Originally published in Natural Gas & Electricity, April 2007.
Environmental diligence has long been viewed as a necessary component (some would say a necessary evil) of any power asset acquisition. Deal lawyers and businesspeople have been known to sink into despair as the environmental diligence process becomes a creature with its own nasty life, rather than a business-oriented exercise focused on getting the deal done.
Nowhere has this tension been greater than in the business of acquiring power-generating and transmission assets. Power assets are changing hands at an increasingly rapid rate. In recent years, we have seen new players enter the power asset acquisition arena, including financial institutions and foreign energy companies, as well as new private equity and hedge funds, all joining the race to acquire "infrastructure." To a slightly lesser extent, these factors are also driving increased acquisition activity and competition for local distribution companies and their assets. The entrance of these new players and the prices they are willing to pay has resulted in a furiously competitive seller’s market with no obvious end in sight, while at the same time compressing the time frame for completing transactions.
Under these circumstances, the slightest anticipation of delay in closing the deal can be determinative in the seller’s choice of a preferred buyer. Indeed, there is more pressure than ever before for bidders to simply accept the seller’s term sheet and purchase and sale agreement without additional or different conditions. Consequently, every member of the acquisition team must be commercially oriented, pragmatic, and able to act decisively within tight time frames based on limited information. That scenario presents a significant challenge for environmental professionals, who typically work in regulatory processes and time frames that are longer and far more deliberate.
Nonetheless, the job can be done on a commercial basis, and the right team can add significant value in a competitive bid scenario.
Traditional Versus Competitive Environmental Diligence
The contrast between traditional environmental diligence and diligence in a competitive auction is quite stark. Traditional environmental diligence typically unfolds over the course of six to twelve weeks. It begins with a detailed written request for documents, including environmental site assessments, internal compliance audits, permits, notices of violation, consent orders, correspondence with government regulators, environmental capital expenditure (capex) and operations expense (opex) budgets, and a multitude of detailed backup information. Until recently, it was common practice for the buyer also to retain its own environmental consultant to conduct an independent on-site environmental site assessment and compliance evaluation.
If the on-site assessment revealed potential subsurface contamination issues, a buyer might insist on intrusive sampling before it would consider purchasing the asset. However, it is fair to say that in most transactions today, that type of diligence, while arguably preferable from the standpoint of rigor, is simply not possible. It has become necessary to do more (or at least enough) with less, in less time.
Environmental diligence today typically takes place for the most part within an electronic universe defined by the seller. A virtual data room is created by the seller’s advisors, sometimes without significant input from the seller’s environmental professionals. The buyer is provided access to a set of documents that may or may not be complete, with limited ability to obtain significant additional documents or information. Concerns about confidentiality often make sellers reluctant to permit detailed on-site environmental assessments, and also result in prohibitions against contact with governmental agencies. To remain competitive, the environmental professionals on the deal team must bring experience, judgment, and focus to the exercise, and do it quickly on an integrated basis.
Fielding the Right Team
The starting point is assembling the right environmental team, preferably at the outset of the transaction, to ensure quick and decisive action once the data room opens. Ideally, that team should include a senior person within the buyer’s organization with environmental compliance experience (this is often possible in the case of a strategic buyer, but less likely to be possible in the case of a financial investor). The team also should include an environmental attorney and an environmental consultant who not only know the power industry, but also have proven experience working together on transactions. The ability to quickly identify, assess, and resolve a difficult issue can prove quite valuable under the time pressure of an auction, as high-level judgment and experience will often be the decisive factor in whether a material issue, once identified, causes the deal to founder, or is resolved on the basis of realistic and commercially reasonable options that would be accepted by a seller with multiple bidders.
Tapping Available Sources of Information
Although telephone conversations, in-person contact, or freedom of information requests to government agencies are typically off-limits in an auction, the Internet can provide significant useful information to supplement what is available in the data room. Federal and state Web sites often contain public information about environmental permits, compliance history, reported releases of contaminants, underground tanks, and whether a target site has been designated as a contaminated site that is subject to remediation. If the target is a public company, Securities and Exchange Commission (SEC) filings may contain reasonably detailed disclosure of environmental information, including analysis of pending enforcement actions and the financial exposures associated with identified environmental contingencies. Commercial databases also can provide aerial photographs, historic land-use and zoning information, and descriptions of prior operations—which will shed light on whether the real estate associated with a given power asset might have legacy contamination issues that could later become an environmental cleanup liability. Public databases also can provide information about environmental litigation, consent orders with environmental agencies, and the magnitude and frequency of environmental violations.
As noted above, traditional on-site environmental site assessments are becoming less common than they were in the past due to timing and other competitive pressures in most auction processes. However, there is no question that it is preferable to have an environmental consultant participate in the facility tour. One way to accomplish that objective is to integrate an environmental consultant into the business team that visits facilities as part of initial business-level site tours (assuming such tours are scheduled). All too often, by the time the environmental team has been assembled, these tours have already happened, and the ability to send out a second set of professionals has been lost.
This potential danger underscores the need for early integration of the environmental team into the diligence effort. Even if an environmental consultant dresses in business attire and tags along with the businesspeople, he or she can often glean important information that will be helpful in assessing the nature of the operations and likely material issues, just based on a walk around the facility and visual observation.
Nevertheless, the value-added part of environmental diligence is not about collecting information: the important part is about using that information in a focused manner to identify material issues for the businesspeople. It is therefore critically important for the environmental team, working the deal team, to define an acceptable materiality level. In a $6 billion transaction, for example, the businesspeople may determine that no issue under $1 million is worth analysis unless it has a reasonable potential to later exceed $1 million in costs. In a smaller transaction, it may be that the appropriate materiality threshold is $500,000, or $100,000, or even $50,000 in small transactions. Given the time pressure that everyone is under in an auction process, it is important to define materiality early and to discipline the environmental diligence process to adhere to the materiality level, while remaining attentive for issues that might be just below the radar but nonetheless potentially significant.
There is quite a bit of art as well as science to the proper application of materiality thresholds. Experience is critical. The cost implications of many issues are by now reasonably well understood. Those issues can be assessed based on industry experience, often without the need for environmental samples or detailed on-site analysis. Many environmental issues involve a low probability of a high-dollar impact. If every worst-case scenario is presented without reference to realistic outcomes, many environmental risks would be improperly perceived as showstoppers. The ability to frame an environmental risk in terms of its reasonable best- and worstcase outcome is what makes an environmental team competitive.
Identifying Bank and Investor Requirements
In defining materiality, as well as the scope of the environmental diligence effort, it is also important to understand whether the financial backers of the bidder have specific requirements that will have to be met in the diligence effort. Understanding these requirements, and discussing whether they are consistent with the auction process, is an early investment of time that pays off quite well. For example, a commercial bank may have an internal policy that all loans require a Phase I environmental site assessment that meets the Environmental Protection Agency’s new "all appropriate inquiry" standard, which requires contact with government agencies. However, auction ground rules may prohibit any such contact. It would become necessary in such circumstances to explain to the bank officer that if the policy is applied to the letter, the bidder would be precluded from participating in the auction.
Similarly, institutional investors may have internal guidelines to satisfy. Typically, if a credible alternative approach has been formulated by the environmental team, the bank or other investor can be made comfortable, especially if they are included early and often in the environmental diligence process. Managing the relationship in that manner helps to avoid last-minute surprises regarding financial institution requirements just before the bid is due.
Assessing The Seller’s Environmental Management System
Because detailed analysis of every issue is not possible in a competitive bid, it is often necessary to evaluate and, if justified, rely to a measured extent on the target’s existing environmental management system reports. Therefore, the diligence process should include review of the seller’s environmental management system policy documents, as well as, if possible, its recent annual reports to management. In a system that is working properly, these reports can provide a very useful road map to material issues, and also provide a sense of whether the company appears to be on top of its issues.
If possible, it is often useful to couple such a review with a telephone interview with the target’s senior environmental health and safety officer, to probe a bit beyond what appears on paper, and to assess how knowledgeable that person is about the company’s environmental issues. This level of review can provide substantial comfort if the company has the right people in place and a good environmental management system.
Identifying Air Compliance Issues
As is evident from California’s recently enacted climate-change legislation, air regulations present a dizzying array of federal, regional, state, and even local regulations that present multiple traps for the unwary in a power acquisition. Some of the issues that are sometimes overlooked include the following:
- Air emission permits that have not been updated to conform to current levels of operation (such that the plant literally cannot comply with its permit limits)
- Historic modifications to plant operations that could arguably give rise to enforcement actions under the "new source review" standards of the federal Clean Air Act
- Facilities that have been categorized as "minor" sources that in fact should be permitted as "major" sources
- Anticipated costs (capex and opex) associated with upcoming air toxic and anticipated greenhouse gas regulations and/or cap-and-trade systems
- Hidden compliance issues arising from permit renewals and planned upgrades
It is important to have an environmental consultant on the team who is steeped in air permitting issues, so that these issues can be identified, quantified, and addressed during the compliance review. Most often, the question is not merely whether the plant is in compliance, but whether the plant will be competitive with other peer plants when anticipated greenhouse gas regulations go into effect, and the costs associated with purchasing necessary emission credits to operate the plant. Many of these issues are a bit too far into the future at present to be fully understood, but as these nascent regulations become more concrete and mature, even at the planning level, it will be important to understand their direction and anticipated costs.
Understanding Hidden Remediation Costs
Under applicable environmental laws in certain states, such as New Jersey, site investigation and remediation costs can be triggered directly by a contemplated transaction. In addition, investigation and cleanup can be triggered by government agency scrutiny or by claims that have been filed by private third parties.
The fact that a facility has not identified subsurface contamination as an issue does not mean that the facility is clean—it merely means there is no identified issue. Therefore, it is important to know about the past uses of the property (including especially historic fuel usage), to understand whether there has been any release of contaminants at the site or onsite waste disposal, and to arrive at an orderof- magnitude estimate regarding environmental investigation and remediation costs, as applicable. If the facility is slated for closure (not a likely scenario in most power deals), environmental exit costs may arise in connection with such closure.
Identifying Offsite Disposal Liabilities
Under federal Superfund legislation and comparable state law, any off-site disposal of material generated at the power plant could give rise to environmental liability. A potential buyer should ask whether the seller has received any requests for information or claims relating to potential responsibility for off-site disposal, and also understand the facility’s current and historic waste streams. For facilities in or near sensitive off-site receptors, such as lakes, rivers, and wetlands, attention also should be paid to potential claims for sediment remediation and/or natural resource damages.
Meshing Diligence With Contract Protections
In an auction context, the typical sellerfriendly agreement will have environmental representations and warranties that are qualified by knowledge, by items disclosed on schedules, and by materiality or material adverse effect. The auction document also may prevent recourse postclosing for a breach of representation and warranty, or limit such recourse to a relatively brief period (a year, for example). Although a variety of contractual mechanisms are available to manage environmental risk, including postclosing escrows, price adjustments, postclosing covenants, and environmental indemnities, in many instances buyers find that these mechanisms may not be achievable because of competitive pressures from other bidders. As the environmental protections in the contract are whittled down, that places much greater pressure on the quality of the environmental diligence, which is also typically being restricted by commercial pressures. Therefore, it is important to monitor the interaction between the level of diligence that has been conducted and the tradeoffs that are being made in the deal document to make sure that an acceptable level of protection is achieved for the client.
Remain Attentive to Public Disclosure Obligations
When representing a buyer that is a public company, the environmental aspects of the seller’s business will eventually be subject to public disclosure under applicable securities regulations and generally accepted accounting principles. Accordingly, the environmental diligence should assess the extent to which environmental disclosures meet these requirements.
The degree of compliance with the letter and spirit of securities regulations varies greatly in the environmental arena. Many companies have upgraded their disclosures to meet investor demands for increased transparency, including detailed disclosures about climate-change risks. Other companies have been alleged by environmental groups to be underreporting their environmental exposures. Understanding whether the seller has properly accounted for environmental risk through the lens of SEC disclosure requirements is therefore important for any public company buyer. It also can be helpful for financial investors that may later want to exit their investment through a public offering.
Consider Environmental Insurance
If a material environmental risk is identified, and the seller is unwilling to provide any postclosing recourse to protect the buyer, it may be possible for the buyer to purchase environmental insurance to cover that risk (with or without costs sharing on the premium and self-insured retention by the buyer). Such insurance is available on commercially reasonable terms, for example, to cover third-party environmental claims, to cover environmental remediation cost overruns, and to cover certain off-site disposal risks. Even when timing or the level of information provided by the seller does not permit insurance to be purchased before the bid is accepted, it is often possible to structure arrangements where additional information is provided between acceptance of the bid and closing, so that an insurance policy is in place to cover an identified risk. On the basis of fairly limited information, sophisticated environmental insurance brokers can advise clients whether an environmental risk is insurable and on what terms, within orders of magnitude, subject to confirmatory diligence after a bid has been accepted.
Environmental diligence is not an end in itself. It is one of the ways that bids can be won or lost. Accordingly, it is critically important to frame the environmental diligence exercise to fit the needs of the deal team. An experience- based pragmatic review that allows bidders to remain competitive is worth far more than an effort that gets details right but loses the bid.
It must be recognized that environmental issues, like other issues, can and must be quantified and analyzed in the commercial context in which environmental issues arise. They must be sorted based on materiality and significance and then be presented to the business team in a manner that facilitates good deal decisions. When that is done successfully, the odds of being a winning bidder can increase dramatically.
Jeffrey Gracer is a partner with the law firm of Sive, Paget & Riesel in New York City. Bernays Barclay and Andrew Schifrin are partners in the New York City office of the law firm of Torys LLP.
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