The integration of ESG into M&A: managing hidden risks and unlocking new opportunities

August 2022  |  SPOTLIGHT | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

August 2022 Issue

The past few years have seen a surge in environmental, social and governance (ESG)-oriented investments, with recent estimates indicating that the value of such investments has surpassed $40 trillion globally. While recent events, particularly ongoing market volatility and the war in Ukraine, have prompted closer investor scrutiny of ESG strategies and products, issues such as climate change, human capital management, diversity, equity and inclusion and cyber security remain top of mind for investors, regulators and other stakeholders.

The first half of 2022 was notable for the flurry of regulatory activity on both sides of the Atlantic. In the US, the Securities and Exchange Commission (SEC) issued much anticipated rulemaking on climate and cyber security disclosures, with further rules on human capital and board diversity expected to come, while, in Europe, the EU Commission adopted a proposal for a Corporate Sustainability Reporting Directive which would significantly expand the scope of the existing Non-Financial Reporting Directive. The International Sustainability Standards Board (ISSB) also released proposed standards on climate and sustainability disclosures. In addition, late last year, the UK Financial Conduct Authority (FCA) adopted new rules requiring UK listed companies and certain large asset managers to publish disclosures aligned with the recommendations of the Task Force on Climate-related Financial Disclosures. The proposed disclosures, which are expected to be adopted as early as the end of this year, will likely further accelerate the integration of ESG issues into critical aspects of M&A. Specifically, the increased availability of comparable and verifiable information will help further inform target selection, due diligence and valuation processes. The same disclosures may also reshape shareholder, analyst and stakeholder reception to transactions and post-merger integration and governance.

These changes are occurring against a backdrop of ongoing pressure on management to improve ESG performance and to integrate ESG into business strategies, including M&A. We highlight some of the key trends below.

ESG-oriented target selection

ESG considerations are shaping target selection and assessments of strategic fit, with acquirers looking for targets that can enhance ESG performance. Transactions that have been directly driven by the need to address ESG risks or to capitalise on new ESG-related opportunities have also seen growth in the past year. Favoured targets for acquisitions include companies with sustainability-oriented operations as well as ESG investment advisers and data analytics providers.

Commitments by major energy companies to expand their renewables businesses, coupled with heightened interest among private equity and other investors in sustainability-oriented businesses have led to a string of transactions in recent months. Chevron recently acquired Renewable Energy Group, a key player in the renewable fuels industry, DuPont acquired Rogers Corporation, a leader in advanced materials for electric vehicles, DigitalBridge acquired Switch, a renewably powered data centre provider, and J.P. Morgan Investment Management acquired South Jersey Industries which announced a comprehensive clean-energy plan in 2021, including a commitment to achieve carbon-neutral operations by 2040. Dragonfly Energy, Amprius Technologies, LanzaTech, Nauticus Robotics, Rubicon Technologies and NuScale Power are among examples of cleantech companies that have gone public in recent months via special purpose acquisition company (SPAC) mergers.

Established financial sector players have also looked to expand their ESG services platforms and analytical capabilities in response to growing investor demand. Moody’s, Blackstone, Nasdaq, JPMorgan, AXA, BlackRock, KKR, Deutsche Börse and McKinsey all acquired data analytics or consulting firms with ESG expertise in the past year. In addition, Goldman Sachs’ acquisition of NN Investment Partners and Affiliated Managers Group’s acquisition of Parnassus reflect the integration of ESG strategies into mainstream investing and the desire among major asset managers to expand their ESG investment platforms.

Meanwhile, ‘brown assets’ have been the target of several notable divestitures. Royal Dutch Shell sold its Permian Basin assets to ConocoPhillips to reduce its global carbon emissions. This transaction provided ConocoPhillips the opportunity to lower its emissions intensity. BP has committed to divesting $25bn of assets by 2025 to support its strategic pivot to renewables and last year divested a stake in its Omani gas fields and oil interests in the UK North Sea. Similarly, Public Service Enterprise Group (PSEG) divested its fossil fuel plants as part of its pivot to renewables. It remains to be seen, however, whether and how this trend of divestments will proceed in coming years, as institutional investors have cautioned companies against sweeping ‘brown assets’ into the private markets where they continue to contribute to greenhouse gas emissions.

Due diligence and valuation

Evidence is growing that acquirers are willing to pay a premium for targets with a positive ESG record. Markets may also react favourably to ESG-friendly transactions. Royal Dutch Shell and ConocoPhillips both saw their stock prices rise following announcement of the former’s sale of its Permian Basin assets to the latter.

Alongside improved access to quality ESG data from mandated public disclosures, the rise of the ‘ESG premium’ will continue to reshape due diligence. In addition to identifying and assessing ESG risks material to the target business, such as climate-related risks, supply chain vulnerabilities, labour relations and human capital management practices and cyber security threats, acquirers will also need to examine related processes and procedures, including the degree of board oversight and the scope and quality of internal and external ESG reporting, to detect latent ESG vulnerabilities. Care will also need to be taken to ensure that ESG data reviewed is accurate and verifiable and that publicly available information is fully integrated into the diligence process.

Acquirers will also need to consider making a determination of the pro forma quantitative ESG impact of a transaction, including direct impacts on valuation – a task that may become more widespread as regulators move to require companies to quantify ESG-related impacts, including on financial statements. On the target side, boards and management will also need to be cognisant that ESG concerns may increasingly factor into shareholder decisions to support or reject a proposed transaction, particularly where the deal consideration includes shares of the acquirer. Integrating ESG into reverse due diligence can help target companies make a stronger case to their shareholders.

Financing costs

The growth of sustainability-linked financing promises to lower the cost of capital for companies that commit to improving their ESG performance. S&P and Moody’s have integrated ESG considerations into credit ratings. In the context of M&A, cheaper financing could make ESG outperformers more desirable targets, though lenders are tightening their monitoring processes and requiring verification of ESG outcomes and efforts from the SEC and the EU regulators to crack down on greenwashing by investment funds may increase scrutiny on lending practices. Conversely, efforts to divest underperforming ESG assets may become more difficult. Chevron noted in its public disclosures that lenders are under pressure to limit funding to companies engaged in fossil fuels extraction, a trend that could impact financing costs and availability.

Regulatory and litigation risks

Proposed rules from the SEC and the EU Commission on ESG disclosures, if adopted, will create new regulatory risks that could affect M&A. Inaccurate or misleading disclosures could lead to enforcement action and significant legal, financial and reputational costs. Enforcement action against greenwashing is on the rise and acquirers will need to take particular care in assessing and verifying the ESG-related claims of potential targets. In addition, the signing into law of the Uyghur Forced Labor Prevention Act (UFLPA) late last year has shifted the burden to US companies to prove their supply chains do not utilise forced labour. US acquirers looking for targets abroad will need to consider compliance with the UFLPA as part of their assessments on supply chain vulnerabilities.

The growing wave of climate and sustainability-related litigation is another new consideration for acquirers. The regulatory landscape on climate-related issues continues to shift, along with climate science, and such changes may form the basis for new lawsuits, the damages for which may not be sufficiently covered by existing insurance policies.

Investor and stakeholder engagement

Companies are increasingly willing to address the ESG-related synergies and opportunities in transaction rollouts, investor presentations, press releases and at analyst and investor meetings. For example, Keith Creel, chief executive officer (CEO) of Canadian Pacific Railway, noted during an investor call following the transaction announcement, how the acquisition of Kansas City Southern could bring supply chain stability to North America and take “thousands of trucks off the road”. Following the announcement of Cimarex’s acquisition of Cabot Oil and Gas, their respective CEOs touted their companies’ shared commitments to environmental stewardship, sustainability and strong corporate governance and their goal to build upon ongoing efforts to improve ESG and sustainability capabilities as a combined business.

ESG activism shaping M&A

Activists will increasingly leverage ESG issues to rally the support of key institutional shareholders in favour of broader strategic changes, including M&A. Third Point’s campaigns to break up Royal Dutch Shell and Prudential and Elliott Management’s efforts to separate SSE are illustrative. AGL Energy, one of Australia’s largest electricity providers, recently scrapped its plans to separate its coal power stations and distribution assets following pressure from its major shareholder, Mike Cannon-Brooks, who viewed the demerger as a threat to the company’s transition plans.

The full impact of ESG on M&A is still to be fully seen, particularly as companies, investors and other stakeholders, as well as regulators, continue to assess and revise their priorities. The regulatory landscape in the US also remains in flux and the quality of ESG disclosures and decision-useful data, while improving, continues to leave much to be desired among investors. What is becoming evident, however, is that ESG has already found its way into the M&A lexicon.

Carmen X. W. Lu is counsel at Wachtell, Lipton, Rosen & Katz. She can be contacted on +1 (212) 403 1138 or by email: cxwlu@wlrk.com.

© Financier Worldwide

BY

Carmen X. W. Lu

Wachtell, Lipton, Rosen & Katz