ESG and the infrastructure sector

April 2021  | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2021 Issue

The emerging environmental, social and governance (ESG) framework has grown rapidly since its early iterations in the form of the Equator Principles and the United Nation’s (UN’s) ‘Guiding Principles on Business and Human Rights’. From a regulatory perspective, ESG has expanded to include a wide range of ‘soft’ and ‘hard’ laws that create a framework of obligations facing businesses, investors and lenders, with the aim of encouraging them to more effectively incorporate material ESG considerations into their decision-making processes.

In the last few years, ESG factors have risen to the forefront of the corporate agenda. This shift is largely due to the growing demands for greater transparency from consumers, voters, activists and investors, and the increasing regulatory and litigation risks associated with ESG, as the number of ESG-related hard laws continues to proliferate.

Businesses are responding by paying closer attention to their role within the communities in which they operate. As a result, a number of businesses have made far-reaching voluntary ESG commitments. For instance, in 2019, 181 of America’s top business and financial leaders signed the Business Roundtable’s ‘Statement on the Purpose of a Corporation’, publicly committing to run their companies for the benefit of wider stakeholders, including customers, employees, suppliers, communities and shareholders.

In addition, longstanding regulations regarding anti-bribery and corruption, anti-money laundering, health and safety, environmental concerns and employment matters are increasingly being accompanied by disclosure and reporting requirements aimed at driving greater transparency. This is particularly the case in Europe, with over 65 percent of all ESG regulation emerging from the region. The package of regulations flowing from the European Green Deal and the European Union (EU) Sustainable Finance Action Plan includes the EU’s Non-Financial Reporting Directive, together with the Taxonomy Regulation and Disclosure Regulation (and much more). These regulations are intensifying the pressure and focus on corporates, asset owners and asset managers providing ESG disclosures relating to the nature of their activities.

This, in turn, is leading to heightened levels of activism and litigation risk as it becomes easier to scrutinise corporate behaviour. For instance, in recent UK company AGMs we have seen an uptick in the number of shareholder resolutions regarding climate change, executive remuneration and pensions, board diversity and human rights issues. The pressure continues to mount on listed companies in particular, as the likes of BlackRock and Vanguard sharpen their activism, especially in relation to climate change.

Such moves reflect the wider shift in investor sentiment in recent years, which has contributed to the stratospheric rise of ESG investing. The major challenge facing investors and businesses alike is the absence of a global, standardised ESG reporting framework. There have been moves in that direction however, and the International Financial Reporting Standards Foundation’s recent proposals regarding the establishment of a global Sustainability Standards Board offers a compelling solution to the current lack of consistency in ESG reporting.

In this context, it is critical for infrastructure companies – and their boards and legal teams – to have a clear understanding of how ESG considerations can be effectively integrated into corporate strategy and risk management efforts. This includes the integration of ESG factors into strategic decisions, such as those relating to M&A and the procurement of suppliers.

ESG and infrastructure sector M&A

ESG issues are increasingly viewed as both a driver and a risk factor for M&A in the infrastructure sector and such factors are increasingly being integrated at all phases of the M&A process – from the assessment of investment proposals, all the way through to exit. For example, the demand for green energy infrastructure assets has risen as investors are assessing their ESG investment profile.

Although ESG risks have impacted M&A decisions for some time, potential bidders are now looking at these issues at a much earlier stage in the M&A process and they are taking deeper dives when doing so. Acquirers are increasingly assessing ESG risks and opportunities from the outset of the target identification stage and they are also trying to anticipate future market and regulatory changes. In particular, they are concerned about how such changes might impact the availability and cost of financing (e.g., ‘green’ borrowers face lower financing costs than ‘brown’ borrowers) and their ability to exit in due course.

Acquirers are also adopting new approaches at the due diligence stage. For instance, they are now undertaking a much broader, forward-looking assessment of possible risk exposures, including in relation to the potential for regulatory or litigious risk further down the road. This forward-looking approach can help buyers reduce the risk of acquiring assets or businesses that become stranded due to regulatory changes and shifts in public opinion. Growing concerns regarding climate change in particular have focused attention on, and increased scrutiny of, the long-term sustainability of high carbon-emitting assets, as well as the opportunities presented by renewable energy and new technologies.

The same applies to the wider ESG agenda. The incorporation of ESG considerations into decision making offers opportunities for buyers to realise upside by developing or supplementing existing products and services and driving operational efficiencies. This is increasingly manifesting in companies with lower ESG scores looking for targets with higher ESG performance. Improvements in ESG performance can also help to lower business costs (e.g., regarding retention of staff and insurance premiums).

It is also important for buyers to go beyond the company or assets being bought and consider ESG factors in the wider business, including supply chains, which may not involve any legal liabilities for an acquirer but could present significant reputational issues. With the list of countries that have enacted anti-modern slavery legislation expanding, and with human rights due diligence regulation proposed for the EU, the focus on supply chain transparency will likely continue to increase in years to come.

ESG issues also need to form part of post-transaction asset management and compliance. Businesses should continue to monitor the ‘soft’ and ‘hard’ legal and regulatory landscape, as well as keeping an eye on where the markets are going. Moreover, sellers that have embraced ESG are no longer focused solely on price and a clean break, they also want assurance that the asset will be managed responsibly post-completion. We are therefore seeing increased due diligence by sellers, even on cash buyers, as well as enhanced post-completion undertakings being sought from buyers.

Where to from here?

Many investors and executives argue that now is the time to ‘build back better’ and create a more sustainable corporate world.

The current coronavirus (COVID-19) pandemic has helped to rebalance the ESG conversation, bringing social matters out from the shadow of the environmental and governance issues that dominated boardroom agendas before the outbreak. Boards and investors are therefore paying more attention to issues like occupational health and safety, social safety nets, worker protection, responsible purchasing practices and supply chain issues, as well as diversity and digital rights, including privacy. Importantly, this shift in focus has not come at the cost of environmental matters, with 79 percent of respondents to a recent UN Principles for Responsible Investment survey stating that they see the COVID-19 recovery phase as a critical opportunity for governments to be more ambitious in their efforts toward net zero and alignment with the Paris Agreement.

It is impossible to predict the ultimate outcomes of the crisis. Nevertheless, it is clear that the intense public scrutiny of corporate conduct and governance during the pandemic has accelerated the ESG agenda, with significant implications for companies, investors and lenders across the globe.

 

Silke Goldberg is a partner and Rebecca Perlman is a senior associate at Herbert Smith Freehills LLP. Ms Goldberg can be contacted on +44 (0)20 7466 2612 or by email: silke.goldberg@hsf.com. Ms Perlman can be contacted on +44 (0)20 7466 2075 or by email: rebecca.perlman@hsf.com.

© Financier Worldwide

BY

Silke Goldberg and Rebecca Perlman

Herbert Smith Freehills LLP

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