More private equity firms in Asia are placing a bigger emphasis on environmental risk in assessing mergers and acquisitions as climate-conscious investors are ratcheting up pressure while major governments in the region are accelerating their decarbonization efforts.

As China, Japan and South Korea recently pledged to go carbon neutral over the next three to four decades, and deal activity in the region's private equity sector has increased in recent years, experts say now is the window for Asian investors of unlisted companies or assets to catch up with other regions in responsible investing to minimize post-deal reputational risk.

"To date, [environmental, social and governance] has largely been the case for inbound investment from Europe and North America," Tim Power, an environmental and planning partner at White & Case law firm. "But it is becoming increasingly relevant for Japanese, Australian and South Korean investors."

Asia, one of the world's fastest-growing economic clusters and a low-cost manufacturing base for industries such as auto-related businesses, has become an attractive target location for private equity firms. However, a priority to boost economic development over protecting the environment as well as a relatively short history of ESG-related government regulations, especially in emerging economies, have made ESG-based investing more challenging in the region than in Europe and North America.

"Environmental issues are the biggest risk among ESG factors to avoid in pursuing a deal," Rokuro Hara, CEO at J-STAR Co. Ltd., a Japanese private equity firm, told S&P Global Market Intelligence. "Investors want to entrust money to a manager [at PEs] that has developed an ESG policy," and integrating ESG into deal assessments helps "increase the value of our investment," he added. The firm became a signatory of the United Nations-supported Principles for Responsible Investment, or PRI, in 2014.

The Asia-Pacific market for private equities has grown in recent years. Average annual deal value between 2016 and 2019 increased to $140 billion from $87 billion for the previous four-year period, in which the Greater China region accounted for about half of the volume, according to the Japan Private Equity Association, which cited a report by AVCJ, an information provider for Asian private equities.

Mixed preferences

The awareness of ESG, particularly the environmental element, will likely grow further in Asia. Recent pledges to achieve zero-net emissions in major countries may force industries such as utilities, automobile and steel makers in those countries to curb carbon dioxide emissions at a faster pace, which will likely affect private equity firms' M&A assessment or strategy, experts add.

J-Star’s Hara said he expects the emission goals will prompt consolidation of smaller businesses in Japan as they need to increase their economies of scale to fund the rising environmental costs. That could give J-Star a chance to acquire some of those smaller companies, he added.

However, Advantage Partners Inc., another Japanese private equity firm, might consider targets that are less weighed by environmental issues, such as digital or e-commerce companies, said Katsuya Baba, the chief administrative officer of the firm.

The firm, which signed up to the PRI in 2016, has recently made ESG assessment a part of due diligence for every deal. "We'll make an assessment of a risk and a [growth] opportunity [of a target] ... more clearly from an ESG perspective," Baba said.

In September, China President Xi Jinping told the United Nations that the world's second-largest economy aims at becoming a net-zero-emission society by 2060. Yoshihide Suga, Japan’s prime minister who took office in September, pledged to achieve a carbon neutrality by 2050 in his first address to the Diet on Oct. 26. South Korea joined Japan two days later, announcing that it aims to be carbon-neutral by the same date.

ESG in general is more important for private equity firms that take over the majority of a target than for asset management funds that own some shares in it, said Tamami Ota, a senior researcher at Daiwa Institute of Research Ltd. "[Private equity firms] tend to be involved in management [of the target] more deeply" than asset management companies, Ota added.

In Japan, nearly 40% of more than 20 buyout funds already have developed an ESG policy, while nearly 30% of them will do so in one to five years, according to a 2019 survey conducted by Preqin, a U.K.-based asset information provider. And nearly 60% of more than 50 private equities in the country also including venture capitalists cited requests from investors as the reason for developing an ESG policy, the survey showed.

"In Asia there is a greater diversity in levels of social and economic development, so due diligence approaches must be tailored to different situations and risks," said Hannes Valtonen, a compliance director at Baring Private Equity Asia.