Sponsored briefing: Impact of ESG on M&As and financings and trends to watch

Economic decisions over the years have had major impacts on the scarce resources of the planet. Overconsumption and over-production brought the environment to a state of destruction and degradation. Consequently, all these alarming developments have led the academics, analysts, commentators, and scientists to work on the solutions to prevent a catastrophic future. As a result, sustainability has become one of the key considerations in decision-making processes.

Sustainability often consists of interdependencies that exist between environment, society, and economy. These three factors can be referred to as Triple Bottom Line and 3Ps as they may also be called as people, planet and profit. Under this Triple Bottom Line measuring system, unlike the traditional reporting framework, organisational performance is measured using environmental and social dimensions along with economic aspects. These are also important elements to measure the sustainability goals.

Another measurement and reporting concept is ESG. Under ESG, there are different aspects to each category (see boxes, below).

Another concept that is helpful to crystallise sustainability and ESGs are Sustainability Development Goals (SDGs). SDGs are a compilation of 17 interconnected global goals set by the UN to be achieved by 2030 at the latest.

These goals are formulated as an optimum plan to build a better future for people and our planet by 2030. The SDGs recognise that ending poverty must go hand in hand with strategies that build economic growth and address a range of social needs while tackling climate change and working to preserve our planet.

Stakeholder Demand and ESGs

ESG has increasingly become a matter of concern to all stakeholders. First of all, more institutional investors are beginning to recognise ESG factors as drivers of value because public interest and limited partner pressure to take ESG factors into account in investing have increased. Stakeholders require greater transparency on ESG policies and performance. Managers are increasingly attributing importance to ESG and are finding that these factors are positive in achieving strong performance. In the private markets, topics of ESG have now reached an inflection point, becoming increasingly crucial for a variety of stakeholders:

i. Consumers

McKinsey’s Gen Z and Millennial Survey reveals that 26% of Millennials and 31% of Gen Z (expected to possess about 60% or about $40trn of spending power by 2030) are willing to pay a premium for products that have the least negative impact on the environment, and 76% of consumers are willing to reject products or services for ethical reasons. A report by Bain suggests that the surveys point out the fact that consumers, especially Millennials and post-Millennials prefer companies that they believe act responsibly. A 2020 Capgemini survey globally found that 79% of buyers were changing their preferences based on sustainability. Bain’s report highlights that, at the same time, only 36% of organisations believed consumers were willing to make these changes. A full 77% said sustainability initiatives increased customer loyalty, and 63% have seen a revenue uptick.

ii Employees

As the talent and workforce shifts to the Millennial generation, ESG considerations gain importance as a factor in choosing employers. Surveys indicate more than half of employees consider the ESG responsibility of an employer in choosing where to work. A global HP survey in 2019 found that 61% believe sustainability is mandatory for companies and nearly 50% said they would only work for a company with sustainable business practices.

iii. Limited partners

By 2018, the largest investment funds allocated 33% of investments to companies in accordance with ESG criteria. The total of these investments amounted to $31trn. The issuance of sustainable debt instruments increased 53% between 2013 and 2020, with a record $732bn issued in 2020.

One reason ESG has become one of the top considerations for private equity firms around the world is that a growing number of limited partners are demanding it. According to the 2020 Edelman Trust Barometer Special Report: Institutional Investors, 88% of limited partners globally use ESG performance indicators in making investment decisions, and 87% said they invest in companies that have reduced their near-term return on capital so they can reallocate that money to ESG initiatives.

iv. Regulators and policy makers

Global ESG regulations and laws have grown by 90% since 2016, and in 2020 various frameworks and taxonomies were standardised. With EU regulation already pushing companies in this direction and comparable legislation widely expected in the US, it is broadly acknowledged that the regulatory environment is shifting, and private equity firms and investors are working quickly to adapt.

The EU Taxonomy, a landmark initiative aimed at channelling private capital into sustainable assets, will force asset managers in the EU to disclose their share of taxonomy-aligned assets under management, inevitably creating an incentive to raise that share to remain competitive.

v. Bankers.

A growing number of the financial institutions assume that sustainable companies are less risky. As a result, private equity firms are finding ways to monetise their ESG strategies by lowering their cost of capital. EQT, for instance, launched two ESG-linked subscription credit facilities in 2020 worth €5bn, with interest rates that decline if the firm performs well against a set of ESG indicators. Firms like Investindustrial and KKR have developed financing instruments with ESG incentives. In 2019, Jeanologia, the Carlyle-owned company that creates clean technologies for jeans manufacturing, agreed to a loan with a rate tied to water savings. EQT Private Equity Advisory Team, calls the shift to credit-linked facilities ‘a game-changing moment’ for the private equity industry: ‘By linking sustainability objectives to hard incentives, we are really challenging ourselves and the portfolio companies to fully embrace the potential of sustainability.’

ESG Trends in M&A and Sustainable Finance

As sustainability and ESG considerations are on the way to becoming mainstream, we witness that certain trends are on the rise.

• ESG-related regulations are increasingly becoming a space to watch across all jurisdictions. The EU Taxonomy will force asset managers in the EU to disclose their share of taxonomy-aligned assets under management. Another crucial novelty brought by the EU to the area of ESG regulation is the draft legislation where mandatory due diligence obligations are planned to be imposed with regards to the supply chains of businesses to ensure that human rights and environmental risks are mitigated. That being said, lawmakers in the US have given special emphasis on double materiality as the draft principles announced by the Office of the Comptroller of Currency stipulate requirements for big US banks to integrate climate risks in their risk portfolio and governance schemes. In addition to the US and the EU, the UK is also carrying out consultations for imposing sustainability disclosure requirements onto financial market participants, requiring them to report on the sustainability impact of the financial products. The Turkish Capital Markets Board published the Framework for Compliance with Sustainability Principles which became effective in 2021. Accordingly, Turkish public companies are required to disclose their sustainable activities as part of their public disclosure requirements, and if they do not comply with these principles, they are required to disclose the impact of environmental and social risks. As a result of these race-like developments under different jurisdictions international businesses will increasingly be confronted with a fragmented scene of obligations on the area of ESG disclosures. Consequently, international entities will increasingly be required to adopt a holistic approach pertaining to ESG standards.
• Sustainability-related loans and bonds, especially the ones which offer discounts or premiums on interest based on ESG-linked Key Performance Indicators (KPIs), have been used increasingly across different markets. The Turkish Capital Markets Board recently published Guidelines on Green Bonds, Sustainable Bonds, Green Lease Certificates and Sustainable Lease Certificates (the Green Bond Guidelines), which set forth the principles that shall be considered in issuance of green and sustainable bonds. The main purpose of the Green Bond Guidelines is to provide new instruments to finance the green and sustainable activities of companies and to attract green and sustainable funds and financing into Turkish capital and debt markets. At this point, a strong emphasis is being put on the relevance and measurability of these indicators used in sustainable finance products. As the market and the know-how evolve, it is anticipated that more consistent and elaborate Specific Performance Targets (SPTs) and KPIs will be established. Finally, external verification schemes, such as second party opinions, are also becoming a point of focus to a great extent in a lot of jurisdictions for ensuring sustainable finance products are in compliance with the related KPIs, and to avoid greenwashing. In line with this emphasis in international markets, the Green Bond Guidelines published by the Turkish Capital Markets Board also require a second-party opinion for the debt instruments to be issued under this regulation.
• Discussions on the supply chain due diligence obligations have finally resulted. First Germany adopted the Supply Chain Law (Lieferkettensorgfaltspflichtengesetz), which will become effective by 1 January 2023, and second the European Commission proposed the draft Value Chain Due Diligence Directive. Both of these regulations aim at enhancing the responsibility of EU and German companies with regards to environmental and human rights violations and prevent them from hiding behind complex supply chain frameworks. The EU and German companies caught by these regulations, would be obliged to conduct the due diligence process in terms of environmental and human rights impacts for their entire value chain. Considering the reorganisation of the supply chain in accordance with these sustainability-related regulations, Turkey stands out as a reliable supplier for the EU market for a number of reasons and could use this trend as a great opportunity, should the Turkish companies manage to line up and comply with the standards brought by these regulations, and this may lead to lucrative M&A opportunities for Turkish companies.
• Decarbonisation, especially for emerging economies, continues to remain at the centre of the conversations on sustainability. Transition from carbon-intensive economies, will bring different opportunities for the M&A scene as well. In particular, investors are becoming more committed to their M&A investments in the areas of emissions reduction, energy-efficient technologies, carbon offsetting and trading markets. As investments in the fossil fuel businesses are being reconsidered, green transition would also require more partnerships between private and public sectors.
• Another popular proposition for ESG-related requirements concerns directors’ duties. Directors are now expected to consider ESG implications of their management decisions. As climate-related litigation and stakeholder activism cases become a bigger risk for companies, the importance of staff training and establishing crisis management plans is undeniable. However, it is also important to note that all these efforts must be conducted taking the greenwashing risk into consideration. As discussed above, the EU Taxonomy Regulation is an example of how policymakers and regulators try to avert this rising threat, especially in the area of sustainable finance.

Conclusion

Sustainability and ESG standards are among those concepts, which are increasingly demanded by all stakeholders, and they are here to stay. In addition to providing sophisticated mechanisms to mitigate the effects of the climate crisis, with all the dynamic developments in the area, they also present exciting new opportunities in the M&A and financing space.