By Paul Davies, Richard Butterwick, Terry Charalambous, and Catherine Campbell

In recent years, China has taken significant steps in developing its environmental policy. In 2014, China’s Premier Li Keqiang declared a “war on pollution”, which began in earnest in 2017. Since then, regulators have been more proactive in enforcing environmental regulations. Factory closures have become a key part of this strategy, causing significant disruption to the global supply chain this year.

In our view, M&A dealmakers and corporates should carefully consider environmental and supply chain due diligence in China, as companies work out how to navigate the factory shutdown process. Corporates should, as part of their environmental, social, and governance (ESG) strategy, review whether their group entities and target companies are likely to be affected in the event that critical supply chains are broken. Engagement with environmental agencies in China is useful, but environmental policy and consistent regulatory enforcement are still maturing. The appropriate level of due diligence could prove to be critical to a company’s ongoing operations.

Supply Chain Issues and ESG Strategies Are Changing

Supply chain issues are increasingly complex, spanning multiple jurisdictions. Unsurprisingly, companies are expected more than ever to understand and manage these risks. Until recently, ESG risk management has focused on corporates and their groups rather than on the broader supply chains. This focus is changing. There are good business reasons, including significant financial benefits, for companies to manage these risks more effectively.

Factory Closures Impact Portfolio Company Supply Chains

Some of the largest environmental crackdowns in Chinese history have occurred in the past few years. Estimates suggest that about 40% of the country’s factories were forced to shut down at some point in 2017, and as many as 70,000 factories were reportedly shut down in the provinces of Hebei, Henan, and Shandong alone.

Factory closures have become an increasing source of frustration and concern for multinational companies this year. Many companies have a supply chain connection into China and are likely to be adversely impacted by the closure programme. Companies may not have full control over small but crucial elements of their supply chain, making closures a difficult problem to address.

Enforcement from China’s environmental agencies shows little sign of slowing. In many cases, companies receive little or no warning of factory shutdowns, while entire industrial parks have been closed based on the bad behaviour of one operator. Furthermore, environmental agencies are often unwilling or unable to give a clear time frame for how long a factory or industrial park will be closed. The immediate impact of closures can leave companies with no time to form a contingency plan, and the decisions taken by environmental agencies pose significant challenges for deal teams.

M&A Deal Teams Should Identify and Mitigate Chinese Environmental and Supply Chain Risks

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Firms operating in China or reliant on Chinese supply chains cannot eliminate the risk and unpredictability of regulatory shutdowns, but they can reduce and mitigate the effects by taking proactive measures.

Dealmakers and companies should be attuned to the regulatory environment and local regulators’ policy directives. Compliance with current regulations is not enough — firms need to “see where the ball is going” in order to anticipate the regulators’ next area of focus. Companies must identify and engage competent local counsel who are familiar with the regional personnel and the local regulator’s practices. This is because local priorities and the local regulators’ discretion drive so much of the uncertainty in enforcement activity in China. Relationships and local familiarity can prove critical in preparing for, and responding to, enforcement actions.

Further, detailed supply chain due diligence is increasingly important. While target environmental due diligence is commonly undertaken, in our view, conducting thorough due diligence on supply chains could help limit exposure to supply chain risk. Dealmakers should look beyond the company itself, tracing key third-party suppliers and partners to see if they are likely to be at risk from government enforcement. A shutdown anywhere in the supply chain can significantly impact production and profitability.