Why Climate-Related Due Diligence is Essential

Why Climate-Related Due Diligence is Essential

November 2, 2018

The recently released Intergovernmental Panel on Climate Change (IPCC) report has been interpreted by many as a bleak warning of the dangers of climate change exceeding 1.5°C. The IPCC report was unambiguous about the existential threat posed by rising temperatures, but after taking a few deep breaths, it is clear that the report also contains reasons for optimism and ideas on how to act moving forward.

One takeaway from the IPCC report was that it appears government action, no matter how drastic, will not be sufficient to mitigate the challenges presented by our changing climate. The private sector will also need to take action. As the private sector stands to make significant gains (or losses) from the shifting climate paradigm, the sector’s growing recognition that climate change will impact all companies’ bottom lines is a welcome development.  This recognition has been demonstrated by the widespread participation in, and adoption of, the recommendations of the G20 Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD). However, not all of the TCFD’s suggestions have received the same amount of attention or uptake. Case in point: the TCFD’s recommendation that climate related risk should be treated on an equal basis with other material risks when conducting environmental due diligence (DD) is only now starting to receive the required attention.

Climate Impacts Affect Asset Value

Investors and other finance leaders continue to stress the importance of evaluating a company’s management of climate change risks and opportunities. The Guide on Climate Change for Private Equity Investors prepared by the Institutional Investors Group on Climate Change (IIGCC) and the U.N.-supported Principles for Responsible Investment (PRI) finds that institutional investors consider it part of their fiduciary duty to include climate related risks into their investment process, as such considerations lead to reduced risk, improved performance and overall better investment decisions. Further, the report recommends taking climate-related risks and opportunities into consideration during the DD process.

Climate impacts have both immediate and longer-term implications for asset value. Identifying climate-related risks and pinpointing strategies to mitigate those risks can potentially: (i) alert investors to often-overlooked asset risks of increasing importance; (ii) materially increase asset valuation; and, (iii) enhance the long-term viability of a potential asset. We have observed that current DD processes lack a comprehensive assessment of climate-related risks, and this lack of assessment may significantly impact asset value.

Climate-related DD considers two streams of climate related risks: physical climate risks and transition risks.

Physical risks may include:

  • Proximity
    • to a coastline, meaning that the asset is at risk of impacts from sea level rise or storm surges
    • location of the asset in an area with heightened flood risk, such as a floodplain
    • proximity to an area with heightened risk of wildfire or drought
    • increased exposure to resource constraints (e.g. lack of water, energy, etc.)
    • supply chain vulnerability to extreme weather events or reduced resource availability
  • regulatory or policy developments that could increase costs or liabilities, potentially strand assets or otherwise affect an asset’s financial viability (e.g. carbon pricing, emissions regulations, building code changes, etc.)
  • market impacts such as altered demand for certain goods and services
  • if the asset in question is a company, governance issues such as insufficient measuring and reporting of the climate related financial risk to the board or investors, or lack of scenario analysis such as a lack of climate change scenario analysis

The three main parties interested in climate-related DD are institutional investors, private equity firms, and real estate developers.

  1. Institutional investors: Institutional investors who are conducting environmental due diligence prior to purchasing stock in a particular entity should attempt to determine: (i) potential climate risks and opportunities; (ii) how climate-related issues may impact the company’s financial planning process; and, (iii) how climate change might impact the company’s products and services, supply chain, operations or investments.
  2. Private Equity: Private equity firms conducting DD for potential asset acquisitions may have been reluctant to incorporate climate-related due diligence into their investment processes due to the assumption that the timeframe for incurring climate-related risk exceeded exit timelines for most assets. However, as the current effects of climate change, and its potential impacts to an asset in the short-to-mid-term, become more fully understood, climate-related due diligence is being recognized as a tool that may allow investors to implement resilience measures that increase an asset’s valuation.
  3. Real Estate: Climate related risks can affect real estate asset valuation either directly by means of physical risks or indirectly by means of transition risks. Physical risks such as floods and extreme storms can damage real estate assets and cause their value to be reduced or completely written off. Meanwhile, transition risks such as changing consumer preferences could make “green buildings” more mainstream and lead to “brown discounts,” where buildings that are not green may rent or sell for less.

The New Normal

Although political debate over how to best address climate change’s impacts continues, the scientific community has reached an undeniable consensus on its existence and its current effects on our society. Business leaders have accepted the established science and have been slowly taking steps to fortify their businesses against the ongoing changes caused by the shifting climate. Climate change impacts and other issues linked to climate-related DD are already being considered by many companies. However, there are fewer companies engaging in targeted, climate-related DD. As companies work towards a systematic approach they will need climate specific expertise to inform DD teams and empower investment, acquisition and development decisions that adequately consider climate-related issues.