ESG Due Diligence is the New Non-Negotiable for many Infrastructure Investors

C-Suite Series: Mergers & Acquisitions

More infrastructure M&A deals will fail or deliver disappointing returns if ESG risks such as the changing climate and digital resilience are not properly accounted for in the due diligence process

ESG is shaping infrastructure deals

At its core infrastructure is about providing social and economic services to society and business across a wide range of critical areas including healthcare, public transport and energy. Consequently, it’s no surprise that ESG considerations have a major part to play. But getting the ESG due diligence right is no easy task and the scope and focus needs to be asset specific. Take energy for example, where infrastructure investors are deploying capital in both fast-developing technologies such as energy storage and long-established assets classes like gas transmission networks. Whilst forecasting the consequences of climate change is still a developing science, investors need to assess how the changing climate will impact a potential target. This includes both the physical risk such as the increased frequency or impact of extreme weather. Transitional risks including policy, technology, market and reputational risks must also be fully evaluated. How often, for example, could an Electricity Distribution Network Operator expect to see the type of storm that caused the outage of a significant portion of the power distribution network in the northern region of the UK in late November 2021? But it is part of the overall ESG risk which, as Aon’s report says, takes many different forms and can lead to issues for investors: “Failure to disclose an environmental, social or other issue, or a gulf between ESG commitment and action, creates a risk of litigation post-transaction.” Infrastructure offers an additional ESG challenge in that investments are usually held over a much longer timeframe than a typical private equity investment and in some instances, are held indefinitely in open ended investment vehicles. The decisions investors make today will play out in terms of value over a very long period, which places even more emphasis on getting the due diligence right to identify, quantify, mitigate, and manage the longer-term uncertainty. Getting an effective balance in terms of the short- and long-term prospects is key.

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The make-up of the due diligence demanded by many investors for infrastructure deals has changed markedly in recent years as new risks have emerged. And right at the top of the new concerns that buyers and sellers must consider and take appropriate steps to understand and mitigate are ESG (environmental, social and governance) risks. Given their potential to devalue or even derail the deal, the need to widen the scope of the due diligence exercise to incorporate ESG concerns ranging from a changing climate to cyber security has never been more critical. So much so that many pension funds and institutional investors will no longer commit capital to fund managers unless ESG is fully embedded at the core of both the investment and asset management strategies.

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“We sold part of our gas infrastructure in 2016 and again in 2020. The investor scrutiny of environmental details of our gas assets in 2020 was much greater than in 2016 – like night and day.” Those were the words of an energy business, reported in Aon’s latest C-Suite Series M&A report – Better decisions for deal value, illustrating how just one ESG risk is influencing and shaping infrastructure deals.

Tackling digital due diligence

The digital landscape and resilience of an asset to cyber security threats is also an area of increasing focus for infrastructure investment under the governance pillar of ESG. Historically, the value in infrastructure deals was underpinned by the physical assets. The ongoing digitalisation of assets including remote monitoring and increasingly sophisticated operating controls to optimise performance is introducing a new risk for asset owners, with much of the potential risk exposure sitting in the broader supply chain. Again, due diligence is a critical part of understanding a target’s digital platform and performance. As Aon’s C-Suite Series M&A study finds: “With digital so central to how businesses operate… buyers need to be able to evaluate the digital assets and capabilities of the [assets] they have in their sights.” Take as an example water and wastewater utilities providing critical services to millions of customers. A successful cyber-attack will cause major problems instantaneously, with significant public health and safety, financial, reputational, and regulatory implications. Incidents of this type are on the rise; the cyber-attack on a water treatment plant in the City of Oldsmar, Florida last year being a recent example of a serious breach where the hackers directly accessed the operational systems.

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Failures like these related to cyber breaches or environmental vulnerabilities could have a significant impact on deal value, but rigorous ESG due diligence still remains a relatively new area of focus with a wide range of approaches seen. In some instances, it remains more of a tick-box exercise. The pressure to deploy capital combined with highly competitive transaction processes means there is always the risk that these areas can be de-prioritised in the cut and thrust of a deal, especially where the economic impact can make a bid less competitive. More positively, others are beginning to see ESG as a central part of the due diligence process recognising that, if they get it right, a robust understanding of overall ESG risk can both secure an investment as well as helping to enhance future returns. Ultimately the growing pressure from institutional investors, as well as some high-profile financial losses will be drivers towards a sharper ESG focus but, in the meantime, more still needs to be done to safeguard future infrastructure investments.

Fierce competition shouldn’t mean corners are cut

For more detail on ESG risk in the deal process as well as the latest on other M&A trends in areas such as SPACs and transaction insurance, download Aon’s latest C-Suite Series M&A report - Better decisions for deal value: Optimising transactions with enhanced insights

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Put ESG at the heart of the deal

The scope and focus of ESG due diligence must be asset specific

Identify, quantify, mitigate and manage the longer-term uncertainty

Understand a target’s digital platform and performance

Don’t let the cut and thrust of the deal de-prioritise ESG factors