Last November, while nations were announcing or reaffirming their net-zero targets at COP26, the Science Based Targets initiative was busy launching guidance specifically for private equity firms on how to set targets to decarbonise both their own organisations and their portfolio companies.

A project born out of the groundwork laid by a collaborative effort between private equity firms, the Initiative Climat International, the science-based targets for private equity are potentially game-changing for the industry.

There is certainly plenty to do on climate action in private companies, which have historically lagged behind their public peers. Of the 41,000 investable public companies, 10.2 percent report on environmental impacts to non-profit organisation CDP; the figure for the 17 million total private investable companies is just 0.03 percent, according to figures quoted in the guidance.

For private equity, there has been a lack of clarity and consistency in firms’ approaches to action on climate change. The SBTs are designed to address this.

“There was a need for private equity-specific guidance because there were no rules previously,” says Viviana Occhionorelli, ESG director at Astorg. “All firms had different ambitions and targets, they had different ideas of which portfolio companies to include and the length of time the targets should apply, and so on. It was very hard for LPs and GPs themselves to judge how ambitious and rigorous they were being.”

The private equity SBTs offer “very clear rules for everyone”, says Occhionorelli. “They are designed to help private equity firms set the right targets. There is also a requirement to have them validated. They are long-term targets – firms commit to having a percentage of their portfolio reach their targets by 2030 or 2040.”

There is also a requirement for targets to be set within two years of the deal close. “That gives a real sense of urgency to collect greenhouse gas emissions data and prepare a reduction plan,” says Occhionorelli.

“Private equity can play a huge role on carbon and sustainability in finance”
Sophie Flak
Eurazeo

So far, seven firms – EQT, Astorg, Bregal Investments, FSN Capital, Hg, Intermediate Capital Group and Investindustrial – have received approval from the SBTi for the decarbonisation targets they have set for their own organisations and for their portfolio companies. A further five (Montagu Private Equity, Altor Equity Partners, Tikehau Capital, Eurazeo and Triton Partners) have said they will follow the new guidance for setting greenhouse gas emissions reduction targets, with the aim of receiving approval in the next two years.

Growing appetite

Although these names represent just a handful of the private equity universe, many point to a real sea change in the industry as a whole.

“There is a lot more to do, but the pace of change in knowledge and understanding in private equity has significantly accelerated in the past 18 months,” says Serge Younes, head of sustainability at Investindustrial. “By early December 2021, the iCI had 133 signatories – that really shows private equity firms’ appetite to get involved in decarbonisation.”

“I’ve been working with private equity for around 25 years,” adds Tim Clare, director, UK, at Anthesis and a co-author of the SBTs. “For the first 15 of these, environmental issues were often seen as an irritation. It’s only really over the past four to five years that we’ve started to see real action and in the past two years, that has really accelerated.”

Clare adds that the fact that the industry has taken a lead on establishing the targets is significant: “The guidance exists because the industry has been proactive. Ten firms funded its creation themselves and we worked on the project pro bono. And the fact that private equity firms, which are naturally very cautious about what they sign up to, are now committing to net-zero targets is pretty ground-breaking.”

Recent progress on climate initiatives has clearly been rapid, given where the industry was not that long ago. “Just 18 months ago, no-one really knew what net zero meant in a private equity context, how we could engage with portfolio companies or whether or not they fell under Scope 3 emissions [which cover suppliers and investments] for firms,” says Ellen de Kreij, lead adviser for Apax Partners’ ESG practice. “Today, we have 133 private equity firms signed up to iCI, we have joined together to create clear guidance on the path to net zero and we know what needs to be done.”

Trickle-through effect

The hope is that the industry as a whole coalesces around the SBTs, yet even with the commitments so far, the reach through firms’ portfolios could have a big impact. “The [corporate] SBTs have been around since 2015,” says Younes. “Around 2,000 companies have committed to them in this time. If the 10 to 12 private equity firms that have said they will commit become validated, that will bring a further 10,000 to 20,000 companies under the SBTs in the next decade. It’s a major step change.”

“Continued net-zero commitments from asset managers across the globe will raise the bar of ‘hygiene-level’ investment criteria”
Julia Wikmark
EQT

In theory, private equity’s active ownership model should also mean the industry makes a big contribution to reaching net zero if firms get on board. “Everyone has a role to play in decarbonisation and if the ambition is to reach net zero, you really can’t ignore private equity, given the scale and scope of the industry’s investments,” says Adam Black, head of ESG and sustainability at Coller Capital. “Yet private equity is also important because firms can get so much done on this if they choose to – they can be really granular and get things done quickly.”

Or, as Sophie Flak, managing partner in charge of ESG and digital at Eurazeo, puts it: “Private equity can play a huge role on carbon and sustainability in finance. Our industry finances a significant chunk of the economy, we have the levers to accelerate the transition and we can choose which companies we finance.”

Why now?

Although some firms are opting to commit to greenhouse gas emissions reductions in part to live up to a responsible investment ethos – Investindustrial, for example, started measuring its own carbon emissions in 2007 – it is clear that this is the direction of travel as the world’s economies decarbonise. It is no longer just the right thing to do; it is becoming commercially imperative. Private equity has a big role to play here, especially as many portfolio companies are seeking support from backers to help them meet their customers’ needs as well as their own.

“We are generally pushing on an open door when we discuss carbon emissions with portfolio company management,” says Seth Brody, a partner and global head of the operational excellence practice at Apax Partners. “We do have some discussions on methodology, but not on philosophy because management teams know they have to do this. Many of our portfolio companies have multinationals as clients with their own Scope 3 requirements and questions – they need to offer good answers to retain and win business.”

“We are generally pushing on an open door when we discuss carbon emissions with portfolio company management”
Seth Brody
Apax Partners

Regulation is helping to shift practice, with Europe leading the regional pack. “Europe now has some real anti-greenwashing regulations and these will require companies and private equity firms to provide the real data on carbon intensity for products,” says Flak. “It’s a painful and costly process, but for the first time, we will have ratios with the same calculations used for all financial products. This will align the whole industry. Carbon ratios will be part of the core KPIs, similar to the way financial ones are, although it will take some time for the data quality to stabilise.”

The imposition of carbon taxes, for example, is becoming more widespread – there is even a proposal to include this in President Joe Biden’s Build Back Better plan in the US. And, as Europe’s experience attests, this can have a significant impact on investments as well as present opportunities. Flak, for example, points to Eurazeo’s investment in Seqens, a manufacturer of healthcare product components: “When we invested [in 2016], the carbon cost was around €8 per tonne; in November 2021, the cost hit €60. What has happened with Seqens will happen everywhere with the generalisation of carbon tax.”

During the holding period, Eurazeo supported the company’s investment of more than €80 million to exit coal and change its energy mix towards renewables. “Thanks to these initiatives, carbon should become a source of revenue for the company within the next two years,” says Flak.

Younes says Investindustrial is even evolving “to set an internal carbon price” as part of its investment plans for portfolio companies. “You have to integrate decarbonisation into the investment thesis to see how this affects EBITDA and operating costs,” he explains. “Carbon taxation, such as EU ETS [Emissions Trading System], is currently around €60 [per tonne], but we believe it should be €100 or more and so we account for this higher figure in our investment thesis. If you put a real and credible number on it, companies can be decisive and it ensures that carbon and climate risk are tangible rather than abstract.”

What next?

With the years to 2030 dubbed the ‘decisive decade’ for halting and mitigating climate change, the decarbonisation agenda is firmly set. Private equity firms will need to keep pace if they are not to face the risk of stranded assets or value destruction. “Continued net-zero commitments from asset managers across the globe will raise the bar of ‘hygiene-level’ investment criteria, but also accelerate the number of truly transformational investment cases,” says Julia Wikmark, sustainability group director at EQT. “It will become harder and harder for PE firms to perform well if they are not able to show clear decarbonisation progress and strategies for their investments.”

It is a point also picked up by Investindustrial head of investor relations, Carl Nauckhoff: “We are moving from the announcement of lots of well-meant ambitions and statements towards convergence of information, verification of actions and audits. In much the same way as financial performance, there will be ramifications if your actions don’t meet your words on decarbonisation and ESG in general.”

Getting to the data

The SBTs will help the industry determine how best to tackle decarbonisation, but implementation may present challenges. Getting to grips with Scope 3 emissions, for example, which move beyond the firms and portfolio companies and towards suppliers, is far from easy.

“Scope 1 and 2 emissions accounting are relatively straightforward to measure and gain commitment to improve,” says Alvar de Wolff, managing director and head of ESG at Bregal Investments. “But value chain reductions are far more complex in terms of data gathering and especially in effecting change. There has to be a lot of dialogue to make that happen.”

Yet there are solutions to the data issue, as Apax Partners’ Seth Brody points out: “Data quality can be very variable. That’s why we have invested in data science tools to use data we already collect to monitor the financial performance of portfolio companies.

“For example, we can monitor spend data at the invoice level and we can use that to translate it into carbon emissions.”