by Derek Six, Chief Business Officer | July 29th, 2020

Financial Due Diligence: Evaluating Environmental Opportunities and Risks

Over the past few years, we have observed a substantial increase in inquiries from Private Equity firms, Investment Advisors, and Mutual Fund managers seeking to better understand the environmental opportunities and risks related to investments in potential target firms.  Providing advice in this area has become one of the most interesting aspects of ClimeCo’s Sustainability, Policy & Advisory practice.  The subject has historically been nebulous and abstract, as many clients struggle to define environmental opportunities and risks, so getting started on this line of inquiry can be difficult.

Environmental Opportunities and Risks

So, what do we mean by the term “environmental opportunities and risks?”  In its simplest form, it can be defined as the impact, either positive or negative, that environmental markets and regulations may have on the value of a portfolio of assets.  While it is common practice to include an environmental assessment to identify potential liabilities associated with a targeted acquisition, we have found that surprisingly little attention is often paid to the potential opportunities and risks posed by environmental markets … those markets that facilitate the trading of environmental assets.

At ClimeCo, we believe in the power of financial markets to solve environmental challenges.  With this lens in mind, our approach to defining the question focuses on what types of environmental markets might impact the firm in question, whether positively or negatively.

For example:

• Is the firm regulated under any local emission/pollution reduction programs?
• Is the firm regulated under any state, regional, or national GHG cap and trade programs?
• Does the firm have a technology or service that could assist other firms in these markets?
• Is the firm likely to be pressured by consumers or other stakeholders to take voluntary action to address environmental impacts, or could it find a competitive advantage in doing so?
• Are there opportunities where addressing environmental impacts can ease regulatory or permitting efforts?

As you can see, the analysis can be complex and requires a deep understanding of the various environmental markets to which a firm might be subject.  ClimeCo takes a unique approach to these questions, flipping the basic question on its head: rather than seeing only risks, we also search for opportunities and value.  Environmental markets provide incentives for firms to improve their operations, and they often convey valuable environmental property rights.

What Firms Should Be Aware Of

We often find that firms are unaware of some of the rights that they might hold.  As an example, a firm considering the shuttering of a manufacturing facility would not typically do so without attempting to sell and maximize the disposal value of the tangible assets on site.  However, we find that they commonly ignore the value of various intangible environmental permits the facility holds.  In regions where there are markets for permit capacity, these can be of significant value but only if sold in a timely manner.

More recently, the bulk of these types of inquiries have come from investment firms seeking to understand the potential impacts of current and proposed climate change legislation.  Entities doing business and/or located in California, Quebec, Alberta, or the US northeast region are likely to be impacted, though there are other states that are seeking to follow suit.  For example, California has comprehensive climate legislation in place; this legislation includes a Cap and Trade program for GHGs with transparent market pricing, as well as a myriad of other complementary programs and regulations.  For some entities that fall into this compliance program, there are provisions for free Allowances (permits to emit one metric ton of CO2e) based on historic emissions while, for others, allocations can be purchased at auction by the state or through a robust secondary spot and futures market. Meanwhile, firms that reside in the state but do not fall within the parameters of the compliance program may have the option to opt-in to the program to capitalize on market opportunities.  Therefore, firms need to understand the impact of this market on their own operations as well as on their supply chains, customers, and utility providers. 

Markets such as these provide opportunities, as there is tangible value in reducing GHG emissions, providing services to these market programs, or providing technologies to these markets.  Helping firms to understand future pricing expectations, potential regulatory changes, and market engagement strategies is one of the most interesting things that we do.

Regardless of what type of firm you are considering investing in, or where that firm has operations, understanding potential environmental market opportunities and risks should no longer be a pro-forma checkbox on your diligence list.  This should be an important lens through which to view every aspect of a firm’s income statement and balance sheet.

About the Author

Derek Six serves as Chief Business Officer at ClimeCo, where he leads the company’s cross-cutting business functions, as well as the firm’s ODS management program and private equity fund. He holds an MBA in investment management and portfolio analysis from Pennsylvania State University’s Smeal College of Business.