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

The EU Commission has set the tone: As part of the European Green Deal, net greenhouse gas emissions are to be cut by at least 55% by 2030 (compared to 1990 levels). Similar actions of the European, as well as national, legislators can be seen when it comes to the “S” and the “G” of ESG. It is clear that achieving the European Green Deal may not be accomplished by government measures at the EU or the EU Member State level alone but will also require a major transition and adaptation of the business models of many enterprises doing business in the EU. 

In 2024, preparing for compliance with the reporting requirements of the Corporate Sustainability Reporting Directive (CSRD), as well as understanding the requirements of the Corporate Sustainability Due Diligence Directive (CSDDD) (on which a provisional deal was reached by the Council and the European Parliament in December 2023), will be high on the agenda for large enterprises doing business in the EU. Against this backdrop, meeting mandatory ESG criteria is increasingly considered to be not only part of a company’s compliance and good governance, but also an integral part of its corporate strategy.  This is also driving increased M&A activity.

Corporate Strategy

Large publicly-listed companies based in the EU were among the first to set up sustainability departments, collecting the relevant data and preparing for the audit and subsequent reporting of such data in their annual reports for the financial year 2024. In accordance with the CSRD thresholds and timeline for gradual implementation, many other companies will follow in the coming years. The proper implementation of the CSRD requirements has to be based on an in-depth analysis (outside-in and inside-out) of a number of core aspects of a company, including its business model and corporate strategy (with a particular focus on reducing net greenhouse gas emissions and reaching the 1.5 degree objective) and its:

• sustainability strategy in general;
• specific sustainability goals, as well as the progress made towards achieving those goals; and
• resilience towards climate risks.

These aspects affect most companies at a fundamental level and therefore, the results of such analysis need to be discussed and approved at the executive board level. 

In December 2023, the Council and the European Parliament reached a provisional deal on the CSDDD. Whilst there is still some uncertainty around the details of the CSDDD requirements, the expected coming into force of the CSDDD will further increase the relevance of ESG criteria to be considered when conducting an environmental and human rights due diligence process to determine the required adaptation of the corporate strategy (upstream/downstream business activities and partners, climate change transition plan, etc.). 

ESG as Deal Driver

As a consequence of the growing relevance of ESG criteria, we have seen a tendency for companies to use M&A to achieve quick wins when executing a sustainability strategy and expect this trend to accelerate in 2024. Once the potential of an ESG-focused M&A strategy has been identified, a proactive management board may take the appropriate measures to execute such a strategy sooner rather than later. On the sell-side, there is a particular focus on reducing the ESG risk profile with the divestment of any potentially stranded assets (provided there are opportunistic buyers) as well as strengthening the company’s governance with the strategic withdrawal from geographic markets that might not ensure due compliance with the upcoming CSDDD requirements (at a reasonable cost). On the buy-side, on the other hand, the goal is to quickly establish and further expand a sustainable business model. 

Relevance of ESG when executing the deal

We see a clear trend of ESG criteria becoming increasingly important in the context of negotiating and executing M&A transactions. This is evident in the strategic and commercial rationale for deals, as well as in the more risk-focused legal and commercial deal terms. Most forms of customary acquisition finance instruments have already reflected ESG criteria for some time (e.g. Green Bonds, ESG-linked loans, etc.), thereby having a direct impact on the business rationale of the deal.

From a risk perspective and in light of the EU legislator’s tendency to link pecuniary fines to a perpetrator’s group turnover, compliance with (constantly increasing) ESG requirements has become a key part of the buyer’s due diligence and often results in specific ESG due diligence exercises being conducted. In order to minimise the risk of severe financial, as well as reputational, damage a detailed review of any greenwashing risks at the level of the target also needs to be conducted. As is the case with all material risks, the identification of the target’s specific ESG risk profile is key to the proper allocation of such risks in the sale and purchase agreement (through representations & warranties, indemnities, W&I insurance, etc.) and helps to facilitate seamless post-merger integration within the buyer’s existing ESG regulatory framework.

What next?

In many ways ESG criteria is playing a more and more important role in many European M&A transactions. Due to the growing significance of ESG criteria for the determination and execution of the corporate strategy of a company, this trend is set to continue and may even further increase in the coming years. It will thus be crucial for boards and management to be actively engaged at an early stage in meaningful discussions about the impact of ESG-related legislation on the corporate strategy, as well as the question of if and how sell-side and/or buy-side M&A measures can contribute to the successful execution of the ESG aspects of such a strategy.