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ESG Due diligence Process For Financial Undertakings

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Due diligence is the process through which enterprises can identify, prevent, mitigate and account for how they address their actual and potential adverse impacts (OECD guidelines for multinational enterprises, chapter II – general policies, para. 10). Due diligence can be included within broader enterprise risk management systems, provided that it goes beyond simply identifying and managing material risks to the enterprise itself, to include the risks of harm related to matters covered by the guidelines.


The European Securities and Markets Authority (ESMA), one of the three European supervisory authorities (ESAs) recommended amending relevant requirements to ask all Undertakings for Collective Investments in Transferable Securities (UCITS) management companies and Alternative Investment Fund Managers (AIFMD) to consider sustainability risks in their internal processes, systems, and controls; devote sufficient resources to the integration of sustainability risks, and ensure that senior management is responsible for the integration of sustainability risks. Fund managers should also consider sustainability risks in their due diligence processes.


The EU has introduced the Sustainable Finance Disclosures Regulation (SFDR) and New Corporate Sustainability Due Diligence and amending Directive, requiring companies among other factors, to increase transparency in their due process to identify, prevent, mitigate and account for how they address their actual and potential adverse impacts.


The Securities and Exchange Commission (SEC) proposed amendments to rules and disclosure forms to promote consistent, comparable, and reliable information for investors concerning funds’ and advisers’ incorporation of environmental, social, and governance (“ESG”) factors. The new rules and form amendments would enhance disclosure by:

  • Requiring additional specific disclosure requirements regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures;

  • Implementing a layered, tabular disclosure approach for ESG funds to allow investors to compare ESG funds at a glance; and

  • Generally requiring certain environmentally focused funds to disclose the greenhouse gas (GHG) emissions associated with their portfolio investments.


EU Technical Expert Group on Sustainable Finance suggests that investors using Taxonomy (such as EU Taxonomy or Common Ground Taxonomy) would most likely use a due-diligence-like process for reviewing the performance of underlying investees. GC Insights believes ESG due diligence is to provide insights into the value of a company’s ESG performance. Help investors mitigate risks and enhance ESG processes by engaging different vendors in the entire ESG eco-chain. Consideration of ESG factors during the investment process, particularly at the due diligence stage is critical, it can help to understand whether and how a business might generate ESG impacts and risks, and detective the company’s controversial or illegal behaviors in advance. By incorporating existing best practices for ESG Due Diligence, GC Insights helps businesses and investors assess their ESG risks and evaluate different procurement options to provide assurance with our customized ESG Due Diligence Solutions.


Case Study

On May 23, 2022, The Securities and Exchange Commission charged BNY Mellon Investment Adviser, Inc. for misstatements and omissions about Environmental, Social, and Governance (ESG) considerations in making investment decisions for certain mutual funds that it managed. To settle the charges, BNY Mellon Investment Adviser agreed to pay a $1.5 million penalty.

The SEC’s order finds that, from July 2018 to September 2021, BNY Mellon Investment Adviser represented or implied in various statements that all investments in the funds had undergone an ESG quality review, even though that was not always the case. The order finds that numerous investments held by certain funds did not have an ESG quality review score as of the time of investment.


SEC has reportedly been on the hunt for potential greenwashing. This case is the latest in a string of SEC enforcement actions concerning ESG after it launched a dedicated greenwashing task force in the agency’s enforcement division last year, according to the Financial Times. Without due action to manage and review ESG considerations while making fraudulent claims to sway investors’ investment decisions led to such charges. ESG due diligence is enforced by financial undertakings to reduce risks of ESG compliance and make sure all fund managers are adhered to the overall investment strategies and prevent greenwashing and penalties as such caused by misconduct when applying ESG strategies.


ESG due diligence requires a long chain of enforcement, it is necessary to prevent ESG risks with due process to identify, prevent, mitigate and account for how they address their actual and potential adverse impacts and ESG risks before they could cause great loss and harm the financial interest of investors. Fund managers’ responsibility shall be extended to where and what they invest with oversight of ESG risks and opportunities using all available resources, including ESG due diligence and the due process to secure the quality and enforcement of the ESG due process.


Sustainability-related taxonomy, such as EU Taxonomy, and Common Ground Taxonomy frameworks are often being used as one of the measurements. One of the primary uses is to measure the environmental performance of investment products. According to PRI, these taxonomy frameworks can also be used by investors to assess beneficiaries’ sustainability preferences, identify sustainable investment opportunities, conduct due diligence on current and potential holdings, and measure the sustainability outcomes of an investment portfolio. Many third-party data vendors have developed such tools to assess alignments with portfolios against taxonomies. PRI also suggests that if using data from third-party providers, conducting due diligence on the assessments is necessary. Take the time to understand the data providers’ methodology, coverage, terminology, and any assumptions they may be making in their assessments.



How to Start An ESG Due Diligence?

ESG due diligence, unlike other risks (e.g. credit risks), companies within the portfolio are assessed with different Environmental, Social, and Governance aspects depending on investors’ risk tolerance towards the underlying ESG factors. Institutional investors are more leaning towards in-house databases or somewhat integrated data sets to conduct their ESG due diligence. Others test the market available options as to which ESG data vendors provide the most comprehensive ESG ratings or insights with better-backtested results.


Due diligence in secondary markets takes a different shape, as it is time-consuming and does not make economic sense to engage with portfolio companies on a one-on-one basis. ESG due diligence in the secondary market typically relies on alternative tools and aggregated analytical results.


According to UBS Group AG’s due diligence statement, its ESG due diligence process is performed upon all its product universe (all funds, not only Sustainable Investing/ESG-focused funds). Its due diligence process includes questionnaires and interviews where investment managers are asked to provide fund-specific information including ESG, e.g., how ESG is integrated within their investment process or what the company-wide ESG efforts are. The company maintains a database of corporate sustainability scores that indicate how well an issuer scores against a set of ESG-related metrics. UBS has developed an in-house proprietary methodology to generate the scores. The process relies on data sourced from multiple best-in-class ESG data providers chosen based on their area of expertise, covering nearly 11,000 equity and bond issuers in 170 countries. Their methodology is said to be in line with the Sustainability Accounting Standards Board (SASB) Materiality Map, which identifies the sustainability issues that impact value creation and financial performance.


ESG Ratings


ESG's due diligence process varies among different investors, ESG ratings present an easy outlay for comparing ESG performance and aggregating ESG rating results during ESG due diligence process. However, as one of the most popular options, ESG ratings are not always reliable for they bear the critics from “methodological biases”, such as size biases, counter-intuitive results due to sector neutrality (e.g. sustainability-related controversial sectors with higher ESG scores), low correlation between ESG rating agencies, stale ratings over time, absence of standardized ESG reporting, language barriers, and source data quality issues, etc.


Alternative Data


The ability to extract ESG insights from alternative data with advanced analytical skills allows investors to improve their understanding of supply chains and consumer behaviors and improve their valuations of the underlying investments. In FCA’s feedback statement: accessing and using wholesale data, the agency pointed out that data and advanced analytics are increasingly used by a wide range of market participants including hedge funds, investment managers, banks, and exchanges typically but not limited to the following activities:

  • generating insights for investment opportunities, including using climate reporting for ESG investments

  • aiding risk management and governance controls

  • fulfilling regulatory activities (such as the EU Sustainable Finance Disclosures Regulation, SFDR for ESG due diligence requirements)

  • tailoring services to end-users


According to Statista Research Department, alternative data is data used by investors to evaluate a company or investment outside of their traditional data sources, which include press releases, SEC filings, and financial statements. Some forms of alternative data include app usage, financial transactions, and geolocation data. Globally, buy-side firms spent $1.71 billion on it during 2020, over half of all hedge funds use it to make investment decisions, and it is increasingly used to validate the sustainability claims of prospective ESG investments. (WilmerHale, 2022) The utilization of alternative data in ESG due diligence is common nowadays, as expanding access to more alternative raw data sources (e.g. social media feeds), increases applications in machine learning and AI technologies (e.g. NLP natural language processing functions to assess ESG sentiments), and higher demand to assess ESG controversies instead of mere ESG ratings are all boosting the growth of alternative data among other incentives.


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