The implications of climate change for M&A activity

The recent release of the Report of the Prime Ministerial Task Group on Emissions Trading and the Government’s announcement that it will largely implement the recommendations, along with the Federal Opposition’s focus on climate change issues demonstrates just how the climate change debate has gathered momentum in Australia over the past year.

The more progressive companies, of course, are already beginning to consider not only the potential risks but also the potential opportunities, which the imposition of a ‘cap and trade’ carbon pricing regime proposed post-2012 may create. Several of those opportunities are likely to present themselves in the listed company M&A arena.

Recently, environmental issues have already taken centre stage in two major M&A transactions in North America—the $US45 billion leveraged buyout (LBO) of TXU, the large Texas power utility, and Rio’s $US38 billion recommended offer for Alcan, the Canadian aluminium producer.

The TXU LBO

TXU had faced sustained opposition from environmental groups over its proposal to construct 11 new coal-fired power stations to feed the strong economic growth in Texas. The LBO proposal, brokered by Goldman Sachs (which is rapidly establishing itself as the most ‘green-aware’ of the major global investment banks), saw a comprehensive environmental settlement which included withdrawing plans for eight of TXU’s coal-fired stations, with their likely replacement to be nuclear generation capacity. TXU also pledged to support a mandatory ‘cap and trade’ program to regulate carbon emissions.

Environmental Defense was the key environmental group involved and retained its own financial counsel to ensure that the interests of its constituency were appropriately protected.

Rio’s bid for Alcan

In mid-July Rio announced its recommended offer for Alcan, trumping Alcoa’s original offer by almost one third and resulting in Alcoa withdrawing its offer.

Rio has acknowledged that one of the key drivers of the transaction is ’Alcan’s excellent hydro power position’, being that Alcan generates a significant proportion of the energy required for its smelters from hydro sources. Electricity is a key input in the energy intensive manufacture of aluminium and the reliance on hydro power reduces carbon emissions from production. This complements Rio’s climate change and energy strategy which designed to position Rio for a carbon constrained future.

Thus, the relative carbon efficiency of Alcan’s assets made it an attractive target and increased shareholder wealth by attracting a 66 per cent premium. One possible explanation for Rio being prepared to offer a substantial premium above Alcoa’s offer price might be that Rio took a more bullish view on future carbon prices, which increased Rio’s valuation of Alcan’s assets.

The implications for Australian M&A

In Australia, the Prime Minister’s Task Group on Emissions Trading has observed that international progress towards a post-Kyoto protocol has been slow, and that ‘on balance’ there would be benefits to the government now settling a post-2012 constraining on emissions—although at this stage it is difficult to predict the magnitude of the impost on the local economy. Based on the European experience, we would expect that the primary emitting industries will initially bear the brunt, particularly power generation, transportation (including airlines) and logistics, and some refining and manufacturing. However, some element of ‘trickle down’ effect is inevitable, given how intrinsic each of these processes is to other major industries.

Thus we do expect to see climate change both affecting and driving M&A activity in Australia well in advance of 2012, in a number of ways:

• Assessing the carbon deficit position of an acquisition target—particularly in ’net emitting’ industries such as those listed above—is likely to become a key due diligence issue for acquirers in the short to medium term
• Likewise, potential targets will need to understand their own carbon footprint and investigate ways that they can efficiently respond to minimise that footprint, whether by improving the efficiency of their processes or purchasing offsets, and
• Affecting valuations—management will need to consider how its response to climate change affects the value of the business it runs and what exposure to a bid or opportunities for an acquisition this creates.

Disclosure issues are also likely to come to the fore in bid and fundraising documentation. In this respect, it is interesting to note that the US Global Warming Reduction Act 2007 (also known as the Kerry-Snowe Bill), if passed, would explicitly require issuers of securities under the Securities Exchange Act 1934 to disclose risks related to climate change. In Australia, specific legislation is probably not required to achieve that result—when one considers the broad disclosure tests for bid documents and prospectuses under the Corporations Act, meaningful disclosure on climate change impacts is likely to be required if those impacts are material. This is an issue which will need to be even more carefully considered now that the government has effectively thrown its support behind carbon pricing through an emissions trading regime, which will be underpinned by the recently announced carbon auditing and reporting regime.

What does all this mean for M&A activity in Australia? In the short term, pricing distortions in the capital markets may be a real possibility, as analysts struggle to modify their valuations to take account of what might be a substantial contingent liability or, potentially, asset, for listed companies. The astute will no doubt see this as an opportunity to either restructure or refocus their own operations, or potentially look to acquire or be acquired by third parties.

For example, integration is a frequently mooted possibility: in particular the idea that mining and power companies will diversify into clean energy generation (including nuclear), or acquire forestry or like assets generating carbon credits to offset their carbon deficits in an efficient manner. Other restructuring may also be warranted to improve transparency and thereby maximise valuations—for example, by housing carbon emitting and carbon neutral or credit producing operations in separate stapled holding vehicles.

At least for the moment, we are largely in the realm of speculation. But that position is clearly set to evolve very quickly as Australia develops its detailed framework for an emissions trading scheme and companies formulate their responses.

Key points

• Climate change economics are already beginning to influence M&A activity globally
• The release of the report of the Prime Minister’s Task Group on Emissions Trading and the government’s response emphasises that there will be both risks and opportunities for M&A activity in Australia, and
• Opportunities may lie in either acquisitions or internal restructures aimed at maximising valuations.

This article was written by Justin Mannolini, Partner and Paul Branston, Senior Associate, of the Perth Corporate team.