10 key trends in transition M&A

Financial investors are discovering the difficulty of assessing and reporting on the (often varied) ESG characteristics and impact of their investments.

Broader trends within private capital are now intersecting with the energy transition.

An increased prevalence of more complex instruments and a wider array of capital providers making investments in energy and infrastructure assets, says Freshfields Partner James Chapman, who advises on energy transition investment. 'With higher interest rates and a glut of dry powder, fund managers are needing to find more niche, interesting and risky opportunities to deploy their capital. This often fits the energy transition profile well alongside the ESG-positive nature of these targets.'

Limited partner (LP) and general partner (GP) consolidation has been particularly noteworthy in the energy and infrastructure space (for example, the recent Blackrock/GIP, General Atlantic/Actis and CVC/DIF buy-outs).

Investment management in this sector is seen as such a significant investment opportunity due to the step up in assets and deal volumes, James adds. 'We anticipate further deal flow in this space to reflect the increased interest in both transactions in, and management of, these assets by non-strategics.'

As reported in Infrastructure Investor's December 2023/January 2024 issue, energy transition is the fastest-growing segment of infrastructure investing, likely to be ‘become as big as the rest of infrastructure over the medium term.’

Governments have recognised the need for the private sector to take an appropriate role in funding the energy transition, James says. 'National balance sheets cannot support the sheer amount of direct capital investment required, and the private sector has proven repeatedly its ability to drive value which can be harnessed by appropriate government action.'

The public sector has, by now, established a keener sense of what is required to attract M&A investment (including from foreign sources). The increased reliability of cashflows from energy assets reliant upon government support has continued to drive the increased private sector investment into these critical assets and businesses.

To support this deployment of private capital into the energy transition, the EU, UK, US and others have rolled out a variety of legislative and policy programmes. The Inflation Reduction Act is the most significant climate legislation in US history and looks to incentivise clean energy through tax reductions and funding incentives.

State support is not new and has long underpinned renewable projects in the UK and Europe. However, the EU and UK, in addition to industry-level environmental and climate regimes around emission reductions and eco-design, are now looking beyond tax incentives and financial support mechanisms to drive investment into the energy transition.

Through a range of ambitious anti-greenwashing and transparency rules, the EU seeks to empower investors and funds to target and deploy capital into more sustainable businesses and projects.

The EU’s Green Deal, which, has given rise to the Sustainable Finance Disclosure Regulation (SFDR), EU Taxonomy and Corporate Sustainability Reporting Directive (CSRD) is forcing investors, financial institutions and corporates to consider and report on the ESG risks and opportunities associated with their businesses and investment products.

This, coupled with ESG benchmarking rules and net zero commitments, signals a clear shift in corporate strategy and investment focus. Energy transition is at the heart of this, and these regulatory developments have played a significant role in accelerating the growth of dedicated impact and green investment funds.

Crucially to remain within the guardrails of these sustainable finance regimes, funds now need to thread the needle for what constitutes ‘sustainable investments’ and be mindful of sometimes-complex ESG rules.

Financial investors are discovering the difficulty of assessing and reporting on the (often varied) ESG characteristics and impact of their investments, says Freshfields Partner and head of the firm’s energy and natural resources practice in Asia Philip Morgan.

'The ESG profile of any business has always been difficult to evaluate across multiple criteria, but the increased complexity and nuance in understanding the wide range of ESG factors, together with a variety of new legislation, has made this more difficult, and can make M&A processes more costly and time-consuming,' Philip adds. 'That said, aligning a project or business with one of the regulatory categorisations – for example, EU taxonomy-aligned or meeting an impact fund’s SFDR Art. 9 criteria – could potentially add real value.'

This is proving far from straightforward. Even for projects which are seen as environmentally beneficial overall, there are often ESG complications.

Green hydrogen projects, for example, have a significant land footprint (for renewable energy supply and the production facilities) and water footprint (including potentially desalination facilities) which, depending on where they are located, could increase pressure on scarce land and water resources.

Ammonia, currently seen as the most likely vector for long-distance hydrogen transport, can be environmentally damaging. There are concerns that parts of the solar panel supply chain may involve unethical employment practices, and that in some cases fossil fuels remain the mainstay power source for the manufacturing of key components of clean energy technologies, such as wind turbines.

While these kinds of complexities are inherent to any large-scale business, the focus of the EU rules on ‘good governance’ and ‘do no significant harm’ is leading to increased scrutiny from LP/shareholders, the wider stakeholder community, and potential future purchasers. Managing these complexities will inevitably introduce friction to the M&A process.