ESG FROM THE OPERATOR'S PERSPECTIVE
In recent years, businesses that demonstrate certain environmental, social, and governance (ESG) criteria have seen a pronounced uptick in interest from many investors, particularly from institutional investors who were in the vanguard of the ESG movement. This interest has manifested not only in higher stock prices on public markets, increased interest in private fundraising rounds, and competitive pricing in project finance, but also in ripple effects through supply chains, hiring, and other aspects of operations. So too do ESG criteria— and public announcements regarding investment decisions made by investors utilizing ESG criteria—increasingly impact a business's brand and consumer relations. In parallel with this trend, businesses around the world have independently created and implemented ESG-related policies in a variety of areas.
But what is ESG in the context of an operating business? Typically, discussions around ESG in this area target various practices that contribute to a business's ESG profile vis-à-vis investors. Consequently, ESG policies and practices are largely about accounting for and mitigating the risk that externalities will negatively impact an investment or business line. Thus, environmental criteria frequently focus on objectively accounting for observed changes in the natural world, regardless of their cause. Social criteria center on objectively accounting for the wider societal and economic impact that working conditions and practices can have. Finally, governance criteria account for the risks inherent in the failure to comply with applicable law, as well as the failure to prevent employee turnover and discontent, or to holistically take into account the views of a range of people—any of whom may be customers, investors, or business partners.
Often, ESG practices are oriented toward the long term and actions beyond only those that are required by law. However, there is wide variation among businesses in how they may approach ESGrelated matters. For example, ESG considerations at the operating company level can include:
- Diversifying a business's workforce, executive team, and board, whether by reference to race, gender, sexual orientation, country of origin, or socioeconomic status, as a way to respond to customer requirements or market changes.
- Taking into account identified externalities that a business creates and taking steps to mitigate them. For example, a dairy farm could identify the costs of methane emissions to local residents and the climate, then mitigate them by installing a digester that captures the methane and converts it to renewable fuel.
- Expanding a business's focus on shareholder value to a focus on stakeholder value. The Business Roundtable has stated that stakeholders include "employees, customers, suppliers, and communities." The 2020 Davos Manifesto expands that slightly to include society at large and states that "the purpose of a company is to engage all its stakeholders in shared and sustained value creation[...]. The best way to understand and harmonize the divergent interests of all stakeholders is through a shared commitment to policies and decisions that strengthen the long-term prosperity of a company."1 Thus, a company that focuses on stakeholder value could consider issues as diverse as compensation of employees relative to executives, scope 3 greenhouse gas emissions, longevity of products sold to customers, and hiring from marginalized communities. Moreover, local law that governs business organizations can affect the extent to which a business considers matters that do not directly impact shareholder value.
- Anticipating and mitigating future and large-scale risks. This is the point at which ESG begins to merge with impact and justice missions. For example, many large companies currently purchase renewable energy credits (RECs). More recently, some have begun purchasing carbon credits, and a few have entered into voluntary carbon removals contracts. While this type of activity is, of course, about using corporate resources to impact climate change, there is wide variation in the reasons for any given company's entrance into this market. For example, some companies may acquire RECs solely in response to customer or investor pressure concerning corporate citizenship or otherwise. Others may be thinking farther into the future about the disruptions that are expected to result from climate change and how that may impact the business's customer or employee base, supply chain, or access to capital. Others still may venture into this market out of a desire to create positive and long-term impacts on the climate, environmental or energy justice communities. Similarly dramatic variations can be seen in the reasons that a company will engage with any ESG-related segment, including: forced labor in supply chains; justice, diversity, equity, inclusion, and accessibility; environmental impacts of supply chain sources and operations; and many others.
It can be difficult to translate these broad concepts into actionable items, particularly in the context of an active business with a traditional focus on near-term financial performance. But an ESG focus can be and is achieved every day around the world; largely by reconciling the values and goals of a business beyond mere profitability with the values and goals of the people with whom the business interacts or seeks alignment. This can be an enormous task requiring a large degree of coordination. It can also seem as though there is no good starting point. So, how are businesses implementing their ESG goals?
One popular option is for a business to create a chief sustainability officer or ESG officer role to implement policies to guide how the business accounts for ESG criteria in certain aspects of its operations or across its entire platform. Consultants are frequently essential to this effort, for example by creating baseline studies, identifying areas where operations are already exemplary or could be with reasonable adjustments, helping the business determine the best steps to advance its goals, identifying opportunities to do so, and designing campaigns to communicate those goals and the business's efforts to meet them.
From there, there are numerous approaches to the integration of ESG criteria into a business, but a few general trends emerge:
- Personnel matters. ESG can factor into a number of decisions related to personnel, from choices about transportation subsidies to fair wages; diversity and inclusion in hiring, responsibilities, and promotions; employee perks at the office; and work-fromhome policies. Each of these categories and many more have the potential to impact environmental sensitivity and justice, labor standards, and governance practices.
- Supplier policies and evaluations, including selection of preferred providers based on the outcome of those evaluations. Businesses without existing policies and procedures can create simple policies that incorporate ESG-related criteria. Businesses with existing policies and procedures can further integrate ESG criteria by including methods designed to evaluate a supplier's compliance with specific types of law and regulations, as well as how the supplier goes above and beyond those requirements by reference to stated criteria or voluntary standards such as those created by the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the World Resources Institute. For example, a procedure may evaluate how the supplier works to mitigate pollution from its operations, whether it uses forced or low-wage labor, whether women or ethnic minorities are treated fairly or given substantial roles, and whether the business takes into account similar criteria when working with its own supply chain.
- Service provider policies and evaluations. It is a growing trend to formally incorporate ESG-related criteria into service provider bidding processes, as well as periodic evaluations. The criteria included in these processes often include factors designed to probe how service providers foster a diverse and inclusive workforce, address their own environmental footprint, and participate in their community or the communities where their customers are located.
- Investments. Many operating businesses invest in other businesses and funds for a variety of reasons; e.g., to foster growth of innovative technologies, grow business partnerships, or simply manage risk and grow value. Needless to say, businesses that make these investments can, and increasingly do, act like an institutional investor in evaluating targets using ESG criteria.
- Mergers and acquisitions. Business mergers and
acquisitions can help both the acquirer and the target to grow
through greater efficiencies, and access to customers, financing,
new markets, and complementary talent and resources. Businesses
that are focused on ESG as a guiding business principle should
consider how ESG criteria are accounted for throughout this
process:
- In the initial evaluation of a potential business combination, both the acquirer and the target should consider each other's ESG metrics and how well their existing practices may fit together, as well as areas where there is room for improvement.
- During due diligence, the acquirer's legal teams and consultants should be instructed to weigh ESG factors in addition to mere legal compliance and overt risk.
- When determining the appropriate price for the target, both parties should consider whether and how much value should be attributed to the target's ESG-related practices.
- When determining whether equity or cash consideration should be used in the transaction, the target's shareholders should consider whether the value of the acquirer's stock is impacted by the acquirer's ESG score and potential future changes in its stock price depending on how its ESG practices may change in the future, including by reason of integrating the target into the acquirer's business after the transaction closes.
- When evaluating how the acquisition will be financed, the acquirer should consider whether its or its target's ESG score warrants preferred lending terms or whether the acquirer could efficiently raise financing using a green, social, or sustainability bond.
- Finally, when integrating the target after the transaction, the acquirer should analyze how and to what extent its own and its new subsidiary's ESG-related practices should be melded. Does the subsidiary already have excellent practices? Should any of them be integrated into the parent company's broader operation? Or, how should the parent company's practices be translated for the new subsidiary?
EVALUATING ESGRELATED PERFORMANCE
While all of these processes can be implemented by creating bespoke criteria, a number of existing ESG-related standards can help businesses evaluate their and their partners' operations and communicate their performance to the public. This handbook's section about ESG and sustainable Investment includes a discussion about notable voluntary standards and guidelines. It also examines standards that are used to score a business' overall performance, such as the more than 70 standards created by SASB, and the nearly 40 standards created by GRI. It further highlights a handful of the numerous existing voluntary standards that are oriented toward products and operations. These product- and operations-focused standards can be challenging to use because they often relate to specific industries and, in some cases, specific geographies.
Translating product- or operations-specific standards to the broader context of overall ESG standards deserves more attention. Many of these specific standards are well established and respected. In addition, because they are typically used by a business to communicate to its customers certain activities and practices that the business wishes to highlight, they are very valuable to businesses that exist in many supply chains. Like the broader business-level ESG ratings, it can be expensive to obtain certification of compliance with product or operations standards. Furthermore, these processes can be complicated and time consuming to complete. Accounting for product or operations specific standards in overarching business-level standards would likely streamline the process of obtaining ESG ratings for many businesses, thus increasing the number of businesses that are able to adopt recognized ESG-related practices. Implementing accessible and comprehensive ESG strategies would bring us all closer to the goal of achieving a sustainable economy.
RENEWABLE ENERGY
UNITED STATES
Renewable energy has quickly become a popular asset class in the United States, with new records for installations of solar and wind established nearly every year, regardless of federal and political trends. By megawatt, most of the installations in the United States are onshore wind and solar operations, but the market share of biomass installations has materially increased in recent years. Some industry observers anticipate a resurgence of hydroelectric power and long-term pumped hydro storage facilities in certain jurisdictions. In addition, it appears that traditional offshore wind is poised to advance in earnest on the East Coast, and that development of floating offshore wind may soon begin on the West Coast— particularly given an announcement made on 13 October 2021 by Secretary of the Interior, Deb Haaland, about significant offshore leasing plans. Please see the most recent version of our Offshore Wind Handbook for more information.
In fact, there are indications that the drive toward renewables will only increase in the near future. In one of his first acts in the Oval Office, on 20 January 2021, President Joseph R. Biden, Jr. caused the United States to rejoin the Paris Climate Agreement (the Agreement), the largest international effort to curb global warming. The United States officially withdrew from the Agreement to limit climate-warming greenhouse gas emissions in late 2020, after Former President Donald J. Trump began the process in 2017. Prior to its withdrawal, the United States had played a large role in creating the 2015 Agreement. The current administration expects to redouble its efforts to participate in the Agreement, which aims to avoid severe climate change scenarios by keeping average global temperatures from rising no more than 2 degrees Celsius, and preferably less than 1.5 degrees Celsius by 2100, as compared to pre-industrial times.
Investors implementing ESG goals in the United States have long been active in the renewable energy sector, drawn by the allure of environmentally friendly power and dependable returns. While a great deal of that investment was once made by strategic and tax equity investors, in the last several years, a much larger variety of businesses have been taking advantage of a wide range of ESG-related financial instruments, which accomplish additionality while substantially reducing or eliminating the investor's exposure to physical asset risk.
Nonetheless, the increase in interest in the aggregate environmental impact of renewable energy and the social prong of ESG have driven a recent refocusing on the renewable energy supply chain, habitat at generation facilities, and opportunities for recycling obsolete materials. Scrutiny has come from the public at large, ESG-focused investors, project finance parties, and governments. For example, after significant news reporting on forced labor conditions in the Xinjiang province of the People's Republic of China, U.S. Homeland Security on 24 June 2021 issued a Withhold Release Order on silica-based products produced in Xinjiang.2 This reporting also gave rise to a protocol issued by the Solar Energy Industries Association designed to prevent forced labor in the solar supply chain,3 and a profusion of additional provisions in private contracts oriented toward the same goal.
EUROPE
For many years now, global attention has been paid to the implementation of the European Union's wide-ranging reforms to revive investor capital moving to tackle climate change. In July 2021, the EU made ambitious revisions to its 2018 directive concerning renewable energy, which demonstrates only the most recent development in what is a fundamental paradigm shift in global perspectives on renewable energy sources. Nonetheless, shifting away from natural gas and coal on a regional basis can present an enormous challenge to affected regions and requires cooperative efforts on many fronts, from efforts to integrate regional energy systems4 to ongoing cooperation efforts among affected countries.5
Several European countries have led this charge by creating abundant renewable energy resources and booming renewable energy sectors. These countries include Denmark, Norway, Sweden, and Finland (on- and offshore wind energy); Germany, Spain, and Italy (solar energy); and Iceland (hydro and geothermal energy). However, of all countries in Europe, Finland, Sweden, Norway, and Denmark are often perceived as forerunners in sustainability efforts. Nordic institutional investors have been among the world's first and most active ESGfocused investors, and issuers in this region often rank high in sustainability rating mechanisms. Of course, these rankings are not exclusively based on renewable energy, but the renewable electricity sources provided in these countries certainly help to support the ESG goals of their companies and issuers. By the end of 2019, each of Finland, Sweden, Norway, and Denmark had already exceeded their 2020 renewable energy goals.6
AUSTRALIA
Australia is blessed with abundant renewable energy resources and plenty of land on which to site renewable energy projects. Investments in utility-scale wind and solar generators have increased steadily over the past decade, with solar, wind, hydro, and other renewable resources comprising 24% of Australia's total electricity generation in 2019. Such growth has been fueled in part by federal and state renewable energy targets and a patchwork of feed-in tariffs or equivalent renewables schemes that vary among the states and territories. Uncertainty remains, however, as there is not likely to be any increase in federal Australian renewable energy targets. Investments are therefore largely reliant on state-based targets to support the ongoing increase in renewables in the Australian electricity market.
Australia hosts one of the largest battery storage systems in the world: the Hornsdale Power Reserve, originally a 150MW/194MWh gridconnected energy storage system co-located with the Hornsdale Wind Farm in the Mid North region of South Australia, which was expanded in 2020 by a further 50MW/64.5MWh to a combined 185 MWh. This system was a key factor in stabilizing the power grid during the loss of a major transmission line in South Australia. Batteries and other storage technologies are expected to continue to play a role in integrating large amounts of renewable energy onto the Australian power grid as the country transitions away from retiring coal-fired generation, while retaining a regulatory lens on the reliability of generation coming onto the grid under the Retailer Reliability Obligation. Other market dynamics and slated reforms may determine the overall success in commercialization of storage options in the Australian market but, to date, there has been a steady development of storage and "storage-ready" assets, particularly among retailers and vertically or semi-vertically integrated energy businesses.
In addition, Australia's focus on green hydrogen production is piquing interest in renewable investments as a whole. In part, because green hydrogen can be technically produced at scale using Australia's ample renewable electricity capabilities, and then exported. In particular, the Murchison Renewable Hydrogen Project, which is backed by Copenhagen Infrastructure Partners, anticipates using five gigawatts of solar and onshore wind electricity to produce hydrogen for export to Japan, South Korea, and other Asian markets; and the Asian Renewable Energy Hub, which is backed by CWP Renewables, Intercontinental Energy, Vestas and most recently Macquarie Group, aims to use more than 11GW of wind and solar electricity to largely produce hydrogen for export.
Finally, offshore wind and electric vehicles are the subjects of increased attention in Australia, but these markets are still at an early stage. Electric vehicles and associated infrastructure are set to increase substantially in the next few years, while hydrogen and electricity vie for position in the heavy vehicle space. Similarly, behind-the-meter opportunities remain largely untapped in terms of size and impact, but there is increasing uptake of rooftop solar and integrated battery storage, hydrogen storage and electric vehicle systems in the commercial and industrial and large-customer space as retailers and other energy stakeholders test the waters on virtual-power-plant opportunities, and distributed energy and customer trading models more broadly.
Footnotes
1 Klaus Schwab, 2020 Davos Manifesto, https://www.weforum.org/agenda/2019/12/davos-manifesto-2020-the-universal-purpose-of-acompany-in-the-fourth-industrial-revolution/ (last visited October 15, 2021).
2 "The Department of Homeland Security Issues Withhold Release Order on Silica-Based Products Made by Forced Labor in Xinjiang", U.S. Customs and Border Protection, https://www.cbp.gov/newsroom/national-media-release/department-homeland-security-issues-withholdrelease-order-silica (last visited October 17, 2021).
3 Solar Supply Chain Traceability Protocol, Solar Energy Industries Association, https://www.seia.org/research-resources/solar-supply-chaintraceability-protocol (last visited October 17, 2021).
4 "Powering a climate-neutral economy: Commission sets out plans for the energy system of the future and clean hydrogen", European Commission, July 8, 2020, https://ec.europa.eu/commission/presscorner/detail/en/ip_20_1259 (last visited October 17, 2021).
5 "Cooperation Mechanisms", European Commission, https://ec.europa.eu/energy/topics/renewable-energy/directive-targets-and-rules/ cooperation-mechanisms_en (last visited October 17, 2021).
6 Renewable Energy Statistics, Eurostat, https://ec.europa.eu/eurostat/statistics-explained/index.php?title=Renewable_energy_statistics (last visited October 17, 2021).
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