Thierry Bosly, Partner & Global Co-Head of White & Case Private Equity; Alexandre Hublet, Local Partner & Head of White & Case Belgium and Luxembourg Disputes; and Hadrien Bosly, Associate PwC Legal Environmental Law, summarise the evolution of the legislative framework, assess the impact of ESG on portfolio companies, and address the key points PE firms should pay attention to.

It is fair to say that not a single week has passed without the announcement of new regulations, reporting obligations, guidelines or other initiatives related to ESG. PE firms increasingly recognise the significant impact of ESG factors on the financial performance and long-term sustainability of both their portfolio companies and themselves, including through the availability and pricing of acquisition financing. In addition, investors increasingly expect private equity firms to integrate these concerns in their investment strategy and demand greater disclosure around ESG practices.

Evolution of the legislative framework

The Non-Financial Reporting Directive (“NFRD”), adopted in 2014, can be considered the world’s first significant piece of ESG legislation. The NFRD required large EU corporations to report on the impact and risk concerning human rights, environmental, social, labour and anti-corruption matters. Since then, an increasing number of regulations have developed, bringing meaningful change to the investment and financial sector.

Having taken the initial lead, the European Union continues to push things forward. In 2018, the EU published a plan for sustainable finance, supported by key legislative actions. Although non-binding, it defines the strategy adopted by the EU and the concrete steps to implement it. Most of the initiatives under the plan have since been adopted. These regulations target not only European companies but also foreign companies active in the EU.

The EU’s strategy is based on three pillars: enhancing transparency on environmental and social impact; shifting capital flows toward sustainable investments; and increasing accountability for non-financial related factors, including climate related risks in the investment sector.

First, on transparency, two main pieces of legislation have come up recently shaping this transparency landscape: (i) the Corporate Sustainability Reporting Directive (“CSRD”); replacing the NFRD, which must be transposed into national law by July 2024 and the first group of companies, large and public-interest entities, will have to publish their first reports in 2025 based on financial year 2024; and (ii) the Corporate Sustainability Due Diligence Directive (“CS3D”), which is yet to be formally adopted. Once adopted, CS3D will require companies to identify, prevent or mitigate, where necessary, adverse impact on human rights or on the environment.

Secondly, investments labelled as environmentally sustainable will have to effectively contribute to climate action objectives and avoid greenwashing. Therefore, the EU adopted extensive regulation: the EU Taxonomy Regulation and associated acts which provide a framework for sustainable investment by establishing a classification system for economic activities defined as environmentally sustainable and by imposing specific disclosure requirements for environmentally sustainable financial products.

Thirdly, the Sustainable Finance Disclosure Regulation, which is already in force and applicable to the financial sector, includes an assessment of a broad range of ESG metrics in addition to financial risks in the investment-making decision. This regulation calls for sustainability disclosure obligations relating to financial products and financial market participants.

EU member states are also taking initiatives at national level. For instance, the French government passed the French Duty of Vigilance Law, and in Germany, the Supply Chain Due Diligence Act was enacted. In Belgium, a law proposal was published on 2 April 2021 introducing a duty of care and a duty of responsibility for companies throughout their value chains. 

The US is also taking action. The Securities and Exchange Commission (“SEC”) introduced a proposal for ESG-related disclosures requiring companies to disclose information on their environmental footprint. US companies are under increased scrutiny when it comes to sustainability. The authorities have launched cases against major financial institutions on claims of greenwashing or misstatements and omissions about ESG considerations.

Importance of ESG for portfolio companies

ESG is an increasingly important aspect to take into account when assessing a portfolio company, either to acquire a target or to maintain an investment.

First, as discussed above, ESG-related legal obligations, mainly in terms of disclosure, are increasing. As the scope of these various (new) requirements varies, it is important to have a dedicated ESG section in the due diligence process.

Besides the specific legal requirements, awareness of the ESG situation of a portfolio company or of a target is important to assess the legal and reputational risk it may pose. The NGO ClientEarth recently brought a claim against the directors of Shell in the UK for failure to take appropriate actions to decrease greenhouse gas emissions. Such claim is based on the general principles of directors’ liability. It is therefore essential for any private equity player to have a proper view of the ESG management of its portfolio companies.

ESG and investment policies

ESG can also have an impact on investment strategies. Even in the absence of any legal obligation not to invest in certain companies based on ESG factors, private equity firms have strong incentives to prefer targets that comply with ESG criteria. Their focus on (long-term) sustainability, can make them financially attractive. In addition, such targets can be expected to have lower costs of ensuring compliance with (upcoming) legal requirements and more limited risk of litigation. Finally, financing for the acquisition of ESG-compliant targets may be more available, and at better terms, compared to non-ESG compliant targets. 

One concrete solution is for the private equity firm to impose ESG policies to targets, either to newly acquired targets with identified ESG-weaknesses or to portfolio companies. As a shareholder, a private equity firm should refrain from carrying out the daily management of the company, at the risk of being considered as de facto manager or exceeding the legal limits of its powers.

Risks related to public disclosure of ESG initiatives

ESG initiatives are often made public, for example via websites, or even used as advertisement or arguments in negotiations. Integration of ESG in investment policy or investment criteria is more and more of public knowledge.

However, doing so potentially exposes private equity firms to greenwashing claims.

Legally, there is no clarity on what constitutes greenwashing, and neither is measuring ESG performance straightforward. The above-mentioned EU Taxonomy Regulation is aimed at providing certain guidance, and its framework could be used to assess the environmental sustainability of a potential investment.

Yet, in the absence of a comprehensive legal ESG framework, private equity firms remain vulnerable to potential greenwashing claims, in particular in cases of ESG-incidents in a target or new investments in companies that would not be considered ESG compliant.

A trend is emerging to pressure private actors to comply with ESG standards, invoking general civil law principles and disclosure obligations. It would not be surprising to see a private equity company sued on the basis of general principles of civil liability, for infringement of due-diligence obligations or human rights law.

Ensuring compliance with applicable ESG standards, and ESG policies more generally is therefore not only potentially financially attractive, but also an increasingly important attention point for private equity firms to avoid potential liability.

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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.