Brief

Decarbonization: How Private Equity Can Make It Work

The PE industry has the power to reduce carbon emissions on a global scale. So, what can be done to accelerate progress?

Di Rebecca Burack, François Faelli, Christophe De Vusser, Kiki Yang, Andrew Tymms, Hannah Morrill, Debra McCoy, e Marc Lino

First published on settembre 16, 2022
Tempo di lettura min.


Let’s face it: Efforts to reduce global carbon emissions cannot succeed without the full engagement of private equity. The industry directly or indirectly controls nearly $6.9 trillion in private assets and is uniquely positioned to press decarbonization efforts across a vast portfolio of companies touching every industry and geography around the world. PE owners typically have influence over who leads these companies, how they make operating decisions, and, often, how they allocate resources to decarbonization strategies. Given its global footprint and time-tested record of creating value on the ground, the industry has an unparalleled opportunity—and ability—to catalyze the global energy transition and reduce the climate impact of carbon emissions. This isn’t simply about “doing good.” Private equity is ideally placed to benefit from decarbonization. At a time of widespread environmental concern and increasing regulatory exposure, decarbonization can translate into reduced operating costs, real gains in market share, and improved employee engagement—all big drivers of cash flow. Decarbonization is also growing as a factor in fund-raising. Around a third (52% in Europe) of limited partners (LPs) have set net-zero commitments that affect investment decisions, according to a recent study conducted by Bain & Company and the Institutional Limited Partners Association. This suggests that the net-zero movement among LPs is only gaining momentum. Yet while a growing number of individual firms, particularly in Europe, are developing decarbonization strategies, the industry as a whole has not made broad commitments to limiting carbon emissions. It’s true that roughly 160 PE firms with approximately $2 trillion in assets under management (AUM) now participate in the industry’s Initiative Climat International (iCI), up from 90 in 2021. But participation in iCI does not equate to specific goals or commitments. Private equity firms, meanwhile, have largely eschewed the $130 trillion Glasgow Financial Alliance for Net Zero, citing concerns that they won’t be able to live up to carbon-reduction promises. What’s standing in the way of broader commitment? There’s no doubt that some segment of the private equity universe simply doesn’t believe that reducing greenhouse gases is necessary. Another group remains unconvinced that decarbonization is compatible with strong investor returns. In our experience, however, many would like to adopt a decarbonization agenda. What holds them back is a set of structural impediments that create a mismatch between carbon transition frameworks and the private equity business model. PE firms are adept at driving change within their portfolio companies, but they need time and space to do so. While that involves the learning and capability building required of any large organization, private equity firms face the unique challenge of forging a path to decarbonization for each company in a constantly changing portfolio. Firms need to develop repeatable models for mobilizing management teams and for working through data limitations, regulatory variances, and resource issues across industries and geographies. Forward-thinking GPs see that there’s real business risk in not gearing up to help portfolio companies participate in the energy transition and reduce carbon emissions. Another issue is the PE model of buying and selling companies every three to five years, which can complicate compliance with carbon-reduction commitments. Goals have often been set at the fund level, calling on firms to produce steady improvement toward emission targets year to year across the entire fund. But for general partners (GPs) with a revolving set of portfolio companies, this means the fund could actually be penalized for cleaning up a company, selling it, and taking on another cleanup project. That can have the unintended consequence of discouraging firms from using their value-creation skills to reduce emissions. Regulatory guidance can also be a challenge. Emerging taxonomies seek to define clear, practical parameters for what can and cannot be considered sustainable, or “green.” But for various reasons, those definitions have tended to create uncertainty around whether businesses and investments will be deemed green enough. This can cloud the decision to take on a high-emitting asset and transition it to a cleaner future. In some cases, it may even have dissuaded uncertainty-averse PE firms from investing in certain companies or whole industries that might not tick the right boxes. GPs, LPs, regulators, and industry bodies are working hard to find solutions to these complex issues, including potentially reshaping taxonomies to more effectively incentivize the reduction of carbon emissions in a changing economy. Ultimately, accelerating decarbonization in the private equity industry will require an intentional, collaborative approach among all participants. GPs need to buy into the decarbonization imperative so they can develop strategies and capabilities to reduce emissions at both the firm level and the portfolio company level. LPs need to assert themselves as a catalyst for change by doubling down on efforts to link decarbonization to fund mandates and investment decisions while pressing GPs for measurable results. Regulators and industry bodies must continue to create spaces for a proactive dialogue and mutually beneficial alignment within the industry. All of this will take time. But the evidence suggests that, over the long term, the decarbonization imperative is not going away. Forward-thinking GPs recognize this and see that there’s real business risk in not gearing up to help portfolio companies participate in the energy transition and reduce carbon emissions. They are mobilizing now to turn uncertainty into an opportunity, much as industry leaders have done during other periods of economic or technological upheaval. These firms are kick-starting their decarbonization strategies by taking several practical steps at the firm and the portfolio company levels to show quick, meaningful progress. Fund-level priorities Align on strategy. As with any significant business initiative, it is critical to establish a clear ambition for a fund-level decarbonization strategy, broken down into a set of near- and long-term objectives. Sustainable success requires leadership buy-in, unambiguous alignment on tactics, and a clear set of accountabilities across the investment life cycle. Embed decarbonization in screening and due diligence. Spotting opportunities and underwriting risk begins with establishing a consistent process to understand a target company’s starting point when it comes to carbon emissions. Does it have decarbonization efforts in the works already? What are the prospects for creating value by pushing decarbonization under ownership, and what challenges might the company face in the years ahead? Strategically, how is carbon efficiency a source of competitive advantage (or disadvantage) from a cost or customer standpoint? How could that change in the future? Invest in the key enablers. Decarbonization is highly complex. Quick progress relies on tapping specialized expertise and building the required capabilities to turn it into a competitive advantage. That includes installing world-class carbon measuring software, creating standard processes for accounting and performance tracking, and developing playbooks to share insights across the portfolio. While this requires investment, leading GPs are taking advantage of their scale to supply these resources affordably at both the firm and portfolio levels. Implement “no regrets” decarbonization initiatives. Quick wins build credibility, especially with portfolio management teams. Since PE firms and companies have the most control over their scope 1 and 2 emissions, that’s the best place to start. Swapping gas-powered fleets for electric vehicles, switching to renewables, and improving the efficiency of buildings are all straightforward, relatively inexpensive ways to demonstrate progress. Firms that have embraced decarbonization can also lead by example. Sign up for industrywide commitments, publicly state decarbonization goals, report on emissions, and share transition progress. Transparency can lure new talent, attract LPs, inspire portfolio companies, and lead to coinvestment opportunities with like-minded firms. Portfolio-level priorities Put decarbonization on the executive agenda. Change begins at the top, and new owners can accelerate decarbonization efforts by prioritizing the discussion at the board level. This starts with explicitly naming decarbonization in the value-creation plan and laying out practical playbooks to develop science-based targets, adopt tools, hire expertise, and otherwise hit the ground running on day one. If decarbonization is a part of screening and diligence, these issues should already be on the table. Establish a carbon fact base. Creating an inventory of where carbon emissions are coming from allows portfolio company management to align around the short-, medium-, and long-term ambition. This can be a major undertaking, so it is important to accelerate the process by focusing on the major sources of emissions first rather than trying to build a comprehensive bottom-up inventory. Once the company has measured and tracked the largest sources of emissions, the effort can shift to building in more granularity. Identify decarbonization levers. Pinpointing the top sources of emissions should go hand in hand with identifying the highest-impact means of reducing them. That includes documenting the level of investment required and the potential value that could accrue from those actions—energy-driven cost savings, market share uplift, resilience against climate risks, and reduced regulatory risk, to name a few. Explicitly linking decarbonization levers to value creation is critical to creating urgency and buy-in. Develop the roadmap. With a strong fact base and clear understanding of the levers needed to make change, firms can establish a more practical and feasible roadmap for taking action. It should lay out the key decarbonization milestones and a process for standing up the enabling teams and tools, as well as a framework for tracking and reporting progress. GP participation is crucial, both to sponsor the initial investment and push for results. Reporting on emissions is an essential first step in reducing them, and there’s ample room for improvement here. Private companies trail public companies by a large margin when it comes to carbon reporting, according to a recent study by Bain and CDP. Create feedback loops. Each portfolio company’s decarbonization journey is unique, but all can benefit from the others’ experience. The most effective GPs create the means to share learning across the portfolio, highlighting effective strategies and potential sources of value while celebrating technical breakthroughs. Bringing operational leaders focused on decarbonization together for training and biannual offsites can ensure that best practices become standard operating procedure across the portfolio. Not only are there scale efficiencies in sharing tools, processes, and expert support, but shared learning helps portfolio companies overcome the technical and regulatory complexity that can stall decarbonization efforts before they get off the ground. Ultimately, of course, decarbonization will only accelerate when PE firms see it as an enabler of growth and a mitigator of risk—not a new cost of doing business. While this is difficult to measure with the kinds of metrics PE firms live by, we now have repeated and consistent examples of how decarbonization has driven positive economic results. Depending on the sector, there are opportunities to gain share, to reduce opex and capex, to lower the cost of capital, and to win the war for talent. These benefits are real and produce win-win outcomes for LPs, GPs, and, critically, the world at large. Over time, the industry has clearly demonstrated what can be accomplished with its core value-creation formula. In 2000, private equity did a little more than $120 billion in deals globally and PE firms owned 3,000 companies. By last year, those numbers had rocketed to $1.2 trillion worth of deals and 23,000 owned companies globally. Focusing the industry’s size, energy, and ingenuity on the decarbonization problem promises to both accelerate the energy transition and create value in bold new ways. For private equity, the opportunity is there for the taking.

Let’s face it: Efforts to reduce global carbon emissions cannot succeed without the full engagement of private equity.

The industry directly or indirectly controls nearly $6.9 trillion in private assets and is uniquely positioned to press decarbonization efforts across a vast portfolio of companies touching every industry and geography around the world.

PE owners typically have influence over who leads these companies, how they make operating decisions, and, often, how they allocate resources to decarbonization strategies. Given its global footprint and time-tested record of creating value on the ground, the industry has an unparalleled opportunity—and ability—to catalyze the global energy transition and reduce the climate impact of carbon emissions.

This isn’t simply about “doing good.” Private equity is ideally placed to benefit from decarbonization. At a time of widespread environmental concern and increasing regulatory exposure, decarbonization can translate into reduced operating costs, real gains in market share, and improved employee engagement—all big drivers of cash flow.

Decarbonization is also growing as a factor in fund-raising. Around a third (52% in Europe) of limited partners (LPs) have set net-zero commitments that affect investment decisions, according to a recent study conducted by Bain & Company and the Institutional Limited Partners Association. This suggests that the net-zero movement among LPs is only gaining momentum.

Yet while a growing number of individual firms, particularly in Europe, are developing decarbonization strategies, the industry as a whole has not made broad commitments to limiting carbon emissions. It’s true that roughly 160 PE firms with approximately $2 trillion in assets under management (AUM) now participate in the industry’s Initiative Climat International (iCI), up from 90 in 2021. But participation in iCI does not equate to specific goals or commitments. Private equity firms, meanwhile, have largely eschewed the $130 trillion Glasgow Financial Alliance for Net Zero, citing concerns that they won’t be able to live up to carbon-reduction promises.

What’s standing in the way of broader commitment?

There’s no doubt that some segment of the private equity universe simply doesn’t believe that reducing greenhouse gases is necessary. Another group remains unconvinced that decarbonization is compatible with strong investor returns. In our experience, however, many would like to adopt a decarbonization agenda. What holds them back is a set of structural impediments that create a mismatch between carbon transition frameworks and the private equity business model.

PE firms are adept at driving change within their portfolio companies, but they need time and space to do so. While that involves the learning and capability building required of any large organization, private equity firms face the unique challenge of forging a path to decarbonization for each company in a constantly changing portfolio. Firms need to develop repeatable models for mobilizing management teams and for working through data limitations, regulatory variances, and resource issues across industries and geographies.

Forward-thinking GPs see that there’s real business risk in not gearing up to help portfolio companies participate in the energy transition and reduce carbon emissions.

Another issue is the PE model of buying and selling companies every three to five years, which can complicate compliance with carbon-reduction commitments. Goals have often been set at the fund level, calling on firms to produce steady improvement toward emission targets year to year across the entire fund. But for general partners (GPs) with a revolving set of portfolio companies, this means the fund could actually be penalized for cleaning up a company, selling it, and taking on another cleanup project. That can have the unintended consequence of discouraging firms from using their value-creation skills to reduce emissions.

Regulatory guidance can also be a challenge. Emerging taxonomies seek to define clear, practical parameters for what can and cannot be considered sustainable, or “green.” But for various reasons, those definitions have tended to create uncertainty around whether businesses and investments will be deemed green enough. This can cloud the decision to take on a high-emitting asset and transition it to a cleaner future. In some cases, it may even have dissuaded uncertainty-averse PE firms from investing in certain companies or whole industries that might not tick the right boxes.

GPs, LPs, regulators, and industry bodies are working hard to find solutions to these complex issues, including potentially reshaping taxonomies to more effectively incentivize the reduction of carbon emissions in a changing economy. Ultimately, accelerating decarbonization in the private equity industry will require an intentional, collaborative approach among all participants. GPs need to buy into the decarbonization imperative so they can develop strategies and capabilities to reduce emissions at both the firm level and the portfolio company level. LPs need to assert themselves as a catalyst for change by doubling down on efforts to link decarbonization to fund mandates and investment decisions while pressing GPs for measurable results. Regulators and industry bodies must continue to create spaces for a proactive dialogue and mutually beneficial alignment within the industry.

All of this will take time. But the evidence suggests that, over the long term, the decarbonization imperative is not going away. Forward-thinking GPs recognize this and see that there’s real business risk in not gearing up to help portfolio companies participate in the energy transition and reduce carbon emissions. They are mobilizing now to turn uncertainty into an opportunity, much as industry leaders have done during other periods of economic or technological upheaval.

These firms are kick-starting their decarbonization strategies by taking several practical steps at the firm and the portfolio company levels to show quick, meaningful progress.

Fund-level priorities

Align on strategy. As with any significant business initiative, it is critical to establish a clear ambition for a fund-level decarbonization strategy, broken down into a set of near- and long-term objectives. Sustainable success requires leadership buy-in, unambiguous alignment on tactics, and a clear set of accountabilities across the investment life cycle.
Embed decarbonization in screening and due diligence. Spotting opportunities and underwriting risk begins with establishing a consistent process to understand a target company’s starting point when it comes to carbon emissions. Does it have decarbonization efforts in the works already? What are the prospects for creating value by pushing decarbonization under ownership, and what challenges might the company face in the years ahead? Strategically, how is carbon efficiency a source of competitive advantage (or disadvantage) from a cost or customer standpoint? How could that change in the future?
Invest in the key enablers. Decarbonization is highly complex. Quick progress relies on tapping specialized expertise and building the required capabilities to turn it into a competitive advantage. That includes installing world-class carbon measuring software, creating standard processes for accounting and performance tracking, and developing playbooks to share insights across the portfolio. While this requires investment, leading GPs are taking advantage of their scale to supply these resources affordably at both the firm and portfolio levels.
Implement “no regrets” decarbonization initiatives. Quick wins build credibility, especially with portfolio management teams. Since PE firms and companies have the most control over their scope 1 and 2 emissions, that’s the best place to start. Swapping gas-powered fleets for electric vehicles, switching to renewables, and improving the efficiency of buildings are all straightforward, relatively inexpensive ways to demonstrate progress. Firms that have embraced decarbonization can also lead by example. Sign up for industrywide commitments, publicly state decarbonization goals, report on emissions, and share transition progress. Transparency can lure new talent, attract LPs, inspire portfolio companies, and lead to coinvestment opportunities with like-minded firms.

Portfolio-level priorities

Put decarbonization on the executive agenda. Change begins at the top, and new owners can accelerate decarbonization efforts by prioritizing the discussion at the board level. This starts with explicitly naming decarbonization in the value-creation plan and laying out practical playbooks to develop science-based targets, adopt tools, hire expertise, and otherwise hit the ground running on day one. If decarbonization is a part of screening and diligence, these issues should already be on the table.
Establish a carbon fact base. Creating an inventory of where carbon emissions are coming from allows portfolio company management to align around the short-, medium-, and long-term ambition. This can be a major undertaking, so it is important to accelerate the process by focusing on the major sources of emissions first rather than trying to build a comprehensive bottom-up inventory. Once the company has measured and tracked the largest sources of emissions, the effort can shift to building in more granularity.
Identify decarbonization levers. Pinpointing the top sources of emissions should go hand in hand with identifying the highest-impact means of reducing them. That includes documenting the level of investment required and the potential value that could accrue from those actions—energy-driven cost savings, market share uplift, resilience against climate risks, and reduced regulatory risk, to name a few. Explicitly linking decarbonization levers to value creation is critical to creating urgency and buy-in.
Develop the roadmap. With a strong fact base and clear understanding of the levers needed to make change, firms can establish a more practical and feasible roadmap for taking action. It should lay out the key decarbonization milestones and a process for standing up the enabling teams and tools, as well as a framework for tracking and reporting progress. GP participation is crucial, both to sponsor the initial investment and push for results. Reporting on emissions is an essential first step in reducing them, and there’s ample room for improvement here. Private companies trail public companies by a large margin when it comes to carbon reporting, according to a recent study by Bain and CDP.
Create feedback loops. Each portfolio company’s decarbonization journey is unique, but all can benefit from the others’ experience. The most effective GPs create the means to share learning across the portfolio, highlighting effective strategies and potential sources of value while celebrating technical breakthroughs. Bringing operational leaders focused on decarbonization together for training and biannual offsites can ensure that best practices become standard operating procedure across the portfolio. Not only are there scale efficiencies in sharing tools, processes, and expert support, but shared learning helps portfolio companies overcome the technical and regulatory complexity that can stall decarbonization efforts before they get off the ground.

Ultimately, of course, decarbonization will only accelerate when PE firms see it as an enabler of growth and a mitigator of risk—not a new cost of doing business. While this is difficult to measure with the kinds of metrics PE firms live by, we now have repeated and consistent examples of how decarbonization has driven positive economic results. Depending on the sector, there are opportunities to gain share, to reduce opex and capex, to lower the cost of capital, and to win the war for talent. These benefits are real and produce win-win outcomes for LPs, GPs, and, critically, the world at large.

Over time, the industry has clearly demonstrated what can be accomplished with its core value-creation formula. In 2000, private equity did a little more than $120 billion in deals globally and PE firms owned 3,000 companies. By last year, those numbers had rocketed to $1.2 trillion worth of deals and 23,000 owned companies globally. Focusing the industry’s size, energy, and ingenuity on the decarbonization problem promises to both accelerate the energy transition and create value in bold new ways. For private equity, the opportunity is there for the taking.