Buyer Beware: EHS Due Diligence Is More Important Than Ever

Paul Kau

Director/Senior Environmental Scientist

Bridget Mainland

Associate, Senior Environmental Scientist

With every merger and acquisition (M&A) deal comes a range of potentially significant risks. You don’t want to unnecessarily pay more for an asset than it’s worth, and you certainly don’t want expensive surprises or obstacles once you’ve already signed on the bottom line. That’s why it’s essential to understand, as fully as possible, just what you’re getting into.

Although the size of the portfolio and the bid deadline are likely to dictate the approach to due diligence, the best results will come from getting a formal due diligence process under way as soon as possible, and with expert support.

There’s much to explore in a due diligence process, but it’s crucial that the scope and complexity of the task don’t lead to a superficial approach. Good due diligence means going beyond the checklist and digging deep on issues that really matter within the limited time available.

Among the range of issues that should be considered in the due diligence process, it’s vital that risks to environment, health and safety (EHS) are high on the agenda from the very beginning. These could be legacy issues (such as soil contamination), current challenges (such as elevated rates of lost-time injuries), or areas of potential future risks (such as exposure to climate impacts or changes in regulations or Best Available Techniques (BAT)).

If the deal is a big one, the level of risk or impact associated with each of the aspects considered in the due diligence process is often large as well. However, the reverse doesn’t hold true when it comes to EHS: small deals don’t necessarily mean lower EHS risks! In fact, smaller deals that comprise minor industries or small production sites can have significant risks, particularly if such assets have not been subject to regular oversight of public authority, have not invested adequately in EHS, or have not had the internal competence to manage their EHS risks over time.

Whatever the size of the deal, not investigating or understanding EHS risks can have major consequences for current and future regulatory compliance and scrutiny, community safety and acceptance, corporate reputation and culture, and business management and operations.

Here are four recommendations to help you better manage risk and avoid liability surprises:

1. Think about environment, health and safety upfront

How will you determine if there are EHS risks, and how much time or expense will be required for mitigation?

It’s important that potential EHS risks are clearly put on the radar of the corporate due diligence team. What EHS information should be requested from the seller and/or examined from the public domain (while also understanding that this may vary significantly from country to country)?

A site inspection is extremely valuable. Although company documentation may tell you what the company or operation aims to do, it’s only by getting your feet on the site and expert eyes on the operation that you can glean genuine insights into actual conditions and practices.

If soil or groundwater contamination concerns, issues or incidents are identified early in the due diligence process, some level of sampling may be possible within the standard due diligence timeframe. Even a preliminary level of investigation can help to support or disprove a hunch or put some boundaries on potential liability.

It’s also worth noting that EHS issues may live far longer than even the smartest indemnification clause, which usually terminates after a maximum of five years. And what about the risks you may not yet have identified? In the case of as-yet-undiscovered asbestos, for example, the deal might not be taking important future risks into account, such as necessary abatement programs or the costly obligation to retire the asset, not to mention the risk of group claims by workers who may have been exposed.

2. Consider risks from multiple perspectives

It’s essential to think about EHS liability from a range of perspectives. Although it’s important to estimate cost in terms of CAPEX/OPEX to make the problems go away, cost is certainly not the only factor in play. What impacts can be expected on your local community and environment, your organisation’s brand and reputation, and on future growth or market value?

For example, an acquisition of a pharmaceutical factory may affect company reputation if it’s perceived – correctly or incorrectly – to impact local human health or ecology, even if the factory is fully compliant within its jurisdiction. An acquisition based on an expectation of increasing production capacity may be curtailed when it’s realised that the factory is located in a groundwater-source zone that prohibits future production growth.

What about a brownfield acquisition based on fast-turnaround remediation and residential development? If permitting and clean-up are likely to be protracted, the deal could run into significant delays and disruptions resulting in a loss of market value – and the stigma could even reduce revenue streams for decades.

Assessment of such risks can sometimes be highly location-specific, so it’s extremely important to seek guidance from a local professional to inform your decision-making, rather than relying on universal wisdom.

3. Be pragmatic and keep everything in proportion

Ultimately, not all risks can be foreseen or avoided, despite the most extensive due diligence process. A level of risk acceptance is necessary for any venture. There’s a balance to be found here between caution and confidence, so that uncertainty and risk aversion don’t lead to an overly conservative bidding strategy that might jeopardise the deal.

A pragmatic approach weighs both severity and probability. For instance, to what extent is it reasonable to proactively resolve something that is highly unlikely to occur and very expensive to manage? What is the risk of delaying that action? What is your materiality threshold?

If certain risks cannot be quantified before closing the deal, then ring-fencing them with post-deal mechanisms may be an alternative solution. It may be that the seller of the asset is already aware of (or has even acted on) the issues and could more cost-effectively mitigate the risks. Mechanisms such as escrows, warranties or indemnities would allow the seller more time to resolve such issues before handing over the assets to the buyer.

To put the EHS issues in proportion and to support the financial decision processes, seek an expert EHS risk assessment that sets out the associated costs as well as the timing of those costs. Only then can the financial allocations of the mitigation costs be estimated based on known industry conditions and benchmarks.

4. Anticipate climate-related obligations and exposure

Undoubtedly, over the coming decades, climate change will pose one of the most important threats to business sustainability and continuity. Business models will need to be transformed, not only to minimise negative environmental impacts, but also to prepare for and cope with changes in environmental conditions. Typical impacts include changing temperature patterns, altered water availability or scarcity, more frequent and intense storms and flooding, and/or the effect of these phenomena on the supply chain. An early understanding of a target asset’s vulnerability to such risks and the asset’s level of preparedness will help to manage the risk as well as to communicate a strong message about a firm’s culture and commitment to sustainability.

For M&A involving financial institutions, consideration of the practice guidelines of the G20-sponsored Taskforce on Climate-Related Financial Disclosures may be useful for assessing climate-related risks.

For any M&A deal, it’s always prudent to know your risks upfront and to build the bid, sale and purchase agreement and business/investment strategy so that they can adapt to potential risks and opportunities. Coming to terms with your EHS risks through due diligence is a crucial activity on the journey towards closing the deal well – and, as we strive towards a safer and more sustainable future, it has never been more important.

Paul Kau

Director/Senior Environmental Scientist

Bridget Mainland

Associate, Senior Environmental Scientist

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