For Dr. Max Horster, Partner and Financial Industry expert at Zurich-based sustainability solutions provider South Pole Group, the future for private equity investors and managers is clear: they must prepare for massive changes. All of us are looking at a global economy undergoing a massive transition, perhaps the greatest one since the beginning of the industrial revolution. The recent COP 21 conference resulted in an agreement among 195 countries to reduce their carbon emissions to hold global warming to less than 2 degrees centigrade. This means doing more than merely limit the growth of greenhouse gas emissions, principally carbon dioxide. Those 195 countries and the businesses that operate within their borders will need to substantially reduce their carbon emission footprints.
Clearly, the most immediate implication of the COP 21 agreement is the expectation for significantly greater regulation. Another key outcome is the growing influence the discussion of regulatory change is already having on investors, emboldening them to aggressively manage climate change risk.
Dr Horster identifies two motivations driving private equity investors and managers in this regard. First, GPs, and by extension their LPs, traditionally have close ties to the executive management within portfolio companies. They also have much greater levels of ownership. Most importantly, private equity invests for the long term, requiring LPs and GPs to carefully consider long-term climate risks.
The second motivation involves identifying climate change risks as opportunities. In this regard, GPs are ideally positioned at the beginning of the curve. They can make strongly focused thematic (i.e., “green") investments, and with their close ties to portfolio company management, they can build a climate change advantage.
The pressure to address climate risk will place a higher premium on transparency for an industry that has only recently begun to deal with such demands from regulators and investors in the wake of the financial crisis of 2008. It makes sense for LPs and GPs to perform their carbon impact assessments early and thus turn transparency into an opportunity by showing responsible management and a full understanding of their climate risks.
One of the big challenges is how to measure climate risk. Dr. Horster believes that it should involve a structured dialogue between GPs and LPs. Rather than focusing on any single aspect, like a carbon footprint for example, such measurement should include the broader climate impact of any investment. An assessment should always evaluate what companies are already measuring, ask if companies are calculating their own emissions, set emissions targets and have a climate strategy.
Once all the critical data has been collected, the question for PE investors and managers is determining the best way to use it. Dr. Horster cautions that transparency and reporting are just the starting points. Having carbon footprint numbers is a good first step because it provides a strong signal that you are dealing with the risk associated with climate change from an investor or manager perspective. It helps focus attention and enables a comparison of emission trends and carbon intensity across a portfolio. Still, there is more to managing climate change risk than “simply trying to bring down GHG across a portfolio."
For LPs, Dr. Horster's advice is to have a process in mind that sets up a key timeline and milestones, be prepared to collect qualitative data, and engage with GPs directly on this information, using automation wherever possible. GPs need to leverage their close relationships to both their LPs and the executives running their portfolio companies.
Finally, he points out that private equity has passed a huge milestone in the past year. “In 2014 there was hardly any discussion at all about climate risk, but since COP21, the topic's importance has soared. Looking back, investors used to say that it couldn't be done, that you couldn't address climate change as an investment opportunity. Now, they see the possibilities of embracing it."