Are physical and transition risks redefining commercial due diligence?
The evolving gamut of physical and transition risks from climate change can impact an investment at any and all stages of its lifecycle. Debt and equity markets alike have become alert to this fact, using tools such as negative screeners to help weed out exposure to climate-constrained investments and ensure portfolio alignment to broader sustainability goals. In fact, in 2022, global investment in low-carbon technologies hit US$1.1 trillion – matching fossil fuel investment for the first time.[1]
However, not all climate-constrained investments are so easily screened out. A typical commercial due diligence process considers the target’s market positioning, revenue model, and potential for growth. Whereas, today's investors and decision-makers must also evaluate these considerations in light of both the direct and immediate physical risks of climate change, such as extreme weather events, and the intricate web of long-term transition risks that emerge from shifting regulations, evolving technologies, and changing market preferences. Properly identifying these risks and assessing their impact on strategic and commercial deal hypotheses during the due diligence process can be an enormous undertaking, evidenced by the 50% year-on-year growth in content stored in due diligence data rooms, largely due to ESG inputs.[2]
It is clear the potential for post-transaction value erosion from unforeseen physical and/or transition risks is fundamentally changing the scope of a ‘typical’ commercial due diligence process. But unlike other investment risks, climate change is unique in its ability to impact both the downside and upside of an investment or exit. What this necessitates then, is expert climate intelligence and a pragmatic, sector-based approach that doesn't just avert the hazards but seizes opportunities for growth.
For those going to market for commercial due diligence in today's climate-constrained world, there are four capabilities to look for in addition to strategic commerciality assessments:
Sector expertise: The ability to identify sector-specific climate vulnerabilities is crucial for limiting value erosion. This takes more than desktop research. It requires deep sector knowledge and an ear to the ground to identify likely and potential headwinds and tailwinds that could materially impact a given opportunity.
Scenario analysis: Modelling realistic climate scenarios to gauge physical and transition impacts on an investment can be a challenging exercise, but one that is necessary to evaluate likely returns under a variety of possible outcomes. Embracing climate uncertainty through forward-thinking, quality scenario analysis is essential for maintaining objectivity in a transaction and positioning for potential upside.
Benchmarking capability: Competitive forces, regulatory requirements, voluntary commitments, and market preferences are evolving with, and shaping, the transition to net-zero. Evaluating a target’s ability to perform against these evolving metrics are benchmarking exercises best conducted by experts with the depth of data and reach in their networks to conduct more than a basic ‘tick and flick’ exercise.
Financial materiality assessments: Kicking the tires on investment hypotheses cannot be underestimated in an age of increased shareholder activism and publicly scrutinized investment decisions. This is where objective and authentic financial materiality assessments help; they are an imperative to unearth any red flags, biases, or unfounded assumptions that could jeopardise value, and reputation, if left un-tested.
The bedrock of quality climate-conscious commercial due diligence lies in uncovering opportunities that arise from sustainable practices, market transitions, and expertly integrated physical and transition risk considerations. It’s not just about knowing the scope of climate risk, it’s about knowing what questions to ask and how the answers will ultimately impact the bottom line.
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[1] Bloomberg New Energy Finance (2023)
[2] Nasdaq (2021)
