In May this year buyout giant KKR announced a partnership with non-profit organisation the Environmental Defense Fund to help the private equity house improve the environmental performance of its portfolio companies. As part of the deal KKR committed to raising the energy efficiency of its own offices and having an environmental audit.
The move signals how much environmental issues have moved up the agenda for business, including private equity (PE). This growing awareness is linked to commercial drivers, such as the increasing importance of environmental issues to brands and to growing regulation on disposal of products and other ecological issues.
Tim Clare, technical director at WSP Environmental, says that he does not necessarily expect other PE firms to imitate KKR and embark on a measurement of portfolio companies’ carbon footprint. But he does more firms to look at the wider sustainability performance of their assets, “if their bottom lines are in danger of being impacted by ever-rising energy, water and other commodity prices and if those businesses are likely to find themselves at commercial disadvantage by not having a positive sustainability strategy to promote to their customers.”
He adds: “There is no getting away now from the fact that energy prices in particular have changed the economic arguments for making environmental improvements and that in certain sectors of the economy, particularly those selling to educated consumers, green issues are now a mainstream element of purchasing decisions.”
David George, director of transaction services in Europe at consultants URS, says that in the past year the firm has been building in sustainability and energy issues into assessments. For example, there is more examination of the energy performance of property. “The environmental performance of a company’s underlying assets is becoming a more important issue,” he says.
Green red tape
Environmental due diligence has traditionally been focused on looking for liabilities that could impact on capital costs, such as remediating a site, removing asbestos or building a new wastewater treatment plant, says Clare. But today the process is evolving in the face of issues related to climate change. For example, much of the European legislation affecting companies is related to environmental concerns. These include the REACH directive on hazardous chemicals and the WEEE directive, which makes producers and importers of electronic goods responsible for recycling their products.
The REACH (Regulation, Evaluation and Authorisation of Chemicals) directive is an EU-wide reform of how chemicals are used. It extends the rigorous testing that has been required for chemicals brought in since 1981 to those in use before then, a number estimated at 30,000. The responsibility for providing information and taking risk management measures will be with manufacturers or importers.
The WEEE (Waste Electrical and Electronic Equipment) directive aims to reduce the amount of electronic waste, such as computers, televisions and communications equipment, which ends up in landfill sites. It requires EU countries to collect and recycle four kilograms of such waste for each inhabitant. Producers, importers and sellers of electrical and electronic equipment must have systems that enable customers to recycle their products free of charge.
There is also the RoHS directive, which stands for “the restriction of the use of certain hazardous substances in electrical and electronic equipment”. This law bans the sale in the EU of new electrical and electronic equipment that has more than agreed levels of lead, cadmium, mercury and other substances.
Such directives impact on the operational costs of a target company, not just the capex, says Clare: “In the past we’ve produced long spreadsheets listing issues that could affect capex but now we’re looking at long-term operational costs and those could have a real effect on the business plan.”
The WEEE directive is symptomatic of a tranche of legislation from Europe requiring the producer to be responsible for managing waste, says Clare: “It means additional R&D costs in terms of the design of products and perhaps reducing the amount of material in the product that needs to be recycled. It also means setting up a recycling scheme yourself or, as is more likely, using a third party waste management company to run the scheme, which is what happens in the waste paper industry.”
On REACH he says that the long-term aim of the directive is to encourage a reduction in use of the more hazardous chemicals: “The crucial issue is that there will be costs involved for companies producing chemicals, in terms of the registration process. There is also an issue for manufacturers of products that use those chemicals, which means anyone considering buying a manufacturer that depends on such chemicals should make sure the supply chain is robust.”
In some cases WSP is also beginning to give advice on the implications of climate change for a company’s business plan, says Clare. “This is an area where everyone is still trying to find their feet, but areas include how companies are reacting to climate change in terms of their brand.”
The brand issue is, arguably, part of what fuelled the KKR link up with Environmental Defense Fund. It also meshes with other large corporates, who have also begun to display their environmental awareness. Coca Cola, for example, linked up with World Wildlife Fund on a global water quality scheme.
Paul Davies, a partner specialising in environmental issues at law firm Macfarlanes, says: “EDD is not just about direct liabilities any more but also indirect, so if you’re thinking of buying a business is there going to be a negative PR value from something that business has done in relation to corporate social responsibility?”
Commitments by national governments to reduce carbon emissions will start to hit sectors other than those normally seen as the main polluters, believes Davies. For example, the UK is committed to cutting emission by 60% by 2050. Its carbon reduction commitment (CRC) is due to begin in 2010 and will target non-energy intensive sectors, such as retailing. It will involve a mandatory emissions trading scheme affecting some 5,000 public and private sector organisations.
“Part of the job of EDD is to analyse these issues and highlight the most important ones so that clients are not surprised by the introduction of new legislation but are prepared for it,” says Davies.
Clare says that the changing attitude of regulators and law makers to environmental issues is affecting EDD: “We don’t just look at companies’ industrial sites any more but seek to look at the company as a whole and its carbon emissions. This has mainly been about heavy industry in the past but in the long term is likely to affect whole other sectors of the economy, such as hotels and airlines. These businesses will probably have to measure their carbon emissions and pay to offset them if they exceed their target.”
Nicky Eury, a due diligence principal at consultants ENVIRON, says that the scope of EDD has been adapting quite rapidly in recent year to reflect changes in EU regulation. It is also more focused issues such as energy and fuel costs, which are becoming a key driver on operating costs. “Land contamination liabilities and so on are still important but now there’s much more to consider,” she says.
One new issue that she expects to impact on businesses is the environmental liability directive. This represents a tougher approach to businesses that pollute and covers not only damage to water and land but also to protected species and their natural habitats. It gives the authorities greater recourse to cost recovery, making the polluter pay for the cleanup and requires that any action returns the area to its original condition. “The directive has not fully come in yet, but we’re telling clients when they do due diligence that they should identify sites that are particularly sensitive, such as those near ecological land,” says Eury: “They need to know that if they have an accident or an incident that leads to pollution the liabilities will be much higher.”
One of the first companies that could be affected by the directive is oil business Total, which was responsible for an oil spill on France’s Loire river in March 2008. The application of the directive is a grey area, as France is one of a dozen countries that have so far not implemented the directive even though the deadline was supposed to be April 2007.
EDD consultants, insurers and others are waiting to see how claims under the directive will be brought and whether Total will become an early test case of the legislation.
Climate change issues affecting EDD are not just linked to EU directives or brand profile. There are also the physical effects of climate change that may impact on the performance of target companies. WSP’s Tim Clare cites examples such as a company with a subsidiary in the developing world dependent on the local river for transporting products. “Will that river still be usable in the long term?” he asks.
Julien Famy, a partner at consultants ERM who leads the M&A team for Europe, says: “We’re trying to get clients to look at climate change and the effect on their business, such as rising water levels in some parts of Europe, as well as the increasing cost of carbon credits and higher oil prices.”
But Famy acknowledges that EDD that covers climate change issues is still relatively uncommon. “The standard scope for EDD is to look at the regulatory requirements and whether there are any investments to be made at the site to comply with current and future regulations and whether there are soil and groundwater liabilities. A lot of clients and banks are happy to stick with that and aren’t interested in being more proactive.”
He adds that this attitude is short sighted, but understandable given the four-to-five year investment horizon of most PE houses. “What happens after that, they don’t see as their priority,” says Famy. Nevertheless, ERM is trying to increase the scope of its EDD to cover issues such as energy efficiency, particularly in real estate transactions. But many clients are just interested in securing the investment and therefore will commission the minimum EDD that will help them achieve that, he says.
In the current business climate many would-be acquirers are happy to opt for the minimum. Paul Davies of Macfarlanes says: “There are some who say you should do less EDD in the current climate, but I’d argue that it’s even more important to understand the potential liabilities in a tougher business climate.”
According to Julien Famy, acquirers do not want bad surprises in today’s economic climate and so would prefer the EDD to cover the minimum. On the other hand, he says, the lending banks have more influence and are often requiring some kind of EDD to be carried out, while in the past financial buyers could have got away without it.
There is also the fact that, increasingly, vendor due diligence is the norm. This means, says URS’s David George, that on the buy-site there is generally less of a requirement to do a phase 2 assessment, in which samples of soil or groundwater are taken from a site and analysed. “In the old days we’d go out and look at sites but today people are more prepared to take a view on the vendor due diligence report so we will often go through the report with the management teams and identify key issues.” He adds that the period allotted to EDD on the buyer side has become shorter.
But in the long run it seems likely that the scope of some EDD assessments will become broader, to include issues such as energy efficiency or sourcing or risks to the company’s brand of poor environmental management.
Clare SP believes that environmental awareness will become an increasingly important indicator of how clued-up senior managers are in other areas. “An interesting question is whether the management team of a particular company have considered carbon and climate change issues and the level of risk they might pose for the business,” says Clare: “Those that have not thought about it might be seen as relatively naïve, whereas those that have considered it are likely to be more proactive because there’s no doubt that these issues are having a greater potential impact on the brand.”