In the face of mounting global climate action and inquiries from institutional investors, private equity firms should anticipate that addressing climate change will move from being an emerging interest to a fundamental expectation—just as it has for environmental, social, and governance (ESG) issues.
We are in the midst of a new era of climate action. The UN Principles for Responsible Investment (PRI) recently announced that reporting based on the Task Force for Climate-related Financial Disclosures (TCFD) will become mandatory for PRI signatories. The proposal for a Green New Deal is expanding the boundaries of the US political conversation. More companies are making commitments to science-based targets for emissions reductions, and in December, investors managing $32 trillion in assets called on governments to accelerate climate action.
The upshot for private equity firms is this: It is imperative to better understand, manage, and disclose climate risks and opportunities in your investments. While some call for firms to conduct carbon footprinting for their entire portfolios, others in the industry have expressed concerns that such an undertaking would be resource-intensive and of unclear value. Firms should consider how climate trends affect their investments, not just in terms of flood risk or energy costs, but in terms of the technologies they use, the products they source, and the labor forces they employ.
So the question arises: What courses of action will help private equity firms address climate risks and opportunities in an actionable, meaningful way? BSR suggests two types of approach.
TCFD Maturity in Climate Management
Private equity firms should be in the business of building better managed, more valuable companies. That same objective applies in responding to climate change: Private equity firms should engage with portfolio companies to ensure that all parties can effectively understand and manage climate risks and opportunities. Further, firms should be able to demonstrate such an understanding to investors and stakeholders in relation to the TCFD framework. Firms can do this by applying similar approaches as have been used to address other ESG topics, such as responsible sourcing.
Major steps to improve TCFD maturity in climate management would include:
- Assessing portfolio companies’ exposure to climate risks and opportunities using simple, open-source tools to evaluate physical and transition risk (e.g. the Climate Policy Tracker for Business, developed by BSR)
- Evaluating companies’ climate maturity using the TCFD framework
- Mapping climate exposure vs. maturity for the portfolio to identify the most significant sources of climate risk, the highest priority companies, and the most common gaps in practice
- Using the results to inform firm-level reporting and to enable portfolio companies to report their own information
- Providing guidance, resources, and tools to improve practices for high-priority companies and topics (e.g. sample policies, data sources, and position descriptions)
By using such an approach, private equity firms can avoid more academic exercises and use the TCFD framework to support practical actions, meaningful reporting, and improved business outcomes.
Strategic Foresight and TCFD Climate Scenario Analysis
Given the uncertainty surrounding the cascading impacts of climate change, as well as society’s collective response to the issue, the TCFD has recommended that all firms undertake “climate scenarios analysis” to assess their exposure to a range of climate-related risks and opportunities and enhance their strategic resilience. To derive the true benefit of this methodology, climate scenario analysis should not treat global temperature increase (e.g. 2 degrees vs. 4 degrees) in isolation or as a one-dimensional quantitative calculation.
Unlike forecasts or predictions, scenarios describe multiple plausible futures that may confront a business. Scenario analysis offers a multidimensional perspective that examines how inter-related social, technological, economic, environmental, political, and business factors can drive highly divergent outcomes, with profoundly different impacts on investments. These additional dimensions of information transform scenario analysis from a dry accounting task to a robust, generative activity with major strategic implications, as was illustrated in BSR’s Doing Business in 2030 report.
Scenario planning is a prudent undertaking for current portfolio companies. By assessing companies against relevant scenarios, a firm can better understand the potential impacts of climate change and other related factors; optimize company governance, strategy, risk management, and measurement; protect against future risk and pursue future opportunities; and report on findings to key stakeholders.
Strategic foresight may be even more exciting for assessing future investment opportunities. By exploring multiple plausible futures, scenarios can help companies and investors move beyond present-day thinking, envision disruptive new possibilities, and be proactive in seizing emerging opportunities. Furthermore, unlike large players within industry, private equity investors have the advantage of being able to act quickly to integrate lessons into their investing decisions without major damage to their incumbent interests.
As climate impacts become increasingly material and the pace of change in climate action and expectations increases, it is critical for private equity firms to begin acting now. Through pragmatic, strategic approaches, there are valuable opportunities for firms to ask the big questions on climate change and begin taking action, both to support the long-term success of their investments and the economic, social, and environmental imperatives for climate action.