White & Case LLPStrong ESG credentials and long-term plans to improve their relationship with society and the environment are increasingly important to ensure companies’ access to capital.

Environmental, social and governance (ESG) matters are increasingly important in corporate dealmaking, strategy, disclosure and investment planning. ESG matters encompass a wide range of issues, including climate change and other environmental risks and impacts, employee health and safety, pay equity, board and employee diversity, corporate governance, data security and customer privacy, consumer and product safety standards, business continuity, disaster recovery and crisis management, as well as human rights concerns, including the use of trafficked or child workers in the supply chain.

ESG has become shorthand for the risks and opportunities that could impact a company’s ability to create value in the long-term—and how the company is managing those risks and taking advantage of those opportunities to ensure its long-term economic stability.

A spotlight on ESG in 2020

The events of 2020 have had the unforeseen effect of bringing ESG concerns to the forefront for many companies, especially those in the energy and mining sectors. More banks are scrutinizing investments and loans in greenhouse gas emission-intensive projects, and more energy companies are announcing lower greenhouse gas intensity and emissions targets. But all companies manufacturing, selling and extracting goods and providing services are affected, including tech companies’ approach to their services and products.

“Companies, investors, and governments must prepare for a significant reallocation of capital,” said Larry Fink, CEO of BlackRock, in his annual letter to CEOs in January 2020. The head of the world's largest fund manager, which has US$7 trillion under management, aims to scale up sustainable assets from US$90 billion to US$1 trillion over the next ten years (Wall Street Journal, January 14, 2020).

In the first four months of 2020, at least US$12.2 billion was invested in ESG funds—more than double the investment during the same period last year—and more than 70% of ESG funds performed better than their counterparts during this four month period (Wall Street Journal, May 12, 2020).

The BlackRock letter came just two months before COVID-19 was declared a global pandemic. Since then, the COVID-19 pandemic has only amplified the importance of ESG issues. For example, employee health and safety has taken center stage in company disclosures amid the pandemic like never before, and in broader terms, COVID-19 has placed the spotlight on the importance of crisis management and business continuity—for this crisis, and beyond.

Since Fink’s January letter, the COVID-19 pandemic and ensuing economic downturn caused an 18% drop in U.S. greenhouse gas emissions between March 15 and June 15 compared with last year's levels. Moody's estimates that reduced demand for power in the US will lead to an annual 10%-20% drop in the country's electric power emissions in 2020. While this may be only a temporary fall caused by the short-term economic impacts of the pandemic, a more lasting transition is in motion. Even before the COVID-19 pandemic, wind and solar were on the rise, particularly outside the United States.

The biggest deals in the energy, mining and utilities (EMU) sector so far in 2020 have been strongly motivated by the move away from carbon-intensive energy sources. In fact, the largest deal, the US$20.3 billion asset swap between Abu Dhabi National Energy Company and Abu Dhabi Power Corp., is part of the UAE’s Energy Strategy 2050, a plan to shift power generation to cleaner sources of energy.

It is no coincidence that the second-largest transaction involved another Abu Dhabi state-owned firm and a carbon-intensive energy business. In June, the Abu Dhabi National Oil Company divested itself of a 49% stake in pipeline assets for US$10.1 billion to a global consortium of investors that included Italy’s Snam, Canada’s Ontario Teachers' Pension Plan, Singaporean sovereign wealth fund GIC, US fund manager Global Infrastructure Partners and South Korea’s NH Investment.

The third-largest deal, meanwhile, was Dominion Energy’s sale of gas transmission and storage assets to Berkshire Hathaway for US$9.7 billion, representing a key step in Dominion’s plan to become a pure-play clean energy utility company.

With the oil price crashing once again in 2020, the third major drop in just six years, and the long-term viability of renewables looking especially attractive as they aggressively compete on price with fossil fuels, many energy companies are using the current period of creative destruction to realign their portfolios and strategies for the long haul.

Energy companies have taken strides to respond to climate change over the last eight months. In July, the Oil and Gas Climate Initiative, a group that includes some of the largest oil & gas companies in the world, announced a target to reduce the average carbon intensity of their aggregated upstream oil and gas operations to between 20 kg and 21 kg of CO2 equivalent per barrel of oil equivalent (CO2e/boe) by 2025, from a collective baseline of 23 kg CO2e/boe in 2017. These actions are likely to bring about more transactions involving investments in low greenhouse gas emissions businesses, and more divestitures of traditional carbon intensive energy assets by large energy companies.

In May, Total announced its goal to eliminate or offset all of its carbon dioxide emissions by 2050. Total's plan, which follows similar pledges from BP and Shell following pressure from their shareholders, sets a target of no more than 40 metric megatons of carbon dioxide emissions by 2025. Eni also accelerated its pivot away from conventional refineries to investing in greener facilities as it plans to exit traditional oil refineries in the next decade. Beyond converting refineries into biorefineries, the company will look to divestitures as part of its emissions-reduction plan.

Beyond “E”

It is not only the environment that is directing investor behavior and shaping corporate strategies and values. The unequal impact of COVID 19 on the “have nots’” in society has been widely recognized. This has been compounded by the Black Lives Matter (BLM) movement and protests, which started at the end of May in the United States but quickly spread to Europe and have shone a spotlight on persistent racial injustice and social inequality more broadly.

Many companies have been quick to show solidarity with BLM and its agenda. Walmart pledged US$100 million for a new racial equity center, while Warner Music and Sony Music each announced US$100 million social justice funds. While these funds may not directly affect M&A, they go to the heart of ESG issues and a wider public debate about the role companies play in society.

Investors are also heightening their focus on diversity disclosures since protests began. The NYC Comptroller, on behalf of three New York City Retirement Systems with more than US$200 billion in assets, sent a letter in July 2020 to the CEOs of 67 S&P 100 companies, calling on them to adopt a policy to publicly disclose diversity data with a comprehensive breakdown by race, ethnicity and gender in ten employment categories, including senior management, and provide a written commitment to do so by August 30, 2020 or face the risk of a proposal on this topic submitted to a shareholder vote.

Full disclosure

In addition to discussing capital reallocation, the January 2020 BlackRock letter provided an important lesson for companies on disclosure. Specifically, BlackRock called on the public companies it invests in to publish disclosure in line with the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-related Financial Disclosures (TCFD), and will “hold board members accountable” where companies and boards are not producing effective sustainability disclosures or implementing frameworks for managing sustainability issues.

The announcement from BlackRock confirms what many companies have increasingly noted. First, there is a growing need for many companies to enhance sustainability disclosures on their corporate websites to align with investor sentiment. Second, the two reporting frameworks, SASB and TCFD, have become the leading frameworks favored by the largest investors in US companies.

Shareholder proposals submitted to US public companies have further emphasized this call for disclosure action by companies. During the 2020 proxy season, shareholders submitted proposals on a range of ESG issues demanding reporting that align with SASB or TCFD criteria, with one shareholder proponent, As You Sow, filing seven such proposals this proxy season.

Disclosure frameworks are also actively evolving. In July 2020, the Global Reporting Initiative (GRI), a leading disclosure framework for sustainability reporting, published an initial draft of an ESG disclosure standard for the oil & gas industry. The draft is open for public comment until October 6, 2020. A July statement issued by GRI and SASB also announced a plan to collaborate and facilitate company disclosure against multiple frameworks to satisfy the informational needs of different stakeholders.

Meanwhile in the European Union (EU), mandatory disclosure was introduced in 2014 in the “EU CSR Directive” —the Non-Financial Reporting Directive (NFRD)—to improve the transparency of listed companies' environmental and social impacts and progress, and allow investors to make more-informed decisions.

Two years after coming into effect, the directive has already come under review. Policymakers are concerned that the NFRD, which operates on a “comply or explain” basis, has fallen short of its intended purpose. Reporting on matters such as carbon footprints and board diversity is not sufficiently reliable or standardized, making it difficult for investors to benchmark and make like-for-like comparisons. The aim of the revised version is to further improve transparency.

The EU has also adopted a new Regulation on sustainability‐related disclosures in the financial services sector, setting out requirements on financial market participants and financial advisors on how to integrate ESG risks and opportunities in their processes and providing more uniform rules on transparency.

Outside of the United States, mandatory ESG related requirements and proposals are a growing trend. A number of countries, including Australia, the United Kingdom, France, Germany and Switzerland, are toughening up their rules on human rights and environmental damage. A number of national supervisory authorities have pushed through initiatives aimed at improving ESG disclosure and preventing “green-washing.” In June, the EU launched a consultation for a legislative proposal on mandatory human rights due diligence with the aim of adoption for 2021.

Around the world, investors want better, more accurate insight into companies' ESG credentials—and not just for “do-gooding” purposes. It is estimated that of approximately 2,000 academic papers on the topic, some 70% find a positive correlation between higher ESG scores and financial returns, measured by either equity returns, profitability or valuation multiples. And globally, ESG investing is seeing a record inflow of funding, as the total value of funds that have integrated environmental, social and governance factors has more than quadrupled since 2014, rising to $485 billion as of 2019 (WSJ, June 10, 2019).

Companies are therefore in a race to increase their ESG ratings and scores to capitalize on the investor-led ESG gold rush. There is a large range of third-party firms that rank and rate company ESG practices for various investors and other stakeholders. Investors are also turning to a growing number of corporate performance rankings on human rights, informing both shareholder resolutions and exclusionary investment policies (see “Human rights benchmarks: Corporate performance rankings on the rise”).

At the end of the day, companies will need to find clarity about their ESG story in the midst of the ESG ratings race, which has been criticized for rating companies based on criteria that are not relevant for a particular business, or are based on inaccurate information about a company’s practices. Expert counsel will be crucial to help find this clarity, and each company will need to tell its own ESG story, focus on its own ESG goals and on its own investors and stakeholders to provide the accurate ESG information they seek.

M&A meets ESG

The growing relationship between M&A and ESG suggests that companies that are telling their ESG story well and have strong ESG propositions are likely to see growing interest not only from investors in capital markets but also from corporate buyers seeking transformative M&A opportunities. Deals can help companies redefine their business models or reshape their product portfolios as they are forced to review their core strategies and learn how to achieve ambitious sustainability goals.

According to a survey conducted by Ipreo in Q1 2019, 53% of respondents said they expect ESG factors to become significantly more important in M&A decisions in the following 12-24 months, with climate change and emissions seen as the most important issues. More than half (53%) said they have walked away from an M&A deal or investment due to a negative assessment of ESG issues at the company.

In a special mid-year survey by White & Case in the mining sector, a stunning 80% of respondents expect that ESG will play a greater part in investors’ decisionmaking, though 65% expect that long-term sustainability initiatives will conflict with the need to cut costs.

The events of 2020 have heightened the urgency of progress on corporate sustainability. As investors prioritize ESG in their allocation decisions, companies that fail to take the topic seriously risk being priced out of financial markets and, eventually, also risk finding themselves rendered obsolete.

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