Damages Relating to Environmental, Social and Governance Issues

Environmental, social and governance (ESG) is a topic of increasing relevance and importance in the assessment of damages in international arbitration. These three issues together represent an organisation’s commitment to sustainability and corporate responsibility. This chapter considers the impact of these issues on damages, particularly the impacts on valuation from an investor’s point of view, as what investors are willing to pay for a business determines its value and there is increasing evidence that ESG focus by companies affects corporate value and investment returns.

So far the largest focus, given climate change concerns, is on E for environmental. This chapter therefore pays particular attention to the impact of environmental issues on damages. Specifically, this chapter explains some of the issues that arise relating to ESG when calculating damages.

As the chief financial officer of Ontario Teachers, one of the world’s largest pension funds, has explained: ‘Climate change and business valuations are inextricably linked. When determining the value of a business, one must consider all the risks and opportunities, of which climate change is one.’

We give an overview, below, of the relevance of ESG issues in a damages context and then discuss how ESG-related considerations may be reflected in the assessment of a damages award. First we explain how, in principle, the assessment of damages may incorporate relevant ESG issues, then we discuss the issue of the level of ESG-related disclosure that might be relied on in practice. Finally we discuss practical ways to consider ESG issues in line with the Accounting for Sustainability framework, which is described further below.

Relevance of ESG issues to damages

ESG issues, particularly environmental ones currently, can be germane to the assessment of damages in two primary ways. The first is a direct claim where the basis of the damage is itself related to ESG, while the second relates to claims in which ESG-related factors are relevant to the assessment of damages even though the issue in dispute is not directly related to ESG considerations.

Examples of the first category (i.e., cases in which the loss arises from breaches of environment-related matters) would be seeking compensation from a company that breached its environmental obligations either under national legislation or under a contract.

One of the highest-profile cases in this area, relevant to arbitration because it shows the overall direction of travel on climate-related claims, is the German litigation case Lliuya v. RWE, a German lawsuit filed in 2015. A Peruvian farmer is seeking damages from the German energy firm, RWE, to contribute towards enhanced measures of protection against potential flooding from a glacier melt-fed lake in Peru. The extra protection is necessary because of increased levels of melting, said to be the result of rising temperatures and other aspects of climate change. Despite the low amount claimed of €17,000, the consequences of the case are potentially enormous if the court finds RWE liable. At the time of writing, the case is expected to move forward again in the near future.

Another example of potential matters in which damages directly relate to ESG are claims against companies for misestimating, misstating or hiding environmental risks and issues facing companies, causing a loss of value for shareholders and possibly others relying on the misleading information, such as final customers.

The second way environmental issues are germane is in relation to claims that do not directly involve environment-related issues as the basis for the claim, but where, nevertheless, environment-related considerations may be material to the assessment of damages. For example, in an investor-state dispute relating to the expropriation of coal assets, the expropriation of those assets itself may not have been the consequence of any environment-related considerations but, nevertheless, those issues may be relevant to the valuation of the asset in question and, therefore, relevant to damages.

This chapter focuses primarily on this second category of damages claims and discusses the possible means by which valuation and damages experts may reflect ESG-related considerations in their assessment of damages.

How ESG-related issues may be reflected in damages assessments

Damages assessments often involve a valuation – be it of a distinct business entity, or of a cash flow stream of one specific project that is part of a broader business. A number of valuation methods can be applied and each can be categorised as within an income approach, a market approach, or a cost-based (or asset-based) approach. The following paragraphs discuss how ESG-related considerations might be reflected under each of the three valuation approaches.

Regardless of the approach that is applied, valuation is essentially a forward-looking exercise that should reflect future expected cash flows and risk as at the date of valuation. ESG-related risks and opportunities can affect the level and riskiness of the future cash flows of a business in a number of ways and, hence, can affect its valuation. The challenge in reflecting these ESG-related risks and opportunities in corporate valuations has historically been threefold: (1) a lack of information about the effects; (2) a lack of consistency in how information is presented; and (3) a lack of consistency in how such information is used for valuation impacts. However, there is a drive to improve in each of these, as discussed further below: ESG-related disclosure generally requiring further information about ESG impacts; the use of ESG ratings, which will improve consistency in how information is presented; and the Accounting for Sustainability framework as one approach to improve consistency in use for valuation.

Income approach

Under the income approach, future cash flows are explicitly forecast for a certain period or assumed to grow at some rate of growth into the future. These cash flows are discounted at a rate that reflects the return investors require to compensate them for the time value of money and for the risks attached to those future cash flows. Thus, the income approach (regardless of the specific method that is employed) consists of two broad components: cash flows and discount rate. Each of these may explicitly reflect certain ESG-related considerations.

First, cash flow forecasts may explicitly reflect expectations regarding a number of ESG-related value drivers. For example, demand may be affected by customer perceptions of the degree to which an organisation is perceived to comply with its ESG-related obligations, and businesses that are well regarded in this respect may be able to achieve premium pricing for their products. The cost side of the business may also be affected through increased costs of compliance with future regulations or in terms of expected changes in the price of certain inputs, such as fuels and energy. In practice, the development of requirements for climate-related financial disclosure will also facilitate the forecasting of these effects on cash flow.

Second, to the extent that the business faces ESG-related risks, these may also be reflected in the discount rate – particularly if those factors cannot be readily reflected in the cash flow forecasts. For example, for coal-fired power plants or coal mines, there may be specific risks that can be included in the cash flow or, if not, the discount rate may need to be adjusted to reflect increased risk perceived by investors in such assets. At the time of writing, there is no consensus within the valuation community as to whether or how such additional risks should be reflected in the assessment of the discount rate – for example, whether a capital asset pricing model approach should be modified to reflect an environmental risk premium and, if so, how such a premium should be estimated. However, there is strong empirical evidence that investors do in fact require additional returns for investing in certain assets owing to changes in the perceived level of risk of those assets. For example, research by the Oxford Institute for Energy Studies shows that institutional investors required an average hurdle rate of return of between 10 per cent and 11 per cent to invest in wind or solar assets, between 15 per cent and 21 per cent to invest in oil assets and 40 per cent to invest in coal assets.

Market approach

Under the market approach, rather than explicitly forecasting cash flows and calculating their net present value, transactions in comparable companies (be they transactions for shares in listed companies or shares in unlisted companies, or even prior transactions relating to the asset being valued) are used as a valuation benchmark. These prices are often scaled by reference to some metric (e.g., some measure of profit) to provide a relative value benchmark, referred to as a valuation ‘multiple’. To ensure that this approach appropriately reflects the ESG value drivers of the business being valued, the selections of comparators and of the appropriate valuation multiple are often important.

When selecting comparators it is important to consider the extent to which their value is affected by ESG-related factors and to compare that with the asset being valued. It may be relevant to consider factors such as geography and applicable regulation, product mix, level of emissions, and so on. As is the case with the application of the market approach more broadly, there may be no perfectly comparable company with respect to exposure to specific ESG-related value drivers but, in combination with other market data and the judgement and reasoning of the valuer, the multiples of such companies may, nevertheless, provide a useful reference point in the valuation.

With respect to the selection of the multiple, it is important to consider how ESG considerations are likely to affect the future cash flow prospects of the business (and, hence, the valuation). A commonly used multiple is EV/EBITDA. To evaluate whether this is appropriate for companies with significant ESG-related value drivers, we need to consider whether and how those value drivers are likely to be reflected in the chosen metric – in this case, EBITDA. For example, if the company being valued is likely to face a higher or lower level of taxation than the average for the industry in which it operates as the result of government ESG-related incentives, then (all else being equal) each dollar of EBITDA earned by the company being valued will equate to a different level of free cash flow than for the average company within that industry. In this case, using the industry EBITDA multiple may overstate or understate the relative value of the company being valued.

Cost approach

Finally, when applying the cost (or asset-based) approach, a company is valued by reference to the value of its constituent assets and liabilities…