Translating ESG: sustainability in the modern energy industry

January 2022  |  SPECIAL REPORT: ENERGY & UTILITIES

Financier Worldwide Magazine

January 2022 Issue

The universe of issues discussed in the name of ‘sustainability’ has grown dramatically in recent years. No longer is the term simply synonymous with environmental efforts. Rather, today is the day of ‘big-tent’ sustainability, under which recycling, greenhouse gas reduction and renewable energy jostle for attention with forced labour and board diversity. Moreover, these topics are appearing in a variety of situations, from project development and supply chains to investor communications and, increasingly, mergers and acquisitions (M&A).

What is ESG?

The United Nations’ (UN’s) Principles for Responsible Investment (PRI) were published in 2005 and are generally recognised as the origin of the concept of environmental, social and corporate governance (ESG)-oriented investment. At the time, the underlying concepts were not new, but nor were they sexy. However, as tens, then hundreds, and now thousands of investors and investment managers have become PRI signatories, ESG considerations have permeated the investment community. At its heart, ESG investment is merely a way to evaluate risk more comprehensively.

What is sustainability?

In the context of industry, sustainability can be thought of as how a business responds to the pressure of the ESG investment trend. In the context of acquisitions and investment, sustainability used to be about acquiring a stake in a company in a favoured industry, such as renewable electricity. Occasionally, sustainability meant investing in a company that had implemented cost-saving efficiency measures, even if those facts did not move the needle on the price per share. As ESG investors have focused on social and governance in addition to environmental factors, many businesses have begun to account for those additional factors in their operations.

However, the story of sustainability is not just about investment; there are other factors in play. In recent years, many companies have found that retaining key talent depends on the company’s ability to meet employee expectations around aspects of sustainability. For example, workplace culture, diversity, equity, inclusion and accessibility (DEIA) in the ranks and in management, fair and equal pay, and the company’s environmental footprint. In addition, companies have found it hard to ignore customers voting with their pocketbooks. Savvy businesses are also increasingly focused on their impact on the communities in which they work. For example, in the renewable energy industry, one of the historical risk factors is permitting. Since permitting decisions are often influenced by the local community, designing the development process to provide long-term community benefits may not only increase a project’s, and its developer’s ESG profile vis-à-vis investors, it may also make the project possible and its developer’s business more financially sustainable.

Creating sustainability in the energy industry

Companies vary widely in their approach to ‘sustainability’. However, in the context of energy, merely producing electricity using solar panels or using electricity produced by wind turbines is no longer sufficient for achieving sustainability.

That said, the energy industry does have a leg up on some. For many years, the energy industry has been creeping toward a tipping point. Renewable electricity is in many circumstances less expensive than most other power generation technologies. Some of this price change results from national and local governments setting standards and incentives. In the last several years, the process has been accelerated by corporate actors setting public goals and then executing on them by purchasing first offsets, then kilowatt hours of electricity, and more recently, investing in generation facilities. Now, the same corporations are focusing on scope two and three emissions, exerting pressure on their suppliers and service providers to use renewable power and fuels.

Renewable energy has become more cost competitive contemporaneously with the surge of interest in ESG investing. This has driven significant investment and acquisition activity in the renewable energy sector and, inevitably, consolidation. In addition, many large players in oil, gas and coal have changed their business plans. In some cases, change has been incremental; in others, total. Perhaps in part because of the recognition that electricity can address only so many of the climate pressures acknowledged by ESG criteria, there has also been a very recent surge of interest in carbon capture, the sequestration and utilisation of captured carbon, and the production of renewable fuels such as hydrogen.

Alongside the shifts in market activity, we have also seen a strong trend toward DEIA and creating an ethical supply chain. The US’s recent withhold release order (WRO) for silicon produced in Xinjiang is just one example of governmental pressure to use natural resources that are produced using ethical labour practices. This trend is also rippling through corporate procurement of renewable energy, but there is yet to be a consensus about how far these efforts can and should go up and down the supply chain, or how to obtain sufficient assurances about the materials and components incorporated into any product.

Sustainability and energy finance

Many investors hold significant expectations with respect to sustainability matters, and some will not consider acquiring equity in businesses that do not meet their standards. Recently, many lenders and insurance providers have also begun to consider sustainability related matters in their underwriting processes. How these evaluations manifest in the transaction process varies.

Target selection. In the last several months, we have seen investors reject solar projects when the developer cannot verify that the project’s photovoltaic panels were not produced using silicon from Xinjiang. While these occurrences are still somewhat uncommon because of the nature of the WRO and historic opacity of the solar supply chain, they are happening nonetheless. Of course, most lawyers have stories about private-market investments or acquisitions that were not made because of legal liability in respect of environmental or labour considerations. Additionally,  there are examples of acquisitions failing when a target has complied with applicable law, but the standards under that law do not comport with an investor’s expectations, either for cultural or economic risk reasons. There has also been a very noticeable trend of private investment dollars seeking opportunities in industries typically seen as more ESG friendly, such as renewable energy.

In the public sector, it is easier to see how sustainability is linked to target selection. An internet search of the term ESG will yield a long list of options for evaluating publicly traded companies. Some national regulators have created or are expected to soon publish ESG-related disclosure standards. There are also several voluntary standards for this purpose. For example, in the US, the Sustainability Accounting Standards Board (SASB) published a scoring system based on 77 factors that can be used to evaluate sustainability at the business level. The recent consolidation of SASB and several other organisations, including the International Integrated Reporting Council, likely will lead to more uniformity in voluntary standards within the US and other countries.

As helpful as reporting standards are for publicly traded corporations, they can also be employed by privately held companies to guide their reporting to investors, insiders and the public. As more private parties begin to publish this information, an uptick in allegations about inferior sustainability practices of competitors has emerged. Implementing robust diligence and reporting mechanisms, such as those developed using the standards above, can help a business ensure that its various statements are supportable and consistent and, therefore, increase the chance of combating complaints by competitors and preserving the goodwill that is essential to an investment or acquisition process.

Pricing and valuation. The fundamental point of ESG investing is to account more comprehensively for risk. Thus, as investors have more frequently taken into consideration primary, secondary and tertiary ESG risks, valuation and pricing around these factors has experienced fluctuation. This trend has been apparent in investments into energy companies. For example, some of the pricing variation in oil & gas securities over the last few years has been linked to concerns about their impact on climate change. Investors have made more detailed consideration of other ESG factors in investments into renewable power and fuels companies, as well as in the project finance process for the facilities they are building. It is worth noting that reputation around ESG issues can be as important as objective data in evaluating a target because reputation can impact sales, retention and in some cases, the ability to get a deal done at all.

Reporting. Related to both target selection and valuation, it is important for businesses to avoid overstating their sustainability attributes to risk engaging in ‘greenwashing’. Greenwashing is a broad concept that covers any activities that convey, through implication or deception, that a company’s practices or products are more sustainable than the underlying facts can support. This is the subject of increasing scrutiny among regulators and prospective purchasers, as well as potential customers. Accordingly, it is important for businesses to carefully vet communications about sustainability practices to avoid running afoul of the law, industry norms or customer expectations.

Conclusion

The dramatic increase in attention to sustainability matters has affected the energy industry in myriad ways. Because of the dynamic nature of sustainability considerations and the constantly shifting legal, regulatory and industry considerations in this area, it is imperative to focus on developments as they occur. Sustainability attributes have become an integral part of the energy industry and staying ahead of the trends in this area will be increasingly essential to achieving success.

 

Elisabeth Yandell McNeil and Elizabeth C. Crouse are partners at K&L Gates. Ms McNeil can be contacted on +1 (206) 370 7824 or by email: elisabeth.mcneil@klgates.com. Ms Crouse can be contacted on +1 (206) 370 6793 or by email: elizabeth.crouse@klgates.com.

© Financier Worldwide

BY

Elisabeth Yandell McNeil and Elizabeth C. Crouse

K&L Gates

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