/writereaddata/EIA_Notifications/1_SO1533E_14092006.pdf.

4  Section 166(2) of the Companies Act, 2013, M.K. Ranjitsinh v. Union of India (2021 SCC OnLine SC 326).

5  Section 135 of the Companies Act, 2013 read with Companies (CSR Policy) Rules, 2014.

6 Circular No. SEBI/HO/CFD/CMD- 2/P/CIR/2021/562, Securities Exchange Board of India, ‘Business responsibility and sustainability reporting by listed entities’, 10 May 2021, https://www.sebi.gov.in/legal/circulars/may-2021/business- responsibility-and-sustainability-reporting-by-listed-entities_50096.html.