By Kimberly Tuthill White and Carina L. Antweil
Environmental, Social, and Governance Due Diligence and Environmental Risk Allocation in Transactions
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n recent years, Environmental, Social, and Governance (“ESG”) factors have risen in importance to the point that they are often a central focus in a transaction. Over the past year, we have seen ESG transactional considerations impact environmental risk allocation practices in two primary ways: (1) due diligence; and (2) contractual risk allocation. 1. Due Diligence For the most part, ESG due diligence looks similar to traditional due diligence, but with an ESG lens. There are numerous “checklists” that are now being used to complete ESG due diligence. These checklists are typically maintained in-house and guide buyers through various ESG factors in an approach similar to that taken in traditional due diligence. ESG due diligence can uncover significant risks and opportunities that can impact the business post-transaction. These issues can be as varied as the ESG factors that companies consider, ranging from operations in water stressed areas, to supply chain human rights considerations, to workplace harassment concerns. ESG risks that are identified in due diligence can be accounted for in the transaction in various ways, including purchase price reductions, interim operating covenants requiring the seller to take certain actions in connection with the ESG risks, and postclosing indemnification obligations for losses arising out of the ESG risks. However, ESG risks also present opportunities for strengthening and improving the business post-transaction. ESG due diligence is primarily performed in-house or with the assistance 32 March/April 2021
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of consultants. Over the past couple of years, a market for ESG financial offerings, such as green or sustainable bonds, has emerged. The underwriters of these types of bonds will require a Second-Party Opinion issued by third-party providers of ESG research and services for investors and organizations. 2. Contractual Risk Allocation Once traditional due diligence is complete, any ESG risks identified that are central to a transaction must be allocated among the parties through contractual methods. For example, a transaction that involves greenhouse gas (“GHG”) emissions associated with a business or product line will specify how emissions will be accounted for, how they will be verified, and any recourse for failure to adhere to performance standards. Consider the following factors when setting out such contractual measures: • Flexibility for a changing regulatory landscape. The legal and regulatory landscape underlying ESG factors, such as GHG emissions associated with green products, is rapidly evolving. Thus, contracts should offer flexibility for a changing regulatory landscape. One way to accomplish this is to include provisions that allow the parties to update the agreement based on changes in the law as they relate to the specified ESG factors. • Accounting and verifying standards. In the absence of regulations that may dictate how a market treats a green product, contracts can also attempt to identify third-party standards or certificates that can be used to account
for or measure ESG factors. • Consistent and precise definitions. It is important to have consistent and accurate definitions that appropriately reflect the legal, scientific, and common understanding of terms. For example, with respect to GHG emissions, there are important nuances between an emissions credit and an emissions allowance, so these terms should not be used interchangeably. • Measures for recourse. If the provisions and goals that are bargained for in the contract are not followed or attained, as applicable, parties should negotiate appropriate recourse. For example, if a business or product fails to meet certain ESG-related performance standards post-transaction, there can be a reduction in price based on market prices for the nonconforming product. In 2021, we expect to see an even greater emphasis on ESG factors in transactions. We also expect to see emerging regulatory regimes for ESG factors in the financial markets, which may have an impact on how they are treated in the context of a transaction. Such developments should be closely monitored in both U.S. and international markets. Kimberly Tuthill White, a senior associate at Baker Botts L.L.P., advises clients on environmental regulatory compliance and represents them in environmental enforcement, litigation, permitting, and transactional matters. Her practice focuses on compliance counseling and enforcement defense for upstream and midstream oil and gas companies, and on ESG and sustainability reporting issues. Carina L. Antweil, a partner at Baker Botts L.L.P., represents public and private companies in a broad range of corporate and securities matters, including mergers and acquisitions, Exchange Act reporting, corporate governance, and general corporate matters. She represents issuers, investment banking firms, and other investors in public offerings and private placements of equity and debt securities, including initial public offerings, follow on and secondary public offerings, and 144A offerings.
