ESG enters M&A mainstream in a year of change

As ESG climbs up the investor agenda, its influence is entering all areas of corporate strategy—including M&A

From climate change to the Black Lives Matters movement and employee health and safety, 2020 was a year that pushed environmental, social and governance (ESG) issues to the forefront of people’s minds. From responding to the COVID-19 crisis to building longer-term resilience, mounting concerns have served to strengthen the ESG mission among corporations and the investment community throughout 2020, with signs of acceleration.

ESG matters encompass a wide range of issues linked to sustainability, 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. ESG also comprises human rights concerns, including the use of forced labor, or trafficked or child workers in the supply chain.

Connected to the renewed focus on sustainable development, 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 and resilience to global changes.

Investment in ESG-related funds has reached a record high in 2020 amid the COVID-19 pandemic, exceeding US$1 trillion for the first time, according to Morningstar. Commitment to ESG issues is coupled with the realization that ESG investment can generate stronger financial returns. A recent global study by Fidelity shows that companies with better ESG ratings generated higher returns than did their peers in 2020.

Energy transition fuels deals across the globe

Companies across the globe issued or boosted commitments to tackling climate change and managing the impacts of their business on the environment in 2020. The global shift toward improving sustainability and mitigating climate change prompted a wave of deals over the course of the year.

Engie’s sale of French water and waste firm Veolia to Suez, announced in October, is reportedly part of its intention to boost investment in renewables. The takeover, valued at US$26.3 billion, highlights the pressure that major global corporations are facing from governments, investors, and public opinion to manage environmental impacts. According to Antoine Frérot, Chairman and CEO of Veolia, the European Green Deal—a set of policy initiatives laid out by the European Commission which aims to reach net-zero greenhouse gas emissions by 2050—was a motivating factor behind the deal.

This commitment to environmental issues is influencing deal strategy across the globe. In the Middle East, the US$20.3 billion merger between TAQA and ADPower, completed in July, supports UAE’s Energy Strategy 2050 and Water Security Strategy 2036, which aims to promote more efficient use of resources and cleaner energy.

Meanwhile in the US, Dominion Energy’s US$9.7 billion sale of gas transmission and storage assets to Berkshire Hathaway shows Dominion’s intention to become a “pure-play” clean energy utility provider. Furthermore, the Biden administration’s support for a more aggressive approach towards regulating impacts to the environment is likely to result in shifting deal dynamics. On January 20, 2021 (Inauguration Day), President Biden revoked a permit for a pipeline that would have carried crude oil from Alberta to existing pipeline infrastructure in Nebraska, then on to refineries located on the Gulf Coast. As a result, a US$1.5 billion Alberta government investment in that pipeline, and related with loan guarantees, are at risk.

Pressure mounts for ESG disclosure

In January 2020, before the impact of COVID-19 was felt, leading fund manager BlackRock called for an improvement in sustainability disclosure among companies, and shareholder proponents have successfully pressured companies to enhance their ESG disclosures. For example, the New York City Comptroller recently announced that 34 S&P 100 companies will begin publicly disclosing the composition of their workforce by race, ethnicity and gender.

The push toward increased ESG disclosure is unrelenting from investors, and is also gathering strength from regulators.

The EU Framework Regulation (Taxonomy), published in June 2020, requires certain large companies to report on the extent to which their turnover and capital and operating expenditure relate to six defined “environmentally sustainable activities,” effective from 2022 and 2023. In September 2020, the European Parliament Committee on Legal Affairs issued a draft report with specific recommendations to implement "mandatory human rights, environmental, and good governance due diligence legislation" to ensure "harmonization, legal certainty and the securing of a level playing field."

In the US, recent amendments to the Securities and Exchange Commission (SEC) disclosure rules now require US public companies to disclose, to the extent material, a description of human capital resources in their upcoming annual reports, including any human capital measures or objectives that a company focuses on. And with the onset of the COVID-19 pandemic, ESG disclosure in SEC filings had already been on the rise.

Meanwhile, the Biden administration is likely to support some level of enhanced ESG disclosure requirements for public companies in reports filed with the SEC. This may include mandatory climate disclosure in periodic reports, among other potential rule initiatives.

As ESG factors become increasingly important in M&A decisions, the ability for companies to tell their ESG story could present them as a more accurate target—beating off competition from firms unable to provide clarity in their ESG reporting.

BlackRock CEO leads ESG charge

In his open “2021 Letter to CEOs” published on BlackRock.com in January, BlackRock Chairman and CEO Larry Fink reasserted and strengthened his declaration from the prior year’s letter, that “climate risk is investment risk.”

“There is no company whose business model won’t be profoundly affected by the transition to a net zero economy,” Fink wrote. “As the transition accelerates, companies with a well-articulated long-term strategy, and a clear plan to address the transition to net zero, will distinguish themselves with their stakeholders—with customers, policymakers, employees and shareholders—by inspiring confidence that they can navigate this global transformation.”

To that end, Fink committed BlackRock to “taking a number of steps to help investors prepare their portfolios for a net zero world, including capturing opportunities created by the net zero transition.”

Fink advises all companies—including large privates—to report in alignment with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB). All companies should disclose a plan for how their business model will be compatible with a net zero economy, articulating how the plan will be incorporated into their long-term strategy, says Fink. Fink also advocates for public-private partnerships for financing critical infrastructure projects, and advises all companies to disclose talent strategy and plans for improving diversity, equity and inclusion.

“I have seen how many companies are taking these challenges seriously—how they are embracing the demands of greater transparency, greater accountability to stakeholders, and better preparation for climate change,” Fink wrote.

ESG directs dealmaking going forward

ESG’s momentum shows no sign of slowing down in 2021. Whether as a means for dealmakers to select attractive M&A targets, a way to identify risk within the deal process or a response to government and investor pressure, ESG considerations are becoming impossible to ignore.

Achieving sustainability goals is a major motivating ESG factor behind M&A deals, as well as avoiding risks of supply chain liabilities. And the commitment to the cause spans beyond the energy and power sector: In December 2020, 13 major global players, including Microsoft, Unilever and Coca Cola European Partners, pledged to become carbon neutral by 2040. Every sector is affected: in mining & metals, 78.8% of respondents to our end-of-year survey expect ESG issues to play a greater part in investors' decision-making, while ESG performance is also seen as the industry's second-most important priority for 2021, after ensuring production can be maintained in the face of the pandemic.

The commitment of major global corporations to enhanced ESG disclosure, including to the Sustainable Development Goals (SDGs) and reporting frameworks like SASB and TCFD, will result in further strategic M&A in 2021, as they look to deals to help reshape their businesses. Improved disclosure of ESG metrics will enable companies to choose the right targets.

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