A guide on climate change for private equity investors

A guide on climate change for private equity investors comprises two sections:

Section 1 summarises the rationale for incorporating climate change concerns in private equity investments;
Section 2 presents a framework that Limited Partners (LPs) and General Partners (GPs) can use in due diligence and when engaging with their fund and portfolio company investments.

The framework presents a series of questions that LPs can ask their GPs, and that GPs can ask current or potential portfolio companies. Each question is supported by guidance explaining the rationale of the question, along with examples of emerging practices. It also provides further background on the risks and opportunities the private equity industry faces, some useful tools and methodologies to assist GPs and LPs and further examples of climate change policies and regulation.

Why consider climate change in private equity investments?

Institutional investors are increasingly demanding greater consideration of climate change opportunities and risks by their internal investment teams and external managers, in both listed and unlisted investments. These investors, including the members of the IIGCC, the PRI and other investor groups, consider it part of their fiduciary duty to integrate these issues into the investment process because it enables them to make better investment decisions, improve performance and reduce risk. Climate change risk and opportunity assessment is a value-creating proposition for investors. It enables them to identify climate related risks that could affect their portfolios and opportunities associated with a transition to a low carbon economy.

Risks and returns

Investment strategies that do not adequately consider the implications of climate change may be exposed to additional risks. The Economist estimates that climate change will result in US$4.3 trillion of losses in privately held assets due to damage caused by extreme weather including droughts, floods and storms and lower returns and slower economic growth. If global temperatures increase by 6°C from pre-industrial levels, the losses could reach US$13.8 trillion.¹

Over the last five years, US coal shares have lost over 80% of their value and over 25 coal companies have filed for bankruptcy.² Hundreds of billions in investor capital have been lost. This decline reflects competition from other fossil fuels (notably shale gas in the US), but also a looming decrease in global demand as governments such as that of China shift away from the most polluting fossil fuels towards lower carbon sources of energy, including renewables, which themselves are falling in cost.

Opportunities

Building a low-carbon global economy to combat climate change requires substantial investment, most of which must come from the private sector.

McKinsey estimates that low-carbon infrastructure alone requires US$6 trillion per year for each of the next 15 years – more than twice the current rate.³ Additional investment will be required in service and supply chain businesses to support that infrastructure growth, and will include substantial private equity opportunities.

Action

Because of the very real investment risks and opportunities, investors are increasingly seeking more information on climate risks in their portfolios, and want their investment managers to act. Investors are employing a range of approaches to make their intentions clear. This can be seen in a variety of institutional investor actions, such as measurement, engagement, reallocation and reinforcement through engaging with policy makers.

Policy and regulation

Since adopting the UN Framework Convention on Climate Change (UNFCCC) in 1992, most OECD countries and many emerging countries have been enacting policies to reduce carbon, foster renewable energy and increase disclosure on carbon usage. The Grantham Research Institute’s legislation database shows that worldwide climate change policies have doubled every five years since 1997.⁴

The 2015 Paris Agreement, a global agreement to limit warming to “well below 2°C above pre-industrial levels”, was an unprecedented climate policy achievement. As the agreement is implemented, new international, national and sub-national policies and regulations will come into effect; affecting most asset classes, including private equity investment. Two likely implications for private equity investors will be compliance and initial public offering (IPO) standards in preparation for exit (for instance, portfolio company climate reporting and engagement could become a prerequisite for listing).

Climate change is not an issue governments can address alone; they will require private companies and investors to play an increasingly important role. According to the International Energy Agency, investments of US$13.5 trillion are required by 2030 just to achieve the carbon cuts that were pledged by countries in the run-up to COP21.⁵ The private equity industry is well-positioned to both support and benefit from government action on implementing technical solutions, promoting responsible business behaviour and creating more responsible business models.

Policies such as carbon pricing, feed-in tariffs and subsidies are likely to create growth opportunities for companies that are positioned to operate in a low-carbon economy, such as those in the renewable energy, energy storage and low-carbon transportation sectors.

Framework for LPs and GPs

Questions for investors and their advisors to ask general partners

Identification of climate change risk and opportunities

How do you assess the risks and opportunities of climate change on existing and new investments? Give examples of previously identified risks and opportunities. Where do you see future risks and opportunities?

Climate change regulatory assessment

What processes do you have in place to identify and understand climate change regulation (both current and emerging) and determine which policies and regulations are relevant to your investments? Please describe in detail including a summary of the key policies and regulations that you have deemed materially relevant, and how you ensure compliance against these.

Management of climate change risk and opportunities

Please provide details of how you engage and work with your portfolio companies to ensure that the identified climate change risks and opportunities are embedded into relevant business processes and overall strategy.

Climate change monitoring and reporting

Please describe the processes you have in place to monitor the performance of your investments in terms of managing climate change risks and opportunities, and how you report on these to LPs.

Portfolio company accountability

How is portfolio company management made both responsible and accountable for complying with climate change regulation, and/or addressing climate change risks, and or taking advantage of the opportunities?

Positive engagement

How are you actively engaging with the private equity industry, or through other organisations, in seeking to understand and address climate change risks and opportunities?

Climate change impact at exit

Have you considered how potential investors or acquirers may view the impact of climate change on your portfolio companies?

For private equity advisors and funds of funds

In your GP evaluation processes, how do you consider the GP’s policies and investment criteria relating to climate change, including but not limited to the matters outlined in the questions above?

Questions for general partners to ask portfolio companies and potential new investee companies

Climate change impact awareness

What are the possible legal, financial and commercial impacts of climate change on your business (e.g. susceptibility to adverse weather conditions; changing supply chains and customer demands; availability of key resources such as water)?

Regulatory awareness

Which current and proposed laws and regulations relating to climate change are you aware of that might impact your business? How do you keep informed? Does, or should, the company have an officer or employee responsible for climate change or environmental measurement and reporting?

Carbon footprint

What is your business’ direct and indirect carbon footprint? What objectives and targets have you set to support the company to reduce the level of carbon emissions it emits?

Market awareness

Are you aware of any action that your competitors are taking to mitigate or assess climate change impact? If so, how do your actions compare with the actions of your peers?

Cost/profitability forecasting

Have you evaluated the impact of rising climate change related costs on the business? Could increases in costs materially affect the profitability of the business? If so, what mitigation efforts have been considered?

Management of climate change related risks and opportunities

Having identified any climate change related risks, what steps are you taking to manage these? Have you established a climate risk mitigation policy and strategy? Do you consider opportunities created by and/or related to climate change? Which functions within your business are responsible for climate change or environmental measurement, management and reporting?