At one level, portfolio construction can be thought of as like mixing colours. A portfolio which is half in a riskless asset and half in a risky asset, has attributes between the two classes. Thinking about adding up beams of light (not subtracting light in the way that pigments do in paint), red/brown light plus green light gives you yellow light. Further addition of blue light would make the overall white (one-third each; red, blue and green).
This mixing process is possible for stocks too, e.g. with half your fund in high or low dividends, or half in high or low systematic risk (stock market beta). Whilst investors can buy or sell small fractions of their investments, they will adapt the characteristics of their stock portfolio in many different ways. Now that investors monitor the carbon intensity of their holdings, if they collectively care about and scrutinise these factors, carbon metrics will be used for inclusion/exclusion decisions. We are already seeing such trades and adjustments affect stock prices for green (solar, wind) and brown (fossil fuel) investments.
However, the financial sector has not always aggregated risk factors well. The 2008 great financial crisis was partially attributable to over-lending and under-reporting of risk in the property sector. Additionally, some financial investments were repackaged and rebranded as lower risk through inappropriate formation of financial securities; factors which caused a crash sell off once they eventually came to light. Therefore, it is important not to repeat these errors in the current context of climate monitoring. The reporting system is focussing in on firms‘ Environmental, Social and Governance metrics, ESG, and how firms perform across the different pillars that support their activities.5
Within finance, some are tracking the component dimensions within ESG scores to see how a company is affecting the environment whilst others are tracking how sensitive a firm is to the physical environment. This means that the metrics will be contested and will differ if used in one direction or the other (a firm might make itself resilient to climate change but still emit a lot or another firm might be vulnerable to climate change even whilst not contributing to it with its own emissions). Either way the debate has moved to discussing and using metrics which are becoming part of the tools used in all financial discussions.
So how do these arguments affect M&A?
Firstly, about half of global business occurs in private and non-listed firms, either because they are smaller and not able to attain a listing or because as family-owned, they have no desire to become publicly listed. This means that many of the arguments above could bypass private and small firms. It is true that these firms often need debt or even trade financing from banks, but the bank monitoring and lending process may be weaker in the TCFD dimension for these firms than for larger listed firms.
However, these firms need M&A services, and a wide range of specialist or boutique firms cater to the need of private and family companies to find new growth and acquisition targets or divestitures as part of their strategic plan. Given that strategies will be increasingly driven by ESG motives and metrics, the M&A search, target, due diligence and execution processes can play a valuable part in sharpening the ESG outcomes in an economy.