Climate change and M&A impact
For most of human history, our activities have not affected Earth’s environment and geology; however, for the last century our economic actions, with their long-lived and durable effects, have shaped ecosystems. Past geological periods were named after the fossilised material in the deposited rock strata but the current period of Earth’s geological time has been informally dubbed the anthropocene since it is the first time that these processes are subject to human influence. This age is characterised by animal extinctions, habitat loss, chemical changes to oceans and soil and, in particular, climate change.
Although non-toxic and a natural product of respiration, carbon dioxide (CO2) is a gas that plays the biggest role in the heat balance of our planet. Like a blanket, CO2 prevents some of the Sun’s rays from escaping back into space; without it the world would be colder1, but too much CO2 and our world heats up due this greenhouse effect. Modern economies require energy and, over the last century, power has been provided through the burning of fossil fuels like coal, oil and gas; all non-renewable resources. In the past the focus was on their potential scarcity, however during past energy crises, at least one leader noted that this era would not end due to a lack of oil, but due to changes in technology.2 The “scarce resource” is the atmosphere’s ability to take up emissions without increasing the temperature of our ecosystem.
Carbon dioxide is measured in the atmosphere as “parts per million”(or ppm), where the current number near 400 ppm represents only 0.4% (= 400/1,000,000) of all air particles. Since human industry started and increased to scale a century ago, the ppm levels of CO2 have risen from about 300 to about 410 ppm. Although the level is small, the increased concentration of greenhouse gas has been enough to lift global temperatures by about 1 degree Celsius (almost 2 degrees) over the period.
Industry continues to burn fossil fuels; each year global emissions are about 35 billion tonnes of carbon dioxide and this increases the stock of CO2 in the air by about 3 ppm each year. This in turn increases the global temperature by about 0.03 degrees Celsius per annum. To limit temperature rises, the fossil fuel age must end soon and long before reserves run out, with remaining stocks becoming stranded and unburnable due to the atmospheric increase in CO2.
Who speaks for the global society?
These 17 UN Sustainability Goals are the culmination of a process that aims to determine what is acceptable within communities globally. Businesses are encouraged to follow these, particularly if they expect support within that society. Items 7 (clean energy), 12 (responsible consumption and production) and 13 (climate action) talk directly about a company’s actions in this area. Those firms wishing to maintain a social license to operate3 must articulate to their stakeholders how their aims are compatible with the UN SDGs.
However, the burning process cannot just be switched off in a few years. Just as the assets that we wish to replace took time and effort to source, renewable energy sources have taken time to research and develop and are still not fully mature. Considerable government subsidies were applied to solar and wind generation in the past, however these industries are now getting to scale and achieving cost parity or even superiority over fossil fuels. These forms of generation are renewable and sustainable because they deplete resources less than fossil fuels, most importantly they do not use the atmosphere’s limited capability to carry greenhouse gases.
To get renewables to this scale took investment, and it will take further outlays before these technologies become dominant. Fossil fuel energy is such a large part of our current economy that replacing it will take considerable time. The larger a project, typically the longer the horizon required to pay it back, and past investment was made in oil and gas before it was known if its assets would become stranded. These factors increase the resistance to writing fossil assets off, however there is the need to now plan for their obsolescence before they are depleted.
Within a series of Conference of Parties (COPs), Governments have announced their commitments to eliminating emissions within their economies, through committing to so-called“net zero emissions” carbon policies: India by 2070, China 2060 and EU+US 2050. Additionally, some stock exchanges are aiming for low-carbon status, and pension funds are declaring dates at which they aim to be net zero, many earlier than their governments.
Therefore, one focus of climate action has moved to investment, and the world of finance is a new front line in the green battle. Although financial investors seek high returns, and the shorter the term the better, the type and longevity of projects they choose have effects on both the economy and the environment over long horizons. Now that investors are seeing good returns from renewables and faster payback periods, they are starting to scale up their investments.
But is the financial system a help or a hindrance?
Participants in the financial system have regulated risk formally and informally for decades by the mutual monitoring of lending and other metrics. Those individual banks who put the financial system further at risk were either regulated or excluded from the system typically following a process managed by the central bank. Often this has been viewed as an insular and self-serving club run by technocrats. However, it was one of their own, Mark Carney, who articulated the risks of climate change not just in simple terms of temperature and ecosystem degradation but in terms of financial risk4. To most in finance, risk means variability of future return, but he made the case that the system itself, i.e. financial stability, depended on maintaining steady ecosystems and environments, both physical and monetary. He chaired the Financial Stability Board whose members created the Task Force on Climate-Related Financial Disclosures, TCFD. This system aims to measure and track emissions firm by firm.
Emissions monitoring
New metrics are now being used to see who is putting the system and the planet at risk with their irresponsible consumption. As well as threatening the Earth directly, emissions are also a threat to economic and financial systems. Just as with traditional lending risk, TCFD reporting is designed to appeal to each banker’s self interest in risk management as well as society’s. The analogy with bank monitoring before formal central bank regulation was when financial players would look at each other suspiciously if any one took too much risk, particularly if it threatened to become systemic. Therefore, the introversion of the financial system itself, often viewed as part of the problem, has now been partly harnessed with banks contributing to the solution through their new and additional reporting procedures. As part of the Financial Stability Board’s TCFD, carbon dioxide emissions are now measured firm by firm and throughout the supply chain:
• Scope 1 emissions are those from operations owned or controlled by a firm directly.
• Scope 2 emissions are those purchased or acquired (e.g. energy) and consumed by a firm indirectly.
• Scope 3 are all other emissions caused by a company’s product up and down the value/supply chain; these are also indirect.
Whilst such methods represent progress, they are not always mutually exclusive; these measures of emissions are not the way a scientist would tackle measurement and attribution, but they do allow businesses to follow a pattern. However imperfect they are, businesses now articulate their contributions to societal risk from emissions. Moreover, financial institutions have always had a stake in each other’s risk - taking, so TCFD taps into a banker’s ability to measure and monitor the risk their clients are contributing to a lending portfolio as well as that of the financial system.
What is the role of stock exchanges?
The US has probably the most dynamic, yet resilient, stock market in the world (it has been described as “antifragile”). Despite several major crashes, it has survived and flourished, producing some of the highest average and unbroken series of returns globally. This is despite its composition changing dramatically over two centuries.
Two centuries ago, the railroad sector dominated stock investment; later came quoted and stock exchange listed banks, followed now by a wide diversity of industrial forms. Currently it is the fossil fuel and traditional energy sectors which are under scrutiny, but new sectors of wind and solar are already emerging, and these sectors will both decarbonise the economy and make it resilient to economic and social change.
Is it bad that some areas of value are being destroyed? Why does capitalism allow this?
Schumpeter called the essential process of renewal within capitalism “creative destruction” and noted that every capitalist and financier needed to pay attention to its consequences; first because they cannot become successful without dismantling another’s product range, secondly because once successful, others will threaten them in the same manner (it’s a jungle out there!). The green revolution is being felt in finance for two reinforcing reasons. Firstly, as the FSB foresaw, financial market participants recognise a self-interest in maintaining a system that is robust to and limits climate change with participants not increasing its risk, and secondly because considerable consumer demand, through product services and investment preferences, are driving business and investment green.
Keynes described the stock market game as guessing “which investment you and others think most beautiful”; he even extended this to “anticipating what average opinion expects the average opinion to be”, etc. With the modern combination of factors coming into play, he might now say:
“It is not a case of choosing those [firms] that, to the best of one‘s judgment, are really the greenest, nor even those that average opinion genuinely thinks greenest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.‘‘
(Keynes, General Theory of Employment, Interest and Money, 1936)
The market is seeking “what you and other investors think is green”. This may seem a cynical view but is probably to be expected within a financial system that is decentralised and comprised of individually profit seeking players, who maintain and embrace opposing views. Remember that the buyer and seller of stocks, green investments included, disagree on the future price direction of that stock. Maybe the only thing they agree on is the idea that these stocks should be traded actively and scrutinised in the first place. Thus, we should view the inclusion of green investments and criteria as a big success.
Of course, there are still those who think that the financial system cannot change or has only partially engaged with the green movement. Many will remain skeptical, but financial markets have embraced the green movement, either because of self-interest, or consumer pressure or both. It may not matter which motivation dominates so long as emissions fall.
What about my pension portfolio?
Financial markets are very attractive because they offer investors the chance to combine assets in ways of their own design. Now that emission reporting is becoming standard, many investors who either think that fossil fuels will disappear or should disappear want to divest now or decrease their allocation over time. The ability of many investors to hold widely different allocations of the same assets is one of the strengths of the financial system; not only does it allow wide diversification so that any one firm’s risk is spread very thinly, it also allows individuals to tailor their risk allocations to their appetite. Now that it has become recognised that the composition of what we invest and trade is at the heart of the problem, investor allocations and holdings are being discussed and scrutinised as never before.
At one level, portfolio construction can be thought of as like mixing colours. A portfolio which is half in a riskless asset and half in a risky asset, has attributes between the two classes. Thinking about adding up beams of light (not subtracting light in the way that pigments do in paint), red/brown light plus green light gives you yellow light. Further addition of blue light would make the overall white (one-third each; red, blue and green).
This mixing process is possible for stocks too, e.g. with half your fund in high or low dividends, or half in high or low systematic risk (stock market beta). Whilst investors can buy or sell small fractions of their investments, they will adapt the characteristics of their stock portfolio in many different ways. Now that investors monitor the carbon intensity of their holdings, if they collectively care about and scrutinise these factors, carbon metrics will be used for inclusion/exclusion decisions. We are already seeing such trades and adjustments affect stock prices for green (solar, wind) and brown (fossil fuel) investments.
However, the financial sector has not always aggregated risk factors well. The 2008 great financial crisis was partially attributable to over-lending and under-reporting of risk in the property sector. Additionally, some financial investments were repackaged and rebranded as lower risk through inappropriate formation of financial securities; factors which caused a crash sell off once they eventually came to light. Therefore, it is important not to repeat these errors in the current context of climate monitoring. The reporting system is focussing in on firms‘ Environmental, Social and Governance metrics, ESG, and how firms perform across the different pillars that support their activities.5
Within finance, some are tracking the component dimensions within ESG scores to see how a company is affecting the environment whilst others are tracking how sensitive a firm is to the physical environment. This means that the metrics will be contested and will differ if used in one direction or the other (a firm might make itself resilient to climate change but still emit a lot or another firm might be vulnerable to climate change even whilst not contributing to it with its own emissions). Either way the debate has moved to discussing and using metrics which are becoming part of the tools used in all financial discussions.
So how do these arguments affect M&A?
Firstly, about half of global business occurs in private and non-listed firms, either because they are smaller and not able to attain a listing or because as family-owned, they have no desire to become publicly listed. This means that many of the arguments above could bypass private and small firms. It is true that these firms often need debt or even trade financing from banks, but the bank monitoring and lending process may be weaker in the TCFD dimension for these firms than for larger listed firms.
However, these firms need M&A services, and a wide range of specialist or boutique firms cater to the need of private and family companies to find new growth and acquisition targets or divestitures as part of their strategic plan. Given that strategies will be increasingly driven by ESG motives and metrics, the M&A search, target, due diligence and execution processes can play a valuable part in sharpening the ESG outcomes in an economy.
Secondly, not all firms and sectors are currently using the “best in class” tools to mitigate emissions and climate damage because this has not been a priority in the past. Many opportunities will arise for firms to specialise in cleaning up brown businesses, meaning that M&A agents can broker deals between existing non-specialist and new emerging specialist environmental firms. Whereas there was no monetary incentive to do this in the past, now if the aggregate TCFD emissions across the acquirer plus divestor decrease as a result of the transfer, there are ESG reasons as well as monetary reasons to motivate a deal.
However, as a caveat, if the overall emission metrics do not change because of the deal, then this activity is just window dressing or “greenwashing” where an attempt is made to cover the brown with the green. However, now in financial portfolios, if Scopes 1-3 are measured properly it will be shown that green plus brown cannot remain green unless emissions actually reduce. If correctly measured and reported, the reality will come out in the TCFD figures that investors can see and base their buy and sell trades upon.
So my question to M&A practitioners is this:
How can climate factors be incorporated into M&A practice?
Banks have started to internalise the risks to their system through the use of the metrics described. As well as rewarding M&A deal flow through measures of deal size such as total USD acquisitions managed, why not incorporate prospective TCFD changes into deal analysis? In addition to tracking asset transfers before and after, each deal sheet could show likely emissions pre and post deal.
This would allow industry awards to M&A firms based on total TCFD emissions reduced. Not just deal of the year by sector, but by emissions reductions. Having a firm sell a highly emitting subsidiary to a rival that can operate similarly but with lower emissions can create Net Present Value through cost reduction. However, even if it is neutral in this monetary dimension, if it lowers emissions in the process, it will make both firms more attractive to carbon-aware investors in aggregate. Imagine a league table for M&A firms that decrease the most emissions, that would really show how the M&A process can help mitigate climate change!
Also, tracking “best in class” metrics based on emissions will clearly show the potential buyers and sellers of brown businesses and will also provide strong incentives for firms to sharpen their thinking in these dimensions. This is to say that M&A advice and competitive pressure can drive ESG into the domain of strategic target selection. It will become a source of competitive advantage and one that others will seek to acquire or emulate.
Finally, it is important to find ways to prevent deals being done for purely cosmetic reasons; the M&A process is intense and intimate, but if a culture of respect for climate action develops, its scrutiny can act as a positive force.
Finally, time is not on our side, the Keeling curve of CO2 ppm levels in the atmosphere continues to rise. It will be years before the actions described give results that can be seen in the global record. However, when that does occur, individuals will feel like their labour has been rewarded and will redouble their effort. Good luck with endeavours in these regards!
1 The atmosphere of Mars is thin and has much too little CO2 so is freezing at -60 degrees C. 2 “The Stone Age didn’t end for lack of stone, and the oil age will end long before the world runs out of oil.” These words have been credited to Ahmed Zaki Yamani, who was the Minister of Oil for Saudi Arabia for more than twenty years. 3 Human trafficking and (modern) slavery are widely considered illegal: whilst still existing, they have not enjoyed social support in almost all economies for a century or more. 4 https://www.un.org/en/climatechange/mark-carney-investing-net-zero-climate-solutions-creates-value-and-rewards 5 https://www.investopedia.com/articles/investing/100515/three-pillars-corporate-sustainability.asp
