ESG and M&A: There is more to come!

ESG as part of the corporate strategy

1) CSRD

The sustainability reports companies are required to publish following the transposition of the European Corporate Sustainability Reporting Directive (CSRD) will become much more comprehensive and, in future, must also contain information on, for example:

• sustainability policies, 
• sustainability objectives and the progress towards achieving them,
• resilience to sustainability risks,
• the business model and corporate strategy and their implementation, particularly with regard to the necessary reduction in greenhouse gas emissions and compatibility with the 1.5 degree target.

Due compliance with the new reporting obligations first requires an in-depth content-wise analysis of the aforementioned criteria at the level of the various management bodies. This analysis should be thoroughly documented so that it can reviewed by an auditor. According to the principle of double materiality, it must separately document both the impact of sustainability issues on the company and its business model (outside-in) and the impact of the company’s business activities on the environment (inside-out). Especially with regard to climate change and the fight against it, the principle of dual materiality raises two questions:

• How are companies and their business models affected by the increasing climate change on the one hand and the legislation resulting from the fight against it on the other?, and
• How do companies contribute to climate change with their business model?

This makes it clear that developing a sustainability strategy and setting sustainability objectives is crucial to the successful continuation of a company. Consequently, the managing bodies (board of directors or management) are required to deal with these issues in detail and report on the relevant findings. Also in this respect, the supervisory board is responsible for controlling the board of directors.

2) Draft CSDDD

The aforementioned development is even intensified and, hence, expedited by the draft European Corporate Sustainability Due Diligence Directive (CSDDD). Art. 25 thereof provides for a direct duty of care of the management bodies when exercising their respective corporate discretion in corporate governance. Accordingly, in fulfilling their respective duties to act in the best interests of the company, the managing bodies, board of directors and the supervisory board must always take into account the consequences of their decisions for sustainability matters in the short, medium and long term.  

Even if it is currently still unclear whether and in what form Art. 25 CSDDD will become legally binding, the course has been set. In the near future, sustainability, including all its relevant areas, i.e. environment, social and governance, will therefore play a direct and absolutely essential part in corporate governance.

ESG as a deal driver in M&A

Already today, ESG criteria are of crucial economic importance for both equity financing (e.g. in the context of Art. 8 and 9 investments or impact investing) and debt financing (e.g. through green bonds, ESG-linked Schuldschein loans, etc.) of companies and management bodies must take them into account when making corporate financing decisions. Hence, they at least indirectly impact the investment and divestment decisions of management bodies. 

This is exemplified by the energy sector and energy-intensive industries. Investments in the European oil, gas and coal industry are being scaled back. Any acquisitions in these sectors are made by opportunistic buyers who deliberately collect “stranded assets” at cheap prices and earn money with them for a few more years. Long-term and institutional investors as well as large energy corporates, on the other hand, invest in renewable energies, battery storage and charging infrastructure for electric cars. The energy-intensive steel and chemical industries use alternative energy sources such as hydrogen and co-investments in offshore wind farms and simultaneously conclude power purchase agreements (PPAs) to secure future green energy supplies.

In the course of implementing the CSRD and CSDDD regulatory requirements with the particular impact on corporate strategy mentioned above, ESG criteria will have an even greater and direct impact on investments and divestments across different sectors in the future. Especially capital market-oriented companies that are keen to present their stakeholders with quick sustainability success will increasingly turn to M&A transactions for realising their corporate sustainabililty strategy. From an ESG perspective, the seller focus is on reducing the risk profile, while the buyer focus is on the intended development and expansion of a sustainable business model. As outlined above, the fight against climate change is a key issue in this context, meaning that a primary objective of purchase and sale transactions is to improve the sustainability footprint. However, besides the “E”, “S” and “G” should not be neglected either. For example, a company may consider strengthening its own governance as well as strategically withdrawing from geographical markets that cannot guarantee compliance with the requirements of the Act on Corporate Due Diligence Obligations in Supply Chains (Lieferkettensorgfaltspflichtengesetz - LkSG) and, in future, the CSDDD.

Besides the proper implementation of the CSRD requirements and continuous monitoring of the CSDDD legislation process, the board of directors or management should, for the purpose of a forward-looking corporate governance, analyse at an early stage the potential of a sustainability-targeted M&A strategy and, if the outcome is positive, not wait too long before implementing it. With a view to possible acquisitions, this is particularly evidenced by the fact that the M&A market has currently weakened, meaning that better prices and more favourable contractual terms for buyers can be achieved in many sectors than was the case a few years ago. Due to the short and medium-term developments foreseen in the field of sustainability, it is also recommended to identify at an early stage the right time to sell parts of the company that no longer fulfil the criteria of the sustainability strategy. There is no guarantee that there will be buyers willing to acquire stranded assets at a reasonable price in the long term. To protect board members from personal liability, these analysis and decision-making processes should be carefully documented.

ESG as a crucial factor in the implementation of M&A transactions

From the increasing strategic importance results a growing significance of ESG criteria in the implementation of M&A transactions. This applies to both the due diligence and the drafting of contracts.

1) Due diligence

ESG as such is not completely new in due diligence. Topics such as Health, Safety & Environment (HSE) and compliance have long been part of careful legal due diligence. Now, however, these and other topics must also be examined from a sustainability perspective, weighted in the analysis and presented accordingly in the due diligence report in order to be taken into account in the sale and purchase agreement (SPA). Moreover, in view of a possible liability of the target company, any potential greenwashing risks have to be analysed. In the future, compliance with the CSRD and the CDDD will play an important role in governance due diligence. This includes questions such as what are the organisational structures and processes, what data is collected for CSRD reporting, how is such data collected and via which reporting channels is it reported to the relevant business functions, how is ESG anchored in the employees’ minds, how are the Act on Corporate Due Diligence Obligations in Supply Chains and the CDDD implemented, is there appropriate reporting and sufficient documentation also in this respect?

The flip side of the increasing importance described above are extensive consequences if ESG risks of the target company are not identified early enough and if their materialisation has a negative impact on the buyer after the acquisition has been completed – be it because an excessively high purchase price has been paid as no valuation discount was applied, because a deterioration of the ESG rating leads to an increase in refinancing costs or because non-compliance on the part of the target company results in significant fines. 

When organising the due diligence process, it must be taken into account that sustainability-related risks are highly company-specific and previously many ESG criteria and sustainability standards have rather been general and not very substantive. Therefore, depending on the individual case, sector, international activity, etc., a different scope and depth of ESG due diligence is required. Due to the ultimately holistic approach to ESG, linking the various workstreams from commercial, financial, tax, technical, environmental and legal due diligence is of crucial importance for the conduct of effective and cost-efficient due diligence. The closer the teams work together, the more likely it is that risks will be identified at an early stage, correctly assessed on the basis of commercial criteria and incorporated into the transaction documentation in a risk-adequate manner. Thus, an appropriate risk allocation in the purchase agreement always requires a careful due diligence.

Recent case law of the Federal Court of Justice shows that the seller is also required to obtain a comprehensive overview and adequately inform the buyer of the ESG risks associated with the target company as, otherwise, it may be exposed to the risk of incurring legal liability for breach of the pre-contractual duty to provide information. Even if a seller due diligence is associated with costs, it directly serves to protect the seller from liability risks and, as an integral part of a structured sales process, increases transaction security to the seller’s benefit. 

2) Purchase agreement

Just like any other risks, ESG-specific risks must be accounted for in the SPA according to their type. If they can be assessed precisely and have already materialised, the purchase price has to be adjusted. If the materialisation or exact amount of loss associated with a particular risk is still uncertain, a corresponding indemnity is required. Abstract risks are typically covered by a guarantee catalogue. With the increased – and still increasing – density of regulation, also the scope of ESG-related guarantees in SPAs is extending. 

It is therefore not surprising that such guarantees can be insured to an increasing extent by W&I policies. However, the importance of careful due diligence is to be kept in mind also this respect, as the willingness of insurers to cover ESG-specific risks by way of a W&I policy depends not only on the amount of the premium but also on the question of whether the buyer has conducted appropriate ESG-related due diligence. From the seller’s perspective, a structured sales process can thus be further improved, and the implementation of the transaction can be accelerated, by the conduct of a vendor due diligence and ‘stapled insurance’.

Summary

ESG has come to play a significant role in M&A transactions already. With the implementation of the CSRD and the CSDDD this development will continue, as the consideration of ESG criteria will become a direct component of a company’s individual corporate strategy. In the interests of forward-looking corporate planning, the board of directors and management should therefore not just wait and see, but determine already at an early stage whether an M&A strategy on the buyer and/or seller side can contribute to the successful development and implementation of their corporate sustainability strategy. 

When carrying out M&A transactions, the scope and depth of the due diligence needs to be tailored to the individual case taking into account the increasing importance of ESG in order to protect the buyer from loss after completion of the transaction. Linking the various due diligence workstreams is particularly important in terms of efficiency and effectiveness. The ESG risk profile identified during due diligence must be discussed with the seller and adequately addressed in the SPA.
The seller, on its part, should obtain a sufficient overview of the target company’s ESG risk profile in order to be able to appropriately reduce any liability risks that may be incurred by it in connection with the transaction.