Investors increasingly prioritize Environmental, Social, and Governance (ESG) factors—specifically climate change—in their investment strategy, revealing a new reality: climate risk is financial risk. Regulatory frameworks like the SEC rule, California climate bills, CSRD, SFDR, and the EU taxonomy, alongside market initiatives from GFANZ and EDCI, are solidifying this shift across financial sector actors. These regulations, built upon existing institutional investor-driven frameworks, reflect a clear demand for transparency in sustainability practices.
Private equity firms must prioritize decarbonization efforts to stay compliant and capitalize on this strategic shift. This article explores how PE firms can navigate this evolving landscape.
PE firms driving climate action: Power and pressure
New regulatory pressures on PE firms and their portfolio companies to embrace sustainability initiatives abound—from the new California legislation to the U.S. SEC’s focus on more granular financial risk-based disclosures and CSRD’s comprehensive approach. In other words, climate change translates into financial risk for businesses. And with control over nearly $6.9 trillion in assets and influence across a broad spectrum of industries and geographies, PE firms are uniquely impacted.
Extreme weather events, rising sea levels, and resource scarcity pose significant operational threats—and financial risks—to portfolio companies. However, by helping portfolio companies decarbonize, PE firms can mitigate these risks, leading to improved operational efficiency and cost reduction.
A BCG survey and the Sustainable Markets Initiative's Private Equity Taskforce (PESMIT) revealed that 70% of private equity leaders and CEOs anticipate a premium valuation for companies demonstrating effective decarbonization strategies during their investment period. In other words, PE firms that effectively manage their financed emissions—the emissions coming from portfolio companies, similar to the carbon footprint of a financial institution’s investments and loans—and integrate climate factors into their core investment strategy will reap long-term business benefits.
Decarbonization isn’t just about risk mitigation—it’s about unlocking new market opportunities. Consumers increasingly gravitate toward sustainable products and services, creating a growing market for companies with strong ESG credentials. By guiding portfolio companies towards sustainable practices, PE firms can position them to capitalize on this demand, potentially leading to increased market share and revenue growth.
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How to empower portfolio companies to decarbonize
Translating this imperative into action requires a multi-pronged approach.
Portfolio assessment and baselining
The first step toward decarbonization is a comprehensive portfolio assessment to quantify the carbon footprint of each portfolio company. Focus on direct emissions (scope 1) and indirect emissions from purchased energy (scope 2). This baseline data becomes crucial for setting realistic reduction targets, tracking progress over time, and prioritizing your efforts. Naturally, the portfolio companies with the highest mitigation potential are the best to start with. That said, some industries have more opportunities to decarbonize than others (aviation, for instance, represents a hard-to-abate sector due to its reliance on aviation fuel, and current cost and production limitations of sustainable aviation fuel (SAF). When creating an emissions baseline for an investment portfolio, firms should assess emissions data quality against sector trends.
Building a collaborative team
Successful decarbonization necessitates a dedicated team between the firm and the portfolio company. Many PE-backed portfolio companies do not have dedicated ESG teams, and it’s vital to identify key stakeholders who can fulfill these responsibilities alongside their primary duties. This team will likely comprise:
- PE firm liaison: A central contact at the PE firm acts as a bridge, clarifying expectations and providing crucial support for the portfolio company’s decarbonization efforts.
- Executive owner: A high-level leader with significant influence over strategy and budget assumes responsibility for achieving the program’s goals. This individual could oversee departments like Finance, Legal, Operations, or Marketing.
- Program manager: This individual, ideally residing within an existing ESG team, spearheads the program's execution and implementation. Executive buy-in is crucial to ensure this person has the authority and resources to prioritize and effectively manage the program.
Goal setting
Based on a recent survey led by Bain and Institutional Limited Partners Association (ILPA), one-third of LPs have set net-zero commitments, indicating an increasing norm for investors. The most common framework employed is the Science-Based Targets Initiative (SBTi), which prescribes how to set ambitious emissions reduction goals in line with the Paris Agreement’s objective to limit global warming to 1.5°C. For PE firms, getting portfolio companies to set an SBT is a great way to begin to align efforts and unite a business around climate action.
Engagement and collaboration
Decarbonization is a collaborative journey. PE firms must actively engage with portfolio company management teams to develop and implement decarbonization strategies tailored to each company’s industry and operations. This could involve identifying energy efficiency opportunities, exploring renewable energy options, or investing in clean technologies. PE firms should aim to leverage expertise and resources to support companies in accessing necessary resources to implement these strategies. One common way to do this is for PE firms to recommend a preferred carbon accounting platform—like Sustain.Life—to centralize carbon emissions data collection across their entire portfolio.
Operational efficiency and innovation
Optimizing operational efficiency is low-hanging fruit for decarbonization. For instance, upgrading equipment to be more energy-efficient, eliminating single-use plastics, or optimizing delivery routes to use less fuel.
Additionally, by analyzing energy consumption patterns, PE firms can encourage portfolio companies to implement process improvements and adopt energy-saving technologies—an easy, high-impact swap.
Lastly, look at the supply chain: supporting investment in clean technologies and circular economy principles can drive significant emission reductions while fostering innovation within the portfolio companies.
Making initial climate-driven investment decisions
Beyond optimizing existing companies, PE firms can actively seek investment opportunities in companies developing and deploying climate solutions. An “impact investing” approach allows PE firms to contribute directly to the transition to a low-carbon economy while potentially generating strong financial returns.
Transparency and reporting
Open and transparent communication with investors and stakeholders is critical. PE firms should establish clear decarbonization goals based on tangible metrics for their portfolios and develop a robust reporting framework to track progress.
The role of private equity in driving global sustainability efforts is pivotal. By taking immediate action toward portfolio decarbonization and setting SBTs, PE firms align with global climate goals and position themselves as leaders in the transition toward a sustainable economy.
Sources
1. Bain & Company, “Decarbonization: How Private Equity Can Make It Work” https://www.bain.com/insights/decarbonization-how-private-equity-can-make-it-work/
2. BCG, “Private Equity’s Pivotal Role in the Climate Battle” https://www.bcg.com/publications/2023/how-private-equity-firms-can-help-win-the-climate-battle
3. Sustainable Markets Initiative, “Private Equity Task Force” https://www.sustainable-markets.org/taskforces/private-equity/
4. PWC, “Generating upside from ESG: Opportunities for private equity” https://www.pwc.com/gx/en/services/sustainability/publications/private-equity-and-the-responsible-investment-survey.html
5. Bain & Company, “Limited Partners and Private Equity Firms Embrace ESG” https://ilpa.org/wp-content/uploads/2022/02/ILPA-BAIN-REPORT-LPs-and-PE-Firms-Embrace-ESG-2022.pdf
