The COP26 summit aimed to find an agreement that will deliver a maximum temperature rise of 1.5C and to conclude negotiations on the rules of the Paris Agreement.
While the 2015 Paris Agreement set two global goals, limiting temperature rise to well below 2C and striving to limit it to 1.5C, the individual country pledges added up to around 2.7C warming.
Pledges made by individual countries will translate into governance (law and policy) that businesses will need to adopt to achieve net zero by 2050.
This may affect the private equity sector’s ability to achieve a return in the future. It is crucial that all business models align their interests with the goals of COP26 in a shared and collective ideology.
The post-COP26 regulatory framework will affect businesses in different ways depending on their sector and strategic positioning. The decisions taken at the summit may end up making some sectors unviable and reduce the profitability of others, while significantly improving the outlook for sustainable companies.
Many investment managers have already taken significant steps to integrate sustainability issues into their investing criteria to reflect changed regulatory requirements and net-zero targets, as well as consumer demand, but COP26 will require a review and adjustment.
Effect on M&A insurance and due diligence process
The application of warranty and indemnity (W&I) insurance to the private equity model is well established and universally relied upon to enable deals to be done.
Environmental impairment liability (EIL) is usually excluded from general liability insurance, so the due diligence process should look at both the historical risks as well as the future risks that COP26 policy decisions may create for a target company.
This is particularly necessary because most companies in manufacturing, logistics or regulated industries outside the US don’t buy environmental impairment liability insurance. Instead, the majority of environmental impairment insurance is purchased by lenders and asset owners/funders to protect their investments.
Acquirers usually have limited knowledge of historical site activities because pollution didn’t have the same importance and level of regulatory scrutiny in the past as it does now. Past incidents are therefore likely to not have been documented appropriately.
Uncertainty surrounding historical events increases the more time passes, and acquirers and investors may want to reduce this risk before agreeing to a deal. Acquirers may face costs related to historical pollution linked to activities on the company’s property, on third-party land and during transportation.
Among the costs the new owner may face are cleaning up, third-party bodily injury and property damage, as well as legal defence resulting from pollution.
This will require protection against environmental risks for historical pollution events excluding time limitation and limitation of specific stipulations on how pollution has occurred and developed, and include protection against changes in law. Historical environmental risks can cause significant costs in the future, particularly as regulation becomes stricter.
Rapid legal change may represent a significant threat to the bottom line for businesses, and insurance, in all its guises, is the mechanism to transfer exposure and protect the entity.
The insurance industry has the ability to assess and transfer the unexpected outcomes that may impact companies, property and the planet in general.
If the scope of representations and warranties is widened to account for changes of law, reporting obligation and stakeholder risk private equity insurance for W&I insurance should include these increased exposures.
The fact that pollution is excluded from most M&A/W&I insurance placements magnifies the importance of EIL insurance to protect the past, present and future liabilities for private equity firms.
Such insurance policies would usually be requested by the buyer/investor as they would otherwise be taking over potential environmental liability exposures. However, it is also possible that a seller may want such protection – for example, to make the company more attractive to potential acquirers, to banks or lenders or to property developers.
James Alexander, environmental practice leader
If you have any questions about professional indemnity insurance, please contact your Lockton account manager for further advice or email ACCAaccountants@uk.lockton.com.
Lockton is ACCA’s recommended broker for professional indemnity insurance