Net-Zero Transition: An Inconvenient Truth About Carbon Asset Divestment

When oil majors started to exit the Niger Delta, one of the most polluted areas in the world, it became a cause of celebration. It ostensibly showed that companies such as Shell, Eni, ExxonMobil, and TotalEnergies were making progress towards low-carbon operations in line with their lofty net-zero plans and targets. What followed, however, was rather disappointing: as local companies gradually took over Nigeria’s oil production, the region experienced growing production, a dramatic increase in flaring and unattended oil spills, which translated into more greenhouse gas emissions (GHG) and more harm to the climate and broader environment.

Divestments of their carbon-intensive assets (such as oil, gas, and coal) help divesting companies to claim progress towards environmental goals, for example, by hitting their net-zero targets and reducing their emissions, whether or not the transactions have this specific goal in mind. Yet, buyers usually have less commitment to environmental goals and operate under less climate action pressure and transparency, as in the case of the local producers in the Niger Delta. In our new paper, we zoom in on such divestments and evaluate their legal and economic implications.

As alarm bells ring louder regarding climate change, firms are increasingly coming under pressure to reduce their GHG emissions by investors, stakeholders, and regulators, with many firms relatedly adopting net-zero transition plans and targets. Much has been said about the credibility of these targets, and rightly so. We further highlight that any achievement claimed towards such plans and targets might not translate into a real positive impact on the climate when divestments are the sources of this achievement. The danger is twofold: (i) divested assets might operate as before under new owners, making emissions reduction reported by divesting firms illusory and misleading and (ii) worse, such assets can be operated in a way that causes more emissions as new owners are more likely to be inattentive to climate goals and untransparent.

This danger is underlined by the economics of M&A transactions. Climate action creates a new transactional surplus for highly emitting assets to switch owners. Firms and their investors might arrive at different valuations of such assets as they differ in their opinion on at which pace and under which conditions the net-zero transition will occur. Those not expecting a swift and sharp transition should value those assets more and have incentives to acquire them. More importantly, perhaps, different ecosystems firms find themselves in regarding climate action pressure also create different valuations of highly polluting assets for a transaction to take place. For firms under pressure to take climate action from their investors, stakeholders, or regulators, holding highly emitting assets will be costly, reducing their value for such firms. In contrast, for firms that are relatively immune to this pressure, there will not be a similar cost element, and they will value such assets higher and have the incentive to acquire them. Therefore, equilibrium outcomes would involve highly emitting assets passing to owners that do not expect a swift net-zero transition or, more importantly, to those that operate in a more comfortable ecosystem in terms of climate action and, therefore, can be expected to be non-committal to climate goals. This might lead to higher emissions associated with the asset.

Based on the theory we present in our paper, we contend that assets might switch to privately held parties and state-owned entities. These owners face little to no investor pressure, are less likely to be targeted by stakeholders and can be (wrongly) omitted by regulators from their interventions (such as climate-related disclosure rules and mandatory adoption of net-zero transition plans and targets). Transactions between publicly held parties should not be, however, without concern as some publicly held players might still face less investor pressure, for example, when they are small-cap or have controlling shareholders. Alternatively, they might be local producers with different investor bases and social/regulatory expectations.

Indeed, emerging empirical and anecdotal evidence and reports from industry participants and stakeholders confirm these concerns. Our look at the transactional characteristics post the Paris Agreement also indicates that transactions in which private players are acquirers and publicly held parties are sellers make up the biggest share of the transaction universe (in number but not in value). The list of frequent acquirers also features many private companies, while they are not among frequent sellers.

In a recent case, a Singaporean-listed company, Sembcorp Industries, sold its Indian coal power plants to a private consortium to cut its GHG emissions and avoid triggering paying higher interest payments on its sustainability-linked debts. This suggests that while market pressure might green some firms, the emission reduction might not be real when achieved through such divestments.

We see a role for regulators and private ordering in ensuring a framework where M&A transactions of carbon-intensive assets do not hamper climate goals. Such transactions can also be efficiency-driven rather than based on a surplus created by climate action-driven differences. Therefore, an important task is to separate those transactions from those that can undermine climate-action-related goals.

This perspective precludes the option of a ban on these transactions, but regulators can be given the power of vetting certain transactions in terms of their alignment with climate goals, and they might require some climate standards to be complied with by transacting parties. Regulators should also remove arbitrage opportunities where some firms are under less pressure to decarbonise and thus have incentives to acquire highly polluting assets. This is especially true with climate-related disclosure rules that have traditionally applied only to publicly held companies in the EU and the UK, which is now being remedied by extending the scope of these rules to some private companies. In all likelihood, this parity will, however, not be the case in the US if and when the proposed SEC rules are implemented.

Private ordering options are also important. Such transactions are not in the interest of climate-conscious investors even though the transaction can be value-maximizing for the investee firm. For such investors, overall climate impact can be important for financial reasons or due to their non-financial preferences. Thus, they might oppose transactions whereby highly emitting assets switch to owners likely to be non-committal to climate-action-related goals, especially privately held parties and state-owned enterprises. These investors have various tools to express their ‘voice’: voting on M&A transactions, say on firms’ net-zero transition plans, private engagements, and taking positions in relevant activist hedge fund campaigns.

Another important tool is to utilise deal terms. The idea is to put covenants or other provisions in the contract to bind new owners to climate-related goals and standards. For example, if the seller is committed to net zero by a certain date, the buyer is required to do the same. Or, other climate-beneficial commitments in terms of how new owners handle the acquired assets can come into question (disclosing emissions, reducing flaring, plugging inactive wells etc). The usefulness of such covenants is that they eliminate the transactional surplus when it stems from the ability or willingness of the buyer to exploit the acquired assets fully or to engage in more climate-harmful activities. This prevents such-surplus-dependent transactions while not affecting otherwise efficiency-driven transactions (where buyers have incentives to acquire assets not to benefit from climate-action-related arbitrage but rather have some real efficiency sources). We, however, see some enforcement problems with such deal terms, especially relating to specific performance and penalty clauses. Nevertheless, private enforcement can be supported by reputational issues and complemented by regulatory powers.

In conclusion, as we accelerate the climate transition, it is important to ensure that divestments of carbon-intensive assets do not lull us into a false sense of security or, worse, hamper climate goals.

Wolf-Georg Ringe is Professor of Law and Finance and Director of the Institute of Law & Economics at the University of Hamburg, and Visiting Professor at the University of Oxford.

Alperen A Gözlügöl is Assistant Professor at the Law & Finance cluster of the Leibniz Institute for Financial Research SAFE.

This post was first published on the ECGI blog and can be accessed here.