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By: Annemargaret Connolly and Thomas Goslin, Weil Gotshal & Manges LLP
CLIMATE CHANGE IS ARGUABLY THE MOST HIGH-PROFILE and rapidly evolving environmental issue facing the global business community today. Governments of nearly every nation have acknowledged the risks posed by a warming climate and taken some action either to combat those risks, to mitigate the physical effects of climate change, or both. In addition, many corporations have publicly announced efforts to reduce emissions of greenhouse gasses (GHGs) associated with their operations and to otherwise take steps to combat climate change. Companies involved in certain mergers and acquisitions need to be aware of the risks related to climate change that may arise in the transactional context. While not every deal will involve climate change-related diligence, more and more industries are becoming subject to regulations and legal actions aimed at combatting climate change. Others have found that a changing climate may present direct risks to property and supply chains. In addition, many companies have taken to marketing themselves as climate-friendly organizations in an effort to attract businesses and investment, therefore creating a risk that failure to live up to those claims may prove off-putting to customers and investors and possibly result in legal liability. In order to properly assess and value corporate assets in M&A transactions, buyers and sellers of regulated assets need to understand the potential impact of climate change on business and successfully anticipate developments in this rapidly evolving area of law and policy.
There is no set formula for assessing climate risk in the transactional context. Due diligence will need to be tailored to the target and will vary substantially depending on the industry and the location of the target’s operations. That said, risks associated with climate change generally fall into one of four categories: physical risks, customer and investor considerations, compliance risks, and litigation risks, each of which is discussed in more detail below. Given the potential enormity of the issues presented by climate change, and the wideranging efforts taken in response, climate change diligence is no longer limited to deals involving power plants and heavy industry. At a minimum, parties in nearly every M&A transaction should conduct a preliminary assessment to determine whether any or all of these categories of risk are present with respect to a target.
While perhaps the most difficult to assess, climate change’s most obvious risks relate to disruptions to a company’s business or damage to a company’s assets (e.g., facilities, infrastructure, land, or resources) due to physical impacts, such as rising sea levels, more extreme storms, floods, fires, and drought. The 2017 hurricane season and the forest fires that blazed across the western United States serve as a reminder of the devastation that can be caused by natural disasters, the prevalence and intensity of which some are attributing to climate change. Although it can be argued that virtually every sector of the U.S. economy faces risks for the short- and long-term physical effects of climate change, it appears likely that certain sectors will be disproportionately impacted. For example, the agriculture sector faces greater risks associated with water scarcity and droughts, as well as increased exposure to new pests and diseases.
Likewise, due to climate change, the tourism industry is vulnerable to increased weather extremes, rising temperatures, coastal erosion, droughts, and changes in precipitation patterns and snow reliability. The insurance industry, perhaps more than any other, faces increased risks from virtually all physical impacts of climate change. At meetings at the United Nations in 2015, top insurers called on governments to step up global efforts to build resilience against natural disasters exacerbated by climate change and highlighted that average economic losses from disasters in the last decade amounted to around $190 billion annually, while average insured losses were about $60 billion.
Assessing the physical risks posed by climate change can be extraordinarily difficult, given the randomness of natural disasters and the vicissitudes in weather. Droughts, hurricanes, floods, and fires are nearly impossible to predict with any certainty. That said, it is becoming easier in certain circumstances to observe trends, particularly with respect to rising sea levels. For example, a recent study by the University of Miami found that Miami Beach flooding events have increased significantly over the last decade due to an acceleration of sea-level rise in South Florida. Thus, should a target company hold significant assets in South Florida, or in any other coastal area experiencing increased flooding, a potential buyer would be wise to assess what impacts such flooding could have on the target’s operations and assets. Likewise, tourism-based assets such as ski or beach resorts may have a limited carbon footprint yet face substantial physical risks due to warmer long-term temperatures or rising sea levels. A recent study by the European Geosciences Union found that European ski resorts may lose up to 70% of their snow cover by 2100 due to climate change.
In addition, there may be significant physical risks associated with a target’s supply chain potentially affecting the target’s ability to reliably produce its products and deliver services. For example, at first glance, a clothing manufacturer targeted in an acquisition may seem unlikely to be subject to material risks associated with climate change. However, if the clothing manufacturer sources its products from a low-lying area like Bangladesh, an essential source for many clothing retailers globally, risks associated with climate may be far greater than originally anticipated, as Bangladesh is frequently cited as a country most likely to be impacted by the anticipated sea-level rise associated with climate change. While supply chain due diligence is now a common element of any M&A transaction, it is becoming increasingly important to assess how climate change could impact a target’s suppliers as well as raw materials used in the target’s operations.
Carbon-intensive businesses, such as oil and gas exploration and production, electric utilities, and chemical manufacturers, also face risks related to a growing cadre of institutional and other investors who have pledged to reduce or eliminate the carbon-intensity of their investments and portfolios. Known as fossil fuel divestment or portfolio decarbonization, these socially motivated campaigns seek to achieve reductions in GHG emissions by shifting investment capital from particularly carbon-intensive companies, projects, and technologies in each sector and by reinvesting that capital into carbon-efficient companies, projects, and technologies of the same sector. If a sufficient number of institutional investors start to engage and/or reallocate capital on the basis of companies’ GHG emissions, it can provide a strong incentive for those companies to rechannel their own investments from carbon-intensive to lowcarbon activities, assets, and technologies. According to an October 2013 University of Oxford study, the divestment campaign to persuade investors to take their money out of the fossil fuel sector is growing faster than any previous divestment campaign and could cause significant damage to carbon-intensive companies. Although the direct financial impact on share prices related to such campaigns is likely to be small in the short term, the report concluded that the reputational damage, or stigmatization, can still have major financial consequences. In particular, significant reputational damage to carbon-intensive businesses could reduce the availability or increase the cost of debt, both short-term working capital and longdated securities.
In the wake of the agreement reached at the 2015 United Nations Framework Convention on Climate Change (UNFCCC) meeting in Paris, known widely as the Paris Agreement, there were 89 shareholder resolutions filed on climate change in 2016. Many institutional investors are now considering climate-related factors in their investment decisions. In fact, Blackrock, the world’s largest asset manager with $5.4 trillion in assets under management, has identified climate risk disclosure as one of five top engagement priorities.
In a similar vein, another concept potentially relevant to carbonintensive businesses is that of stranded assets, a financial term that describes corporate assets that become subject to unanticipated or premature write-downs, devaluations, or conversion to liabilities. With respect to climate change, the term has become more prevalent in recent years as economists and scientists study the potential ramifications of regulatory policies, technological advances, consumer behaviors, or other market actions that could dramatically decrease the use of fossil fuels. Investors are also beginning to take notice, expressing concern that action needed to curtail the increase in global temperatures ultimately will result in a regulatory mandate to leave proven reserves of fossil fuels in the ground or will otherwise make it uneconomical to produce or use fossil fuels. Certain institutional investors have gone on record to state that stranded asset-related concerns have led them to divest, while others are pressuring companies to disclose their strategies to deal with the potential for stranded assets.
When assessing carbon-intensive targets in an M&A transaction, it is important to understand how that target, and its industry, is perceived by investors and financial institutions. Coal companies, for example, may have a much more difficult time attracting investment given perceptions about the negative environmental attributes of the industry. This could result in depressed pricing for the target’s assets, and it could also make it more difficult to obtain debt financing, if needed. Certainly, financial investors should understand the risks of reputational damage to carbon-intensive businesses, and any trends in those risks, as such concerns may increase during the hold period and jeopardize a successful exit.
Despite a varied and rapidly shifting regulatory landscape on climate, parties to an M&A transaction should identify and assess compliance risks. Many jurisdictions have passed laws or promulgated rules and regulations aimed at combatting climate change. Some of these legal requirements may directly affect a target company, while others may have indirect effects on supply chains, the price of raw materials, or otherwise impact operating costs. Buyers and lenders in M&A deals, therefore, need to understand the current state of climate change regulation to determine whether a target’s business is directly or indirectly affected by such regulation. Given the rapid developments in climate change regulation, this is not always an easy task.
Federal Climate Change Regulation
The U.S. government’s effort to regulate climate change serves as a vivid example of the unsettled state of domestic climate change law. In 2007, the U.S. Supreme Court ruled in Massachusetts v. EPA, 549 U.S. 497 (2007), that GHGs must be regulated under the federal Clean Air Act, a law first passed in 1970 (long before climate change entered the lexicon), provided that the Environmental Protection Agency (EPA) issues a finding that GHGs endangered the public health and welfare, which EPA has since done. Around this time, Congress made several attempts to amend the Clean Air Act to impose restrictions on GHG emissions; however, these efforts never met with success. Frustrated with Congress’ inability to pass what it saw as important restrictions on GHG emissions, the Obama administration attempted to bypass Congress by promulgating several regulations under the existing Clean Air Act aimed at reducing GHG emissions from the power sector, the largest emitter of GHGs in the U.S. These rules, promulgated by the EPA, imposed standards on both new and existing power plants1. These rules were immediately challenged in court by plaintiffs who argued that the EPA overstepped its authority under the Clean Air Act, and many of these challenges remain pending. As such, it remains unclear to what extent the EPA can regulate GHGs, notwithstanding the Supreme Court’s finding that it must.
The state of federal climate change regulation was further disrupted by the 2016 election of Donald Trump to the presidency. Since taking office in January, President Trump has made it clear that his administration has no interest in taking any legislative or regulatory action to mitigate or adapt to the effects of climate change. Rather, he has suggested that climate change is a hoax and withdrew the United States from the Paris Agreement. In furtherance of these views, EPA Administrator Scott Pruitt (who led several of the legal challenges against the Obama administration climate change rules) issued a public notice that the EPA will repeal the rules imposing GHG emission standards on existing power plants. This action is certain to spur a new round of legal challenges, where plaintiffs will almost certainly argue that, given the Supreme Court’s ruling in Massachusetts v. EPA, the federal government is required to regulate GHG emissions. If the past is predictive, legal disputes over federal regulation of GHG emissions likely will remain unresolved well into the next presidency.
The unsettled state of federal law concerning climate change makes it very difficult to assess what impact, if any, federal regulation will have on a particular business operating in the United States. Certainly, those in the power generation industry remain subject to a shifting legal regime that could have profound impacts on their operations. For companies assessing potential M&A transactions with targets in the traditional or renewable energy industries, including any of their suppliers or major customers (which now include many Fortune 500 companies that have directly contracted for energy from solar and wind farms), assessing possible impacts from federal climate regulation will be key to any due diligence exercise.
State Regulation of Climate Change
In the absence of stable federal policy concerning climate change, many states have taken action to reduce GHG emissions or otherwise respond to climate change. For example, a block of nine states in the Northeast and Mid-Atlantic have joined together to establish a cap-and-trade program, known as the Regional Greenhouse Gas Initiative (RGGI), regulating GHG emissions from power plants located within the member states (as of the date of this writing, Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont). Under a cap-and-trade program, GHG emitters either are granted or must purchase credits equal to the amount of GHGs emitted over a certain period of time. The number of available credits is capped, ensuring that total GHGs emitted from all regulated sources do not exceed a preset amount, which often lowers over time. Under the RGGI program, for example, the cap is reduced by 2.5% each year until 2020. It is up to the source either to reduce emissions or obtain sufficient credits to match its emissions. In general, market forces set the price of a credit on an open market.
While RGGI is focused exclusively on the power generation sector, California (the world’s sixth-largest economy) has enacted, under the California Global Warming Solutions Act of 2006, 2006 Cal ALS 488, a more expansive cap-and-trade program that applies to utilities, large industrial facilities, and certain fuel distribution companies, regulating 85% of all of California’s GHG emissions. One interesting aspect of the California program is that it allows for what are known as offset credits, whereby businesses that voluntarily reduce GHG emissions can generate credits equal to their GHG reduction, which credits can then be sold to regulated entities to meet their compliance obligations under the cap-and-trade program. California recently renewed its commitment to its cap-and-trade law, extending the program until 2030 and requiring that it reduce GHG emissions by 40% below 1990 levels over the next 13 years.
In addition to cap-and-trade programs, a majority of states have taken action to promote the use of renewable energy technologies. Twenty-nine states and the District of Columbia currently have adopted binding renewable portfolio standards, which require that a certain percentage of the retail electricity power consumed or generated come from renewable energy sources, typically wind, geothermal, solar, hydro, landfill gas, or biomass (and nine additional states have renewable or alternate energy goals, which generally are not legally binding).
In short, many states have acted to fill the void left by the federal government in the area of climate change regulation. Parties to M&A transactions need to be aware of state-level requirements, both those on the books and those pending in the state legislatures and regulatory agencies. Much like the federal government, the status of climate change regulation at the state level remains in flux, though unlike at the federal level, the trend appears to be towards greater regulation. Depending on the state and the industry, the operating costs associated with these regulations could be substantial.
International Climate Change Regulation
Parties to M&A transactions that involve overseas operations also need to be aware that many foreign jurisdictions have enacted laws aimed at combatting climate change, and it is likely that many more will in the next decade. This is because 176 nations have ratified the Paris Agreement, which requires signatories to take steps to keep global temperature rise below 2 degrees Celsius above pre-industrial temperatures while pursuing efforts to limit it to 1.5 degrees Celsius. The Paris Agreement seeks to increase the ability of the global community to adapt to, and directs funds towards, low-emission and climate-resilient development. Paris Agreement parties generally are permitted to adopt whatever means they choose for achieving those goals, though countries are to submit plans to the UNFCCC by 2020 detailing those efforts, and are required to update those plans every five years.
Of course, the Paris Agreement is not the first international undertaking to combat climate change. Businesses operating in the European Union likely are familiar with its GHG cap-and-trade program, known as the EU Emissions Trading System (EU ETS), which is the world’s first international emissions trading system to address GHG emissions from companies and is by far the biggest carbon market today. It covers more than 11,000 power plants and manufacturing facilities in the 28 EU member states as well as Iceland, Liechtenstein, and Norway. In addition, airline operators flying within and between most of these countries are also regulated under the programs such that, in total, around 45% of total EU emissions are limited by the EU ETS.
China, the world’s largest emitter of GHGs, is also taking steps to combat climate change. A Paris Agreement signatory, China has committed to reducing GHG emissions by up to 45% from 2005 levels by 2020 and increasing renewable energy production so that it will meet 20% of national electricity needs by 2030. In addition, since 2011, China has implemented a number of cap-and-trade pilot programs in cities and provinces around the country, testing marketbased mechanisms for reducing GHG emissions.
Outside the United States, it is largely accepted that climate change poses a significant threat to human health, the environment, and many industries. Almost without exception, the trend internationally has been towards greater regulation, and given the commitments embodied in the Paris Agreement, there is little reason to believe this trend will not continue. Therefore, parties to M&A deals involving foreign operations will need to assess what steps the foreign jurisdiction is taking to combat climate change, and because there is no overarching international agreement as to what those steps should be, a country-by-country analysis will be required.
It also is increasingly important in M&A transactions to assess potential litigation risks arising out of climate change. Over the past few years, climate change litigation against private parties has arisen in numerous contexts, though the largest GHG emitters, particularly those in the oil and gas industry, appear to be the most likely targets.
Government Investigations into Climate-Related Disclosures
One litigation risk concerns government investigations into disclosure practices surrounding the existence or potential impacts of climate change. These investigations seek to determine whether disinformation campaign to create doubt about the existence of climate change and to undermine scientific findings regarding climate change. In November 2015, the New York Attorney General announced that a two-year investigation found that Peabody Energy Corporation, the largest publicly traded coal company in the world, had violated New York laws prohibiting false and misleading conduct in the company’s statements to the public and investors regarding financial risks associated with climate change and potential regulatory responses. As part of the agreement concluding the investigation, Peabody agreed to file revised shareholder disclosures with the U.S. Securities and Exchange Commission that are to “accurately and objectively represent these risks to investors and the public.” That same month, the New York Attorney General issued ExxonMobil a subpoena ordering the company to turn over four decades worth of research findings and communications into the causes and effects of climate change. Massachusetts and California have since commenced similar investigation into ExxonMobil’s conduct with respect to climate change disclosures. In addition, members of Congress have called on the Department of Justice to investigate whether Shell Oil deceived the public on climate change at the same time it was preparing its business operations for rising sea levels. The ultimate impact of such investigations into fossil fuel company conduct regarding climate change is unclear. To date, lawsuits generally have not been filed, and it is uncertain whether the investigations of the attorneys general will identify information that would allow a lawsuit to proceed against the companies under investigation. Nevertheless, governmental investigations can be costly, both in terms of legal fees and reputationally. As such, parties to M&A transactions involving energy companies and other large sources of GHGs should assess a target’s disclosures concerning climate change to determine whether they present any issues.
Large emitters of GHGs also face litigation risks associated with tort claims alleging various injuries related to climate change. Several cases have been brought in courts across the country alleging damages related to climate change under tort theories such as nuisance, trespass, and negligence. For example, in Conn. v. Am. Elec. Power Co., 406 F. Supp. 2d 265 (S.D.N.Y. 2005), eight states, the City of New York, and three environmental groups filed suit against five energy companies, alleging that the carbon dioxide emissions from the companies’ power plants contribute to the public nuisance of global warming. Plaintiffs asked the district court to cap carbon dioxide emissions and mandate annual emissions reductions. The court granted defendants’ motions to dismiss on the grounds that the case raised non-justiciable political questions; however, on appeal the U.S. Court of Appeals for the Second Circuit reversed the decision, holding that the plaintiffs had standing to bring their claims.2 The U.S. Supreme Court later reversed the Second Circuit, holding that the plaintiffs’ claims were preempted by the Clean Air Act, which the Court found delegated authority to regulate harms associated with GHG emissions to the EPA.3
Another example of climate change tort litigation can be found in the case of Comer v. Murphy Oil. In the district court case, Mississippi property owners had brought suit against numerous insurers, chemical companies, oil companies, and coal companies, alleging that the defendants’ carbon dioxide emissions contributed to global warming, which warmed the waters in the Gulf of Mexico and increased the frequency and severity of hurricanes, including Hurricane Katrina.4 Under theories of private nuisance, trespass, and negligence, the plaintiffs sought damages for loss of property, loss of income, cleanup expenses, loss of loved ones, and emotional distress. The suit was dismissed on standing and political question grounds and plaintiffs appealed to the U.S. Court of Appeals for the Fifth Circuit, which initially overturned the district court ruling for the same reasons cited by the Second Circuit in the Connecticut v. American Electric Power Co. case.5 However, after a protracted legal battle over procedural rules, the district court’s decision ultimately was allowed to stand.6
Although courts have held that climate-related tort litigation claims are preempted by the Clean Air Act, some are beginning to question whether the United States may soon experience a renewed round of climate-related tort litigation prompted, in part, by the Trump administration’s actions aimed at rolling back existing GHG regulations. In fact, in July of 2017, three local governments in California (San Mateo County, Marin County, and the City of Imperial Beach) each sued 20 fossil fuel companies, including Chevron, ExxonMobil, Peabody Energy, and Arch Coal, under various state common law tort theories alleging that each defendant is responsible for contributing to climate change, which has resulted in sea level rise and increased flooding that resulted in the local governments’ incurring damages. Whether these three cases are a sign of things to come remains to be seen, but it is noteworthy that the plaintiffs’ claims were brought under state common law, which is not preempted by the federal Clean Air Act.
To date, climate-related litigation has been limited largely to parties or projects involved in oil and gas and other major GHG-emitting industries. There also has been something of a recent lull in the number of climate-related cases filed in the courts; however, many attribute this to the fact that the Obama administration was seen as taking a proactive role in addressing climate change. Given the change in approach adopted by the Trump administration, it would not be surprising to see a surge in climate change litigation in the near future. As such, parties to M&A transactions involving major GHG emitters would be wise to assess the risk that the target may be named in such litigation.
Assessing climate change risks in M&A transactions can be difficult, at times subjective, and in many cases speculative. Any diligence exercise in this area must be tailored to the particular target, the location and operations of its assets, the nature of its supply chain, and the target’s own experience managing climate-related risk. There simply is no standard procedure for conducting this type of due diligence. That said, every climate change diligence exercise in an M&A transaction will require the parties to consider the totality of a target’s operations and anticipate infrequent occurrences that may present catastrophic risks.
When assessing companies that emit significant quantities of GHGs, the parties and their counsel must examine issues concerning the target’s current and future compliance obligations with climate change-related regulations. Some questions to ask in M&A due diligence include:
While it is perhaps obvious that climate change-related diligence of major GHG emitters is important, it is becoming clear that such diligence is just as important in M&A deals involving companies with little or no GHG emissions. These types of questions need to be asked regardless of whether the target operates in a carbonintensive industry:
Certainly not all of these risks will be present in every M&A deal; however, where they do materialize, they can be material to the transaction. As such, it is key for those involved in M&A deals to understand the risks and think creatively about how they can be assessed and, if possible, managed in the transactional context.
See the complete practice note in Lexis Practice Advisor at Corporate and M&A > Specialist Issues in M&A > Environmental > Practice Notes.
Annemargaret Connolly is a partner based in the Washington D.C. office of Weil, Gotshal & Manges LLP. She is the head of Weil’s Environmental practice, a leader of Weil’s Climate Change Practice Group, and a member of the firm’s hydraulic fracturing task force. She advises clients on a wide range of global environmental compliance and liability issues, most notably in the context of mergers & acquisitions, real estate transfers, financing transactions, and infrastructure projects. Thomas Goslin is counsel based in the Washington D.C. office of Weil, Gotshal & Manges LLP. He focuses on a wide range of environmental, energy, and other regulatory concerns in the context of mergers and acquisitions, private equity investments, financing transactions, infrastructure projects and corporate restructurings.
RESEARCH PATH: Corporate and M&A > Specialist Issues in M&A > Environmental > Practice Notes
For a general discussion on the environmental risks that arise in corporate transactions and defenses that may be obtained through due diligence, see
> ENVIRONMENTAL DUE DILIGENCE IN M&A TRANSACTIONS
For an explanation about the most important contractual provisions for allocating environmental liabilities in an M&A agreement, see
> ALLOCATING ENVIRONMENTAL RISKS IN THE TRANSACTION AGREEMENT
For information on environmental concerns that must be considered during and after closing an M&A transaction, see
> CLOSING AND POST-CLOSING ENVIRONMENTAL LAW CONSIDERATIONS
To explore the role that environmental insurance can play in M&A transactions by allowing the parties to transfer environmental risks to an insurer, see
> ENVIRONMENTAL INSURANCE AS M&A RISK MANAGEMENT TOOL
For a review of topics that counsel should consider in a due diligence investigation for an M&A transaction, see
> COMMON TOPICS OF REVIEW IN M&A DUE DILIGENCE
RESEARCH PATH: Corporate and M&A > Due Diligence > Due Diligence in M&A Deals > Practice Notes
For a checklist of considerations for the M&A practitioner when addressing environmental issues in a purchase or merger agreement, see
> ENVIRONMENTAL PROVISIONS IN ACQUISITION AGREEMENTS CHECKLIST
RESEARCH PATH: Corporate and M&A > Specialist Issues in M&A > Environmental > Checklists
For a list of the of the resources available on Lexis Practice Advisor relating to the M&A due diligence process, see
> DUE DILIGENCE RESOURCE KIT: SUMMARY CHART
For an overview of the due diligence process to be undertaken before the potential acquisition of a public company, see
> DUE DILIGENCE CHECKLIST (PUBLIC DEALS)
RESEARCH PATH: Corporate and M&A > Due Diligence > Due Diligence in M&A Deals > Checklists
1. 82 Fed. Reg. 48035 (October 16, 2017). 2. Conn. v. Am. Elec. Power Co., 582 F.3d 309 (2d Cir. 2009). 3. Am. Elec. Power Co. v. Conn., 564 U.S. 410 (2011). 4. Comer v. Nationwide Mut. Ins. Co., 2006 U.S. Dist. LEXIS 33123 (S.D. Miss. Feb. 23, 2006). 5. Comer v. Murphy Oil USA, 585 F.3d 855 (5th Cir. 2009). 6. Comer v. Murphy Oil USA, 718 F.3d 460 (5th Cir. 2013).