Travers Smith's Sustainability Insights: Making a Paris-aligned net zero commitment

Travers Smith's Sustainability Insights: Making a Paris-aligned net zero commitment
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Overview

A regular briefing for the alternative asset management industry. 

Last week, Carlyle pledged net zero greenhouse gas (GHG) emissions across its investment portfolio by 2050, and committed to significant progress by 2025. The goal itself is important, of course, but the way it will be achieved is perhaps even more newsworthy. As for other private equity firms who have set GHG reduction targets, the commitment is not founded on asset allocation or divestment – an approach whose effectiveness is questioned by academics. As emphasised in Carlyle's announcement, the firm will use the significant influence that it has over the companies in its portfolio to help transition their businesses to a pathway that is consistent with the goals of the Paris Agreement.

This focus on transitioning business through the super-charged engagement that comes with private equity ownership matters. As the Chief Executive of the European industry association, Invest Europe, said recently, the unique features of the private equity and venture capital business model mean that the asset class has a real chance to deliver positive change. That applies to changes that further social and environmental goals just as must as it does to changes that improve financial performance – although, of course, those objectives are increasingly inseparable. Not only is it becoming clear that more capital will flow to asset managers that can contribute to the "just transition", it is also widely recognised that (material) sustainability issues will have a direct impact on risk and on exit value and, therefore, on fund returns.

But the challenges in grasping this opportunity should not be under-estimated. Conscious of reputational and regulatory concerns – and indeed ethical issues – firms are understandably reluctant to sign up to commitments they are not confident they can achieve. Decarbonisation, at least in some sectors and regions, is very challenging, while commitments to invest in climate solutions rely on investible projects being available.

Many private equity and venture capital firms are relatively small and need to invest significantly in the expertise required, both at manager and portfolio company-level. Such investment is certainly in evidence in private markets – and so is guidance that is specifically addressed to private equity. Invest Europe's Climate Change Guide and the private equity specific guidance issued by the SBTi are two prominent examples. Last week saw publication of a consultation draft of another very helpful resource: the IIGCC Net Zero Investment Framework's Private Equity module.

The IIGCC – the Institutional Investors Group on Climate Change – combines over 370 asset owners and asset managers, together speaking for around €50 trillion. The Group launched their Net Zero Investment Framework in March last year, but did not cover private equity. A working group has now addressed that gap, and the draft module is intended to complement the main Investment Framework, giving general partners and limited partners a clear path to committing to Net Zero across the portfolio. The consultation is open until 27 February and the industry may want to weigh in on some of the detail.

The IIGCC Private Equity guidance covers private equity and growth capital, with some recommendations also addressed to venture capital firms. The guidance is designed to be used by investors and by primary funds, but also by funds of funds and secondaries funds – who may find it more difficult to pull the levers needed to fully comply.

...the unique features of the private equity and venture capital business model mean that the asset class has a real chance to deliver positive change...

Ideally, all portfolio companies would be in scope of the recommendations but, where that is not practicable, firms may scope out certain portfolio companies where the investor does not have "meaningful" influence over the company, where the company does not operate in a "high impact" sector and so long as at least 70% of net asset value or emissions is covered. The latter coverage requirement rises to at least 90% of total portfolio emissions by 2030.

Using criteria laid out in the guide, portfolio companies that are in scope are then put into four categories by the investor: "Net Zero", "Aligned", "Aligning" and "Early progress". Emissions must be measured for each investment and 5-year targets set at fund level with a view to having all companies classified as "Net Zero", "Aligned" or "Aligning" by 2040. There are more demanding requirements for new assets: 100% should be "Aligned" or "Net Zero" by 2030 or, for acquisitions after 2025, within 5 years of investment.

Targets are set and reported on for each fund, and can be re-based and updated to reflect changes in holdings. Annual reporting of emissions and related information is also required.

Where relevant, managers or investors should also set targets for investment in climate solutions, using the EU Taxonomy or equivalent criteria to qualify relevant activities. Funds of funds subscribing to the framework should move towards only investing in primary funds that have set targets using this approach.

The guidance offers a series of recommended actions for LPs and GPs to transition a portfolio and increase portfolio company alignment with the Paris pathway. There is a recognition that LPs have less direct influence over underlying companies, but can have an impact through asset allocations, manager relationships and the selection, appointment and monitoring of GPs. The sponsors themselves, on the other hand, are expected to consider their approach to climate issues when fundraising, when undertaking pre-acquisition due diligence on an investment and through the acquisition process, while holding the asset, and again on exit.

The Guide has been prepared so that it builds on existing methodologies, such as the TCFD and the SBTi, and should allow firms to apply a common approach when claiming Paris-aligned emissions reduction targets. It is a document well worth attention by managers who are evaluating how and when to commit to Net Zero. Although it draws attention to the scale of the challenge, it also offers some very helpful practical guidance and a template for a consistent industry-wide approach.

 

Read previous issues of Travers Smith's Alternative and Sustainability Insights

For more information on Travers Smith's sustainable business resources, please visit our Sustainable Business Hub.

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TRAVERS SMITH'S ALTERNATIVE ASSET MANAGEMENT & SUSTAINABILITY INSIGHTS

A series of regular briefings for the alternative asset management industry.

TRAVERS SMITH'S ALTERNATIVE ASSET MANAGEMENT & SUSTAINABILITY INSIGHTS
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