Suggested priorities for private equity and their portfolio companies
United Nations Secretary-General António Guterres recently called climate change “the defining issue of our time.” The ‘Fridays for Future’ movement and climate activists like Greta Thunberg accelerated the momentum to fight against climate change by asking political leaders around the world to act.
With the Paris Agreement and the European Green Deal, political leaders have started to take action — defining preliminary targets to decarbonize the global economy. Accelerated by Covid-19, the private sector is also taking an active role by proactively committing to company-specific carbon emission reduction targets. For instance, with the Initiative Climate International (iCI), the global private equity community has acknowledged the decarbonization challenge and seeks to lead by example.
PwC’s Responsible Investment Survey also shows a real shift among leaders — from considering environmental topics and thinking about risk mitigation to now prioritizing value creation. This research suggests growing, industry-wide ambitions to make a change when it comes to decarbonization. In fact, two-thirds of survey respondents ranked value creation as their top driver for environmental and claim to consider it in their transformation or value creation plan. Yet, when it comes to declaring specific goals and actively managing decarbonization, there still seems to be a behavioral gap between concern and action in the private equity industry.
While 88% of respondents said they are concerned about climate risk and carbon footprint, only 48% reported taking action to decarbonize their assets. Hence, a gap exists - with 40% of respondents who are concerned but don’t act.
Of course, acting on climate risks and opportunities across your portfolio is complicated, as knowledge, consistent data, and resources may be limited. However, as regulatory requirements tighten and limited partners increasingly factor climate risk into their own investment decisions, private equity firms need to have a greater level of knowledge and sophistication to chart the right course. As you approach your own decarbonization journey, consider these priorities, which we’ve assembled based on our project experience in this area.
Decarbonization priorities for the private equity industry
The basic reason to prioritize decarbonization is simple: Decarbonization is about value, not only values! In other words, As a private equity firm, incorporating decarbonization into your business model and into your portfolio companies can translate into improved cashflow due to reduced operating expenditure, captured market shares of new customer segments, and more motivated employees. Some private equity firms, especially in the Nordics, are already adopting the decarbonization imperative. They see decarbonization as an opportunity and consider not prioritizing it as a business risk, which over time might limit their access to funding and reduce returns. In other parts of the world, as well, leading private equity firms are carefully weighing their internal and portfolio company–level priorities to quickly progress on the decarbonization journey:
1. Develop a decarbonization strategy. For private equity firms, properly defining your decarbonization strategy is the most important starting point. Such a strategy typically sets out the overarching ambition level and articulates carbon emission reduction targets, which can be broken down into short- and long-term measures. It is critical to align these targets with the firm’s overall ESG and fund strategy. This strategy can then serve as a guide for limited partners and the investment team.
2. Embed decarbonization in the investment cycle. Decarbonization should be considered like other key upside or downside topics on the ownership agenda, and therefore be integrated along the entire investment cycle from sourcing to exit in your firm’s ownership playbook. More specifically, here’s how to embed decarbonization in different areas:
- Sourcing: Climate change has created new attractive industries, such as climate tech and ESG professional services. These emerging industries should be on your firm’s radar and monitored for targets.
- Investment: Understanding a company’s carbon emissions profile, including both the associated risks and opportunities, is subject to the due diligence process. That same due diligence process also might include risk mitigating and value creating levers with the aim of improving carbon efficiency.
- Ownership: As an owner, it’s important to work together with management to implement the prioritized decarbonization levers and provide guidance. Your firm should, therefore, develop decarbonization blueprints with recommended frameworks, tools, and clearly expressed expectations. Developing science-based targets (SBTi) with portfolio companies is also gaining more popularity among private equity firms.
- Exit: These days, getting an asset ready for sale should include a review of its decarbonization efforts, progress, and results. The results of the review should be documented and included in sell-side material.
3. Adapt your operating model. Once your firm has a decarbonization strategy in place, you need to operationalize it by adapting your operating model, particularly in these four dimensions.
- Process: Incorporate decarbonization in your firm’s ownership playbook and communicate expectations to internal staff and portfolio companies.
- Organization: Clearly assign roles and responsibilities for managing decarbonization internally, as well as in your daily business interactions with portfolio companies. The internal firm’s operative decarbonization efforts are typically assigned to the portfolio company.
- Tools and technology: Invest in technology that enables carbon emission measuring and progress tracking. Many specialized software vendors exist in this market.
- Performance management: Define your specific carbon emission KPIs (scope 1, 2, and 3) and regularly review of these KPIs to check your own progression. This progression can also be tied to performance bonuses of your portfolio companies’ management. Note: Scope 1 and 2 emissions are owned or controlled by a company, so they are typically easier to calculate. Scope 3 carbon emissions (e.g., upstream and downstream transportation), however, are a consequence of the activities of the company but occur from sources not owned or controlled by it and therefore are more challenging to estimate and calculate.
4. Kick-start decarbonization journey. When embarking on a decarbonization journey, it is critical to bring your team with you. Make sure your leadership is aligned with the investment team and provide hands-on guidance for employees on how to use your decarbonization playbook, highlight useful tools for them, and showcase examples of best practices. A series of specialized upskilling sessions is also recommended to prepare your team, so that they can better engage with the management teams of their portfolio companies. Investment managers typically support or supervise a company’s decarbonization strategy, conclude short- and long-term measures, and share best practices. Providing portfolio company guidance on scope 1 and 2 carbon emissions is recommended as these emissions are under the direct control of the company and quick wins can be realized.
1. Establish a carbon baseline. Decarbonization should be on top of each portfolio company’s executive agenda. Understanding the company’s carbon emission profile along the value chain including scope 1, 2, and 3 is the starting point. To determine a company’s carbon emission baseline, carbon accounting is needed. Data availability is typically limited, but a variety of carbon accounting software tools exist to estimate and manage carbon emissions.
2. Develop a reduction plan. After a quantified carbon emission profile — the baseline — has been established, a carbon reduction plan should be developed. This reduction plan should be developed and supervised by investment managers of the private equity firm to share best practices and make sure targets are aligned to the firm’s level of ambition.
- Levers: The carbon baseline provides an overview of the company’s top carbon emission sources. Naturally, the costs and impact of reducing the emissions at these sources should be evaluated and prioritized. If quick-win leavers with low costs and high impact are identified (e.g., building energy efficiency), they should be included in the business plan. Linking these levers to value creation as part of the business plan is critical to motivate management for decarbonization.
- Define reduction targets: Companies typically define their own carbon emission targets in line with the Paris Agreement. If you’re not sure how to start, the Science Based Targets initiative (SBTi) also offers a framework to define such targets. SBTi, for example, requires that a company set both near-term and long-term targets to decarbonize a company (or reach net zero) by 2050. So what does that mean?
- Near-term targets aim for immediate carbon emission reductions for the next 5 to 10 years and are in line with the 1.5 C pathway. They must also cover at least 95% of companywide scope 1 and 2 carbon emissions.
- Long-term targets reduce emissions to a residual level in line with 1.5 C scenarios by no later than 2050. According to SBTi, they must cover at least 95% of companywide scope 1 and 2 emissions and 90% of scope 3 emissions.
- Develop a roadmap: To start, it’s critical to have a clear understanding of a company’s carbon emission baseline, identified effective levers, and required reduction targets in line with the Paris Agreement. Your company’s roadmap should also take local regulation into account, assign clear responsibilities, and establish key milestones against which the company can measure progress.
3. Set-up carbon reporting: Once the baseline has been established and reduction targets have been defined, a portfolio company may want to (or be obliged to) publish a report on its carbon emissions (e.g., following SBTi) and decarbonization efforts; the results are often integrated into a company’s ESG or sustainability report. But wherever these results are reported, it is vital to base carbon accounting and reporting on a consistent and accepted methodology to ensure quality and comparability with peers.
Setting the right priorities can help private equity firms to walk the talk on decarbonization and start to take advantage of the many opportunities that are out there for the taking! With globally $4.2 trillion private assets under management, the private equity industry is uniquely positioned to be a leader on the decarbonization front and has already acknowledged the responsibility to do so.
Contact us
