As merger-and-acquisition activities increase in the midstream energy sector, managers are finding that environmental liabilities can be significant. Purchasers' risks can include remedial obligations and compliance risks that should be quantified.

Customary due-diligence approaches used in other industries are not relevant or practical due to the unique nature of midstream assets and the associated multiple regulatory frameworks. Therefore, it is important, as well as prudent, that midstream operators be aware of—and consider—several critical elements to achieve successful environmental due diligence for soil, water, waste and air compliance. These critical due-diligence elements include:

• Deal structure

• Confidentiality and cooperation

• Regulatory compliance

• Pollution liability

• Estimated liability

• Asset list and asset profile

• Purchase and sale agreement

• Allocated risks

• Consultants

Challenges

Due-diligence timeframes are often short, unscheduled and unpredictable, adding significant demands to key environmental staff. Also, company staff and consultants are most likely subject to the terms of a confidentiality agreement (CA), further restricting when, where and how asset information is disclosed or discovered.

Regulatory frameworks and jurisdictions can have a significant impact on future costs for environmental compliance and remediation. Current and future permit requirements can restrict proposed expansions and adversely affect the commercial viability of the asset. Unless otherwise negotiated, the typical purchase and sale agreement (PSA) allows only for visual inspection of assets and records, and restricts any intrusive investigation (like sampling of soil, water, waste, air emissions or bulk media) prior to the final bidding process.

Additionally, the assets can encompass many miles of gathering pipelines and scores of gas-processing plants, compressor stations, drip stations, metering stations or other facilities in multiple states or regions. Without a good asset list, vacant parcels or idle, abandoned and dismantled facilities might easily be overlooked by both buyer and seller.

Deal structure

The due-diligence process and strategy will be dictated (in part) by the structure of the proposed deal. For example, an exclusive offering is typically kept highly confidential, where a bid process will be known to several competitors, or can even be announced in the public domain. A company acquisition will typically be an all-or-nothing, as-is, where-is offering, which can include all historic liability, where an asset acquisition can present an opportunity to carve out non-operational or other high-risk assets. An internal drop-down or financial deal can present other opportunities to allocate risk, including purchase-price negotiations, indemnities or insurance.

Additionally, the risk tolerance of the buyer can be affected by the value of the transaction. For example, a $100,000 liability might be defined by the buyer as material in a $1-million transaction, but would not meet the materiality threshold in a $10-million transaction.

Confidentiality and cooperation

In any deal structure, a CA will likely restrict when, where and how information is disclosed or discovered. Virtual data rooms, usually sponsored by the investment bank on behalf of the seller, or in–house data rooms, usually sponsored directly by the seller, have become the preferred technology for the controlled release of confidential and non-confidential information. Whatever method is used, the quality and quantity of the data room documentation is controlled by the seller. If adequate environmental documentation is not provided in a timely manner, the buyer might be compelled to look outside the data room. In these cases, care should be taken to comply with the CA and the due-diligence objectives.

Many environmental agencies provide online databases and scanned documentation that can be accessed without a breach of confidentiality. On the other hand, a freedom-of-information (FOI) request or agency file-room review can inadvertently trigger such a breach. Additionally, agency interviews or FOI requests can trigger updated regulatory scrutiny into the site files that have been requested. For these reasons an FOI request cannot always be in the best interest of the parties. The parties should recognize that potential confidentiality issues can be avoided if the seller takes care to fully populate the data room in a timely manner to allow for proper due diligence.

Regulatory compliance

The key environmental laws governing soil, water, waste and air compliance issues for the typical midstream gathering system are the federal Clean Air Act (CAA), the Clean Water Act (CWA) and the Resource Conservation and Recovery Act (RCRA).

In most states, primacy for enforcement and compliance with the acts is with a state Department of Environmental Quality (DEQ), provided the agency meets or exceeds federal standards. In addition, most states have an oil and gas agency or commission that can enforce differing RCRA standards based, in part, on an EPA exemption for oil and gas exploration and production (E&P) wastes.

Exempted E&P waste can be generated from the wellhead facilities, gathering pipelines, gathering compressor stations and gas-processing plants all the way to the point of delivery of pipeline quality gas (typically the discharge meter at the gas-processing plant).

Some examples of wastes that might not be E&P exempt include used lube oil, typically found at most gathering compressor stations, and mercury, lab wastes and polychlorinated biphenyls (PCBs), sometimes associated with historic midstream facilities or pipelines.

Numerous additional rules apply when mixing exempt and non-exempt waste streams. The final waste classification depends on the characteristics of the resulting mixture. For these and several other beneficial reasons, midstream personnel should take care to properly segregate, manage and dispose of E&P exempt waste.

Examples of E&P exempt waste liabilities that a well-executed midstream due diligence will capture include an evaluation of the waste-handling infrastructure (e.g. skids, drains, sumps, slop tanks, leach-fields), the regulatory drivers for infrastructure modifications (e.g. used oil profile, remediation of sump leaks, overflows, sump replacement, mixed-waste profile, used oil tank and berm installations), and associated costs (e.g. remediation, permitting, compliance, capital expenditures).

Pollution liability

The key environmental laws governing pollution liability are the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) and the All Appropriate Inquiry (AAI) rule. Many commercial and industrial entities utilize ASTM Standard E 1527-05 to complete a Phase I Environmental Site Assessment (ESA) as their environmental due diligence, with the objective of securing an "innocent landowner defense" to CERCLA liability.

A Phase I ESA is a limited investigation designed to determine if a recognized environmental condition (REC) exists on the site or on an adjoining site. ASTM Standard 1527-05 defines a REC as "the presence or likely presence of any hazardous substances or petroleum products on a property under conditions that indicate an existing release, a past release, or a material threat of a release of any hazardous substances or petroleum products into structures on the property or into the ground, groundwater, or surface water of the property."

Field gas, natural gas liquids, produced water or condensate are not defined as petroleum products or hazardous materials under CERCLA, and pollution resulting from E&P exempt waste does not trigger CERCLA liability. The ASTM Standard specifically excludes, in part, evaluation of regulatory compliance, asbestos, vapor intrusion and lead-based paint.

Additionally, the ASTM methods rely on the selection and evaluation of a finite parcel of property. Accordingly, the ASTM Standard appears better suited for the purchase of (for instance) vacant land or a non-industrial facility, where property boundaries are well defined and compliance issues are not a concern.

Comprehensive asset list and profile

A critical aspect of midstream due diligence is the capture, documentation and verification of an accurate asset list, including pipeline segments, and an asset profile (ownership, location, vintage, operational specifications, potential receptors, etc.). Most gathering systems are large enough that only a representative number of facilities might be visited during the due-diligence site walks.

Data gaps can go unresolved as project deadlines approach. Records for minor facilities might not be readily available or practically reviewable within the due-diligence timeframe. In these cases, the asset list and asset profile are used to estimate liabilities at the remaining facilities where less information is provided or discovered during the course of the due diligence. Whereas operations, rights-of-way or commercial due diligence can only focus on active or operational assets and future business opportunities, a complete and accurate asset list is essential for environmental due diligence.

Remediation expenditures might be disclosed in a financial or legal document that was not otherwise disclosed to the environmental reviewers. Similarly, pipeline integrity reviews can identify pipeline releases, trends or data that are also of interest to the environmental review.

Accordingly, real-time sharing of disclosures and discoveries should be encouraged among all of the due-diligence team members. A well-documented asset profile will include detailed summary information about the who, what, where, when and how that relate to the asset. This profile should include identification of the current and past owners and operators, equipment inventory, other risky infrastructure, facility locations, the asset vintage (including pipelines and individual facilities), operational history, environmental history, current operational status, potential receptors (depth to groundwater, nearby residences, nearby registered water wells) and any past, threatened or pending complaints, litigation, administrative orders or notice of violation regarding environmental matters.

Field forms, checklists and guidance formats to assist in the completion of these tasks can be developed by the operator or provided by various associations, law firms or environmental consulting firms.

Purchase and sale agreements

Most environmental due diligence is conducted prior to the finalization of the purchase and sale agreement (PSA). A typical PSA might define a material environmental defect as a violation of environmental law or a required remediation or response action. Thus, it is important to anticipate, verify and challenge (if needed) the environmental PSA elements that will be required in the final transaction document. These include:

• Asset lists and descriptions

• Sellers representations and warranties with respect to environmental matters

• Terms of any environmental indemnifications or seller-retained liabilities

• Disclosure schedules identifying excluded assets

• Disclosure schedules identifying environmental matters

Estimating liability

Environmental-liability estimating methods have exceptions and limitations that are inherent to the process. For example, potential third-party liability cannot reasonably be predicted and is typically excluded. However, the dollar amount for a proposed or pending settlement agreement or consent decree might be included.

Also, it can be reasonable to estimate an environmental component for a short-term asset retirement obligation (ARO) at an abandoned facility, but not a long term ARO at an active facility.

And environmental permitting costs might be included in the environmental models, while capital expenditures for resulting equipment or infrastructure upgrades to bring a facility into environmental compliance are not.

Care should be exercised to assure that costs for remediation, permitting and compliance are not duplicated by operations or other members of the due-diligence team. The accuracy of environmental-liability cost estimating increases in tandem with site-specific data, which can be limited by data room content and quality, the CA, the project scope, project budgets, project timeframes and site access.

Depending on the level of data that is available, methods for estimating liability might include:

1. Remedial cost estimating of known environmental liabilities or areas of concern (AOCs), where sufficient data exists to reasonably quantify the site-specific remedial options or compliance obligations

2. Remedial cost estimating of suspected environmental liabilities or AOCs, where assumptions based on industry knowledge of like-kind facilities are used if site-specific data are not available

3. Development of several cost scenarios for each known or suspected liability or AOC, based on industry knowledge and experience regarding the variables that can affect the cost estimate

Such cost-estimate scenarios can include an optimistic case, a likely case and a worst case. Optimistic case costs are based on attainment of risk-based closure or the absence of a regulatory obligation, if actual site conditions were known at the time of evaluation or a reasonable expectation of agency closure was apparent.

Likely case costs are based on attainment of regulatory closure based on the currently applicable standard for compliance at the assumed property boundary. Assumptions regarding magnitude and extent of known or suspected contaminants of concern are based on the reported concentration averages and estimated migration velocity, if known, or experience at similar sites (like-kind analysis) if not known.

Reasonable worst-case costs are based on potential or unknown site conditions that could reasonably require more aggressive remedial action and longer timeframes.

Allocating risk

Traditional mechanisms to allocate risk include purchase-price negotiations, indemnities, escrows or reserves, pre-closing exclusions, seller-retained liability, post-closing adjustments, pollution loss and liability (PLL) insurance and liability-transfer products that can be purchased from nationally recognized firms. High-risk properties might be excluded if the transaction is an asset sale and the facility or property is not required for the current or proposed operations.

Known environmental liabilities and ongoing remedial obligations are typically captured in negotiated seller-retained liabilities, purchase price reductions, indemnities, escrows or reserves. If environmental sampling and analysis of media is allowed but is not feasible within the due-diligence time-frame, post-closing adjustments or escrows might be negotiated that are released pending the results of post-closing due diligence.

PLL policies (with or without coverage for affected third parties) will typically exclude known contamination, but commercially available liability transfer products can be obtained once the risk is properly quantified by way of sampling and analysis.

Using consultants

Many midstream operators internalize due diligence and do not, or have yet to, consider the use of outside environmental consultants. However, the use of consultants can be beneficial in several ways. If the buyer is a publically traded company, a qualified environmental consultant will provide an impartial third-party evaluation of the known and potential environmental liabilities in accordance with generally accepted accounting principles.

A qualified environmental consultant is familiar with the nuance of national, state and local regulatory frameworks, is skilled in site investigation techniques and will generate remedial cost estimates and regulatory-compliance evaluations in the course of their regular business. In addition, they will be properly insured, appropriately licensed and will have standing or affiliation with a nationally recognized firm.

Conclusion

Due-diligence timeframes are often short, unscheduled and unpredictable, adding significant demands to a midstream operator's key environmental staff. Staff and consultants are most likely subject to the terms of a CA, further restricting when, where and how asset information is disclosed or discovered.

Regulatory frameworks and jurisdictions can have a significant impact on the future costs for environmental compliance and remediation. Current and future permit requirements can restrict proposed expansions, and adversely affect the commercial viability of the asset.

Further, the typical PSA allows only for visual inspection of assets and records, and restricts any intrusive investigation (like sampling of soil, water, waste, air emissions or bulk media) prior to the final bidding process.

The assets can encompass many miles of gathering pipelines and scores of gas processing plants, compressor stations, drip stations, metering stations or other facilities in multiple states or regions.

Despite these significant challenges of environmental due diligence for midstream natural gas assets, successful results are possible if all the elements are considered prior to an acquisition. n

Bob Reinhart is a senior project specialist at TRC Cos. Inc., a national engineering consulting and construction management firm serving the energy, environmental and infrastructure markets.

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