In this article, we take a closer look at Private Equity and the role it can play in tackling climate change. The good news is that it can and does play a significant role. In addition to measuring their own carbon footprint, PE firms are in a unique position to control and influence their portfolio companies, particularly important given that ESG and specifically climate-related risks are increasingly material for private equity investors.
Last week’s release of the latest IPCC Report provided sobering reading to add to a somewhat dark and gloomy world. The report reinforces that we are already facing the impacts of climate change, impacts more severe than were anticipated. However, it also provides a glimmer of hope – that we still have a chance to prevent much more severe impacts of climate change by reducing greenhouse gas emissions (by 50% by 2030) and scaling up adaptation resilience. Other key findings of the report included:
- Increasing temperatures leading to extreme heat and increased wildfires.
- Increased flooding leading to economic and physical dislocation.
which, will in turn lead to:
- Biodiversity loss.
- Increased exposure to drought, water stress, and water security.
- Increased economic costs for food production.
We still have a chance to prevent the much more severe impacts of climate change but the window to act is closing fast. And so, we need to do more, faster.
Pivotal Role of the Finance Industry
As previously noted, the Financial Industry plays a key role as it is well placed to direct capital flows and ensure acquisitions, investments, and loans are sustainable. To guide the Financial Industry, the Financial Stability Board (FSB) created the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information focusing on the four key financial sectors: asset management, asset owners, banks and insurance.
Integrating ESG in Private Equity
PE firms are in a unique position to influence their portfolio companies, particularly important given that ESG and specifically climate-related risks are increasingly material for private equity investors, given that:
- Portfolio companies face impacts from both the physical effects of climate change, known as physical risks, and transitional risks such as regulatory actions designed to reduce greenhouse gas emissions (e.g., carbon tax).
- Partner (LP) investors are increasingly requiring GPs to report on their approach to addressing climate-related risks.
Key Roles Within Private Equity
Key Challenges integrating ESG in Private Equity
General Partners (GPs) often cite several challenges in assessing, managing, and reporting on climate-related risks, including:
- Ongoing resource constraints and lack of specific expertise on ESG and climate-related risk assessments.
- Difficulty navigating the ESG and climate data landscape (lack of transparency, and lack of standardized definitions).
- Productionizing climate change assessments for an entire portfolio.
These challenges are compounded by Partner (LP) investors increasingly requiring GPs to disclose on how they are addressing climate-related risks.
Application of ESG in Private Equity
TCFD provides an established and well considered approach across its key dimensions and has a tailored version of its technical manual specifically for PE firms. For each portfolio company or significant holding, GP considerations follow the four key areas established by TCFD:
Things To Consider
Climate Risk Governance
Increase climate awareness and education throughout the organization (board, executive team, management team, customers)
Ensure governance is in place to manage climate-related risks
Climate Risk Strategy
Develop a simplified roadmap that focuses only on the material issues impacting the portfolio company and is integrated in the business strategy
Climate Risk Management
Focusing only on material items in portfolio holdings, identify climate risk exposure and define key climate KPIs for each portfolio holding:
- Ensure climate risk is a pre-acquisition due diligence factor
- Determine portfolio holdings with the highest exposure
Ensure climate risk is integral to investment processes
For holdings, provide support structure:
- Consider climate risks that may affect valuations based on material climate indicators
- If/when material risks are identified, define climate targets at a portfolio level.
Metrics & Targets
Pre-acquisition and after climate due diligence, focus on engaging with least resilient companies.
The following simplification addresses the key questions What, How, Who, Where, and When?
Many companies in the PE portfolio holdings are small and medium-sized businesses. Helping these companies to thrive does not come without its challenges and the new ‘challenging’ kid on the block – ESG – is getting bigger daily, fed by a rich diet of risk prevalence, increased regulatory focus and of course, greater investor scrutiny.
Benefits of Integrating ESG into Portfolio Holdings
How best to integrate ESG into your portfolio holdings? ESG is a wide playing field and research shows that those who focus on the ‘material’ aspects of their ESG risks and ‘stay in their lane’ fare far better than those who don’t.
Why now? Getting it right now puts your portfolio businesses at a distinct competitive advantage, freeing up time to focus on the day job of helping your portfolio businesses to thrive.