Climate Change Diligence—An Emerging Focus in U.S. Transactions

In transactions, climate change diligence is generally directed at examining the climate change impact of a potential investment. This involves focusing both on confirming the information provided by the target of the investment and evaluating the impact of the target's climate change profile on the investor's climate change profile. Confirmation of the target's climate change information follows the typical diligence framework with a specific focus on (i) carbon disclosure frameworks used by the target; (ii) carbon reduction objectives established by the target; (iii) third-party verification of climate change reports; and (iv) validity and value of environmental attributes used to meet carbon objectives.

With respect to carbon reduction objectives, fund managers have begun to vote against the management of public companies that do not establish plans to control Scope 1 (direct emissions from company-owned and controlled resources), 2 (indirect emissions from the generation of purchased energy), and 3 (indirect emissions from upstream and downstream activities) emissions by 2030, consistent with the objectives of the Paris accord and, by 2050, consistent with achieving net-zero carbon emissions. Targets that have not established and implemented these plans may incur additional costs to develop and implement them, and investors will want to consider these additional costs in valuation. Targets that have not established or implemented these plans also present opportunities for investors to possibly consider expense reductions as energy conservation measures are implemented.

Environmental attribute validity and allocation is also becoming an increasingly important consideration in transaction diligence. Validity diligence addresses two key issues. First is whether a particular attribute, such as a carbon reduction credit, has been validly issued. The importance of this effort was highlighted by widespread fraud in the creation of renewable fuel credits several years ago. The second validity issue is whether the target has made any statements or taken any actions that effectively retired otherwise valid credits. For example, statements by a target that it is using its own carbon reductions to achieve carbon targets may limit the target's ability to use the reductions to create marketable offsets.

Understanding the scope of available attributes and their allocation between the relevant parties is critical. An investor will want to make sure that a target has received all of the attributes that a particular project could generate. In addition to carbon offsets or other types of emission credits, various kinds of tax credits or other incentive payments also may be available. In projects involving a third-party vendor, such as rooftop solar or agricultural practices, the underlying documents for the project need to be examined to understand ownership and allocation of the attributes that may have been created by a particular project.

Finally, the investor should consider the impact of the target's climate change profile on its own situation. One critical consideration is how the target's profile will impact the investor's ability to meet its carbon targets. This factor is becoming more and more important as a screen for lenders facing scrutiny related to the climate change profiles of their borrowers. In some situations, the ease or difficulty of integrating the target's climate change governance and reporting structures into those of the investor also may be a consideration.

Climate change diligence is in its infancy. The scope and detail of an appropriate diligence effort is sure to change, but fundamental principles of verifying material facts and developing information that allows an investor to consider the potential costs and benefits of a particular investment will continue to apply.

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