What drives M&As - simple math or the green future?

Climate risks will affect every consumer, every corporate, in all sectors and across all geographies. Their impact will likely be correlated, non-linear, irreversible, and subject to tipping points. They will therefore occur on a much greater scale than the other risks we are used to managing.

Sarah Breeden, Executive Director for Financial Stability, Strategy & Risk, Bank of England.¹

Risk categories

Climate change risks may be operational, transitional, or liabilities related. Identifying these risks requires thorough investigation into the target’s operational and strategic risk registers, and by a truly integrated technical and legal team. While there is no universally accepted method for assessing climate related risks as it largely depends on nature and location of the target’s business, some standard risk categories include:

• Regulatory and compliance risks
• Physical risks
• Stranded Asset risks
• Litigation risks
• Reputational risks / considerations

Regulatory and compliance risks

To tackle climate change, governments and regulators have enacted laws and published guidelines. These regulatory changes come under the broader category of “transition risks”, which are financial risks arising from the transition to a lower-carbon economy.

For instance, public joint stock companies listed on the Abu Dhabi Securities Exchange, or the Dubai Financial Market in the UAE are now required by the UAE Securities and Commodities Authority to adhere to specific environmental disclosure requirements.² Most of the Middle Eastern stock exchanges/regulators including Kingdom of Saudi Arabia, have now set guidelines on how businesses should report sustainability information. The Saudi Vision 2030 has climate change and sustainability in focus while rapidly pursuing nation’s goals of developing policies, encouraging investment and creating new energy efficient infrastructure. With Egypt and the UAE hosting the next two United Nations Climate Summits (COP 27 and COP 28), the region’s legal and regulatory framework is anticipated to evolve and broaden drastically to encompass all corporations and sustainability priorities.

While some target companies may be directly impacted by these regulatory requirements, others may have an indirect influence on their supply chains, the cost of raw materials, or operational expenses in other ways. Changes in the law and policy could expose the buyer and the target to an entirely new set of rules in the not-toodistant future, and their future profitability will be determined by their collective  capacity to adapt to climate laws. Parties should be aware that governments’ long-term objectives, such as the UAE’s 2050 strategy and Saudi’s Vision 2030, may have short-term effects for businesses, for instance, the need to align companies’ current climate policies with governments’ climate pledges.

Therefore, assessing target’s capability and willingness to comply with new policies should be a critical part of any M&A due diligence. It is a commercial imperative for the buyers to negotiate specific climate related warranties and ensure that target’s climate policies and reporting standards align with the buyer’s sustainability goals. Companies contemplating M&As in the energy, transportation, and agriculture industries should monitor global legislative and regulatory developments in the sector, in addition to the regional shifts.

Physical risks

Physical risks are financial and reputational risks resulting from extreme climate change-related weather events. These are the most obvious risks associated with climate change and are the most challenging to assess. These risks include business interruptions, supply chain disruption or damage to a company’s assets (such as facilities, infrastructure, land, or resources) as a result of extreme physical impacts, such as rising sea levels, more intense storms, floods, fires, and drought. A recent example is the floods in Pakistan, which are linked to climate change, and are predicted to cause far more than USD 10 billion in damages, besides claiming over 1300 lives.

Bringing these risks back to the context of M&As, assets in a deal might include long-life and capital-intensive fixed assets, such as a mine site or plant. There could be complex supply chains, involving extensive transport networks. Workforces and communities may be vulnerable to climate-related risks, including increased prevalence of diseases. Climate change may affect energy or water availability. Physical climate risks can drive direct and indirect impacts to core operations, value chains and broader networks of the target, which may, among other challenges, reduce the efficiency of production processes and/or cause production stoppages.

While climate change does not necessarily create new risks, it creates a change in the risk profile for risks that are likely to already exist. The “cascade of effects” triggered by climate change events can collectively give rise to systemic risks and material financial implications, one that require express consideration during the due diligence stage. These risks have the potential to jeopardise viability of business strategies (e.g., locational and procurement strategies) and necessitate wholesale transformational change.

Stranded asset risk

As an offshoot of physical and regulatory risks, stranded asset risks have gained centre stage in M&A deals. The idea of stranded assets is used in finance to characterise corporate assets prone to unplanned or premature write-downs, devaluations, or conversion to liabilities.

Some or all of a target’s past infrastructure may have not considered the changing climate in their future use. The assets may require additional capital expenditure to manage the changing requirements imposed by climate change, while the asset life may be shorter than originally planned by the target, leading to some premature asset write-off.

Climate related legislative changes, technology advancements, consumer trends, or other market activities intended to significantly reduce the usage of fossil fuels for instance, are a critical factor in assessing asset sustainability.

Buyers should pay attention to asset sustainability from climate change related risks aspect right at the due diligence and valuation phases, or they could end up purchasing an asset worth far less than priced for, with an elevated exposure to post-transaction value loss.

It comes as no surprise that some notable institutional investors have publicly reported their fears about stranded assets, prompting them to sell their holdings, while others are forcing businesses to reveal their plans for dealing with the possibility of stranded assets.

Litigation risks

Previously unforeseeable and unreported climate risks are becoming increasingly foreseeable and accessible in corporate disclosures. These risks are gaining wider stakeholder attention, and in recent years, frequent climate-related lawsuits have been instituted by the members of the public (including class actions), shareholders, consumers, and even directors & officers, challenging business’s climate denying practices. It is essential that the present and future litigation risks of the target be evaluated considering the litigation pattern in their specific industry and region.

In addition, some of the most significant liability risks are associated with climate disclosures. Buyers should conduct a comprehensive review of target’s climate related risks disclosures reports to determine sufficiency, accuracy, and consistency of the disclosures, in particular, target’s forward-looking statements and worst-case scenario assessments.

Finally, keep in mind that lawsuit know no national boundaries. A purchaser in one country may, for instance, face legal actions for failure to conduct sufficient climate due diligence before acquiring a target in another country. Traditionally, due diligence would investigate target’s current or past liabilities and lawsuits. However, climate change requires a different mindset to address the challenges of an uncertain world, leading to an unprecedented shift in climate litigation landscape.

Reputational risks / considerations

Public perception is important in most large M&A deals. Private equity and corporate investors often want to showcase that the target’s performance aligns with their climate change goals. From a purely financial perspective, reputational risks can directly affect financial performance of a target by lowering sales and diminishing customer loyalty.

Reputation and brand management are key drivers and, if an M&A target risks harming the bidder’s reputation, that has implications for the bidder’s key stakeholders, including consumers and their own employees.³

Lastly, reputational damage or stigmatisation faced by the buyer for acquiring a non-Paris aligned target⁴ may have major financial ramifications, even if the direct financial impact on share prices is small in the immediate term. It may make long-term securities and short-term operating capital less available or more expensive for the buyer. It may negate buyer’s current insurance policies and/or adversely impact future policy placements.

Conclusion

Despite geopolitical tensions, global M&As remain strong, with the Middle East recording a 12 per cent year-on-year rise in 2022. It is hardly shocking that two-thirds of Middle East firms anticipate pursuing M&As this year, for future-proofing business strategy and firm’s operational capabilities. The direction of travel for the region is clear - more M&As.⁵

It can be difficult and subjective to assess climate change risks, although often the biggest deal breakers. Climate considerations get far more relevant in cross border M&As, especially if buyer’s jurisdiction already has matured climate laws with an extra territorial applicability over potential targets.

Every due diligence should therefore be uniquely crafted on the basis of target’s nature and location of assets and operations, its supply chain composition, and its internal knowledge and preparedness to manage climate risks.

Unquestionably, pursuit of profit is still what moves markets, and long-term profitability will be the primary metric used by the stakeholders to assess a company’s real worth. Dealmakers are therefore proactively redesigning their M&A processes and a new model of climate aligned dealmaking is incoming.

This article was first published in the Oath magazine, issue 115, September 2022.

1. Leading the change: climate action in the financial sector - speech by Sarah Breeden | Bank of England
2. Article (76) of the Chairman of SCA Board Decision No. (03 R.M.) of 2020
3. ESG more critical than ever in M&A - Baker Tilly International
4. The Paris Agreement | UNFCCC
5. EY: Two thirds of Middle East CEOs to pursue M&A in 2022