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Net Zero for Private Equity: Best practice for portfolio decarbonisation and value-creation

By Vanessa Sheehan
1st December 2022

PEI’s Responsible Investment Forum Europe 2022 on 16 November 2022 brought together over 450 fund managers, institutional investors, and expert advisors to discuss ESG issues across alternative asset classes. Themes this year included climate, the role of ESG in value creation, and impact investment.

Our experts Matt Cvijan and Vanessa Sheehan presented on day one of the event on the theme of ‘’Reconciling Decarbonisation with Growth’’. In this second of two insights we share their recommendations on the foundations that should be put in place to set credible net zero targets, the current state of portfolio target setting with tips on how to navigate the landscape and how your net zero programme and climate disclosure can create value and resilience. Matt covered insights into the value creation realised through adopting forward-looking indicators that assess the alignment of a portfolio company’s business model to a net zero economy. Here are the key takeaways from their session:

LAYING THE FOUNDATIONS OF NET ZERO

Measuring portfolio GHG emissions generated from investment portfolios is the first step to setting a portfolio decarbonisation target.

To ensure your portfolio carbon footprint calculations are robust and accurate, we would recommend applying the Partnership for Carbon Accounting (PCAF) standard. This guidance will help you quantify not just your emissions profile but also the data quality associated with your portfolio carbon calculations. Data quality is a critical metric as many PE firms are dependent on proxies and sector averages to plug data gaps, particularly when it comes to Scope 3 emissions. However, you won’t be able to meet your net zero goals and drive real world emissions reductions until you get reported emissions from your portfolio companies.

Our top tips for commencing carbon accounting action include:

  • Start engagement to collect GHG emissions early
  • Where feasible, collect GHG emissions data during the due diligence phase – it will take time for smaller private companies to build carbon accounting literacy and competence
  • Be strategic about your limited resource by targeting your engagement efforts Calculate your portfolio companies’ Scope 1 & 2 emissions before their Scope 3 emissions, prioritise collecting data from companies where you have majority stakes before minority stakes and finally, actively increase data quality from portfolio companies in high emitting sectors before low emitting sectors
  • Move away from relying on emission factors and sector benchmarks. This is the only way you will benefit from any real-world decarbonisation happening in your portfolio and fully meet your decarbonisation targets in the long term

TARGET SETTING

PE firms now have access to a range of standardised, credible target setting frameworks to enable the construction of portfolio decarbonisation and alignment targets.

Target methodologies detailed in these target frameworks include:

  • Backward looking, emissions-based targets which track emissions reductions against a sector benchmark
  • Forward looking, engagement based approaches which can take several forms including:

Binary targets: Setting a target for a percentage of portfolio companies to have a Science Based Target initiative (SBTi) approved target by a specific date

Maturity targets: Setting a target for a percentage of portfolio companies to achieve increasing levels of ‘net zero alignment’ measured with a suite of indicators that quantify the alignment of a company’ business model to net zero plans/pathways

Temperature alignment targets: Translating portfolio companies’ GHG targets into equivalent temperature scores and setting a portfolio-level temperature score

PE firms can adopt more than one of the above targets to decarbonise investments and align their portfolios to net zero but should look out for the overlaps and divergence across these methodologies.

Across the diversity of industry guidance notes, there are consistent expectations regarding how PE firms can demonstrate meaningful climate action including to:

  • Adopt one or several targets methodologies most applicable to your asset class, sector, and regional exposures
  • Set engagement and climate solutions targets
  • Publicly disclose performance against target commitments, along with the governance controls and implementation strategies you’ve put in place to operationalise your targets

Targets may be challenging to set where carbon/climate data and tools have not yet caught up with the target methodologies to provide meaningful metrics to the market.

As various target methodologies become better defined and further formalised, PE firms must apply a range of metrics to measure and track target progress. This need for meaningful, methodology-aligned carbon/climate-related metrics has led to a proliferation of data providers, models, data sets, and tools.

Examples where data and carbon/climate tools have not yet caught up with target methodologies include:

  • Credible sector decarbonisation models for the less carbon- intensive industries
  • Tools for downscaling global emissions pathways to regions and sub-sectors
  • Tools for measuring “Fair share”

CLIMATE RESILIENCE AND VALUE CREATION

Decarbonisation forms an embedded element of a portfolio company’s net zero alignment effort.

While emissions metrics are critical for setting and tracking decarbonisation targets, realising net zero alignment at the portfolio level requires adopting forward-looking indicators that assess the alignment of a portfolio company’s business model to a net zero economy.

By adopting both forward and backward looking target methodologies, PE firms can align financing the growth of portfolio companies in the direction of the low carbon transition and toward realising value-creation in a net zero economy.

We recommend considering the following metrics when assessing and supporting the development of a portfolio company’s net zero alignment plan:

  1. GHG emissions accounting, target setting, & disclosure
    – Measure and disclose GHG emissions
    – Set decarbonisation targets
    – Track GHG emissions reduction performance
  2. Governance & strategy
    -Disclose CAPEX /revenue dedicated to the climate solution activities required to achieve emissions target
  3. Produce a transition plan which includes:
    -Clear governance for delivering GHG targets
    -Details on how the business intends to manage climate risk and achieve value creation through harnessing climate-related opportunities
    -Accountability disclosures- for example, naming a director on the board with responsibility for climate-related risk and opportunity management

The resilience and value of your portfolio companies can be realised through effectively managing climate-related risks and opportunities.

The TCFD Framework for General Partners Recommendations outlines key climate-related risks and opportunities categories which can support a company in addressing the set of indicators listed above. Even if not mandated yet, adhering to the TCFD disclosure recommendations is now best practice and certainly a key consideration if you are looking to IPO.

In our experience, it is critical to consider climate-related opportunities and manage both physical and transition risk exposure if portfolio companies are going to effectively enable the net zero transition and create resilient business models that are aligned to a low carbon economy.

Some examples of where we have supported businesses with TCFD and the alignment of their strategy to a net zero economy include:

https://carbon.ci/case-studies/nandos-science-based-target/

https://carbon.ci/case-studies/vidrala/https://carbon.ci/case-studies/britvic/

How we can help

Whilst there is not a one size fits all solution to achieve net zero, a private equity firm will need to apply a tailored approach that reflects the diverse nature of its portfolios. However the key is to make a start. Carbon Intelligence, part of Accenture, is one of the UK’s leading science-based target consultancies and carbon data businesses. Get in touch today if you would like to learn more about how to set and execute a credible net zero target for your firm and what this means for your portfolio companies.

Related blog: https://carbon.ci/insights/net-zero-for-private-equity-why-the-time-to-act-is-now/