ESG goes mainstream: Impact of ESG and sustainable investments on mergers and acquisitions

Background

ESG factors are becoming increasingly important in M&A decision making. The Financial Times reported (based on a survey in December 2020) that 83% of business leaders view ESG factors as increasingly critical to M&A decision making over the next 24 months.¹ Data from Refinitiv in 2021 showed that M&A deal activity involving sustainable companies more than tripled 2020 levels to reach an all-time record of USD197 billion from around 1,270 transactions, a 60% increase on a year ago.² This demonstrates how ESG considerations are becoming more significant across the entire M&A process from target company selection and post-acquisition ESG integration.

In this article, we briefly explore how ESG and sustainable investment strategies are influencing private capital investments and M&A deals, and outline how the Task Force recommendations and guidance are relevant to future acquirers and targets.

ESG and sustainable investment

Institutional investors (such as global private equity funds like BlackRock) play an instrumental role in how sustainability is becoming the new standard for investing and highlighting how critical ESG issues factor into investment decisions. In part, the move towards a stakeholder-centric model is driven by sustainability and ESG issues being higher up on many stakeholders’ agendas ranging from governments to consumers and employees.

Across the globe, different jurisdictions have introduced ESG reporting requirements and additional governance and risk management obligations on companies. These include the UK, Singapore, Japan and Hong Kong.

It is arguably a matter of time before Australia introduces strict legal requirements relating to sustainability frameworks. Currently, Australian regulators have largely supported the announcement made at the UN COP26 Global Summit on Climate Change that the International Financial Reporting Foundation will establish an International Sustainability Standards Board (ISSB). ASIC issued a press release on 14 December 2021³ welcoming the establishment of the ISSB and noted that it is a major step in setting global sustainability standards and addressing climate risk. Additionally, ASIC encourages listed companies to use the Task Force recommendations as the primary framework for climate change-related disclosures. Companies adopting this approach will be well placed to transition to any future standard.

In terms of private capital the Chairperson of BlackRock, Larry Fink, in his 2022 letter to CEOs of their investee companies describes how “the tectonic shift towards sustainable investing is still accelerating” and “we focus on sustainability not because we’re environmentalists, but because we are capitalists and fiduciaries to our clients.”⁴ BlackRock has asked its investee companies to issue reports consistent with the Task Force recommendations and to set short, medium and long term targets for greenhouse gas reductions.

What we are observing is that integrating ESG criteria into investment portfolios is no longer an exercise reserved for a select few companies, and is becoming mainstream. Climate risk is viewed as an investment risk, and is a key driver in reshaping finance and capital allocation as investors seek to make investments which strengthen their ESG profile.

ESG deals

ESG considerations impact the entire M&A deal cycle from early stage negotiations to post-acquisition integration.

Climate Task Force recommendations

Given the significance of ESG, the climate Task Force was created by the Financial Stability Board (which was established after the G20 London Summit in April 2009 to monitor and make recommendations about the global financial system). The Task Force has developed a framework for reporting on climate-related financial disclosures based on key recommendations which apply to all industry sectors. Core elements are governance, strategy, risk management and metrics and targets, with the underlying theme of climate-related risks and opportunities being material for multiple organisations. The Task Force released supplemental guidance in October 2021 for the financial sector and for non-financial industries likely to be most impacted by climate change, which include energy, transportation, materials and buildings, agriculture, food and forest products.

Some takeaways from the Task Force recommendations include:

• climate-related risks and opportunities (CRO) – when considering exposure to CRO, the Task Force suggests organisations consider their value chain over a reasonable time frame across the following factors:
  • climate-related risks including (1) transition risks such as policy restrictions on emissions, imposition of carbon tax, water restrictions, land use restrictions or incentives, and changes to market demand and supply; and (2) physical risks such as the interruption of operations or damage of property; and
  • climate-related opportunities such as access to new markets and new technology (eg carbon capture and storage) or improved reputation.
• responding to CRO – once potential exposure is determined, organisations need to choose how to respond, including risk management actions (eg to accept, avoid, pursue, reduce or share/transfer); and whether:
  • capital expenditures on or financing new technology or facilities may be warranted; or
  • R&D expenditures may be needed.
• effectiveness of response – organisations should monitor implementation of its responses against internal targets and external factors, eg internal revenue targets for sales of new products designed to capitalise on climate-related opportunities.

The ISSB will build upon the Task Force recommendations and other existing frameworks to become the global standard setter for sustainability disclosures within financial markets.

Conclusion

Given the surge in focus and recent developments in the ESG and sustainable investment space, we expect that this movement, in favour of integrating sustainability considerations into corporate strategy and investment decision making, will continue to be a key priority for acquirers considering future M&A deals. Globally, the establishment of the ISSB is a major step in setting sustainability standards and addressing climate risk.

Climate focused disclosure is anticipated to become more prevalent as it is increasingly adopted by more companies seeking a competitive edge in their industry when bench marked against their peers. Addressing climate change is a high priority for stakeholders and investors. It is arguably a matter of time before Australian regulators look to introduce strict legal requirements relating to sustainability frameworks. Companies and organisations who choose to be ahead of the game by adopting the Task Force recommendations will be well placed to transition to any future standard.

This article was written by Thomas Kim, Partner and Kenneth Lee, Senior Associate.

¹Financial Times, ‘ESG and the rise of sustainable dealmaking‘ (17 December 2020) <https://channels.ft.com/en/bigdeal/esg-rise-of-sustainable-dealmaking/>.
²Refinitiv, ‘Sustainable finance continues surge in 2021‘ (2 February 2022) <https://www.refinitiv.com/perspectives/market-insights/sustainable-finance-continues-surge-in-2021/>.
³ASIC media release, ‘ASIC welcomes new International Sustainability Standards Board and updated climate-related disclosure guidance‘ (14 December 2021) <https://asic.gov.au/about-asic/news-centre/find-a-media-release/2021-releases/21-349mr-asic-welcomes-new-international-sustainability-standards-board-and-updated-climate-related-disclosure-guidance/>.
⁴BlackRock, ‘Larry Fink’s 2022 Letter to CEOs‘ (2022) <https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter>.