Capitalising on Climate Risk: How Private Equity Firms Can Generate Value in the Transition to Net Zero

3rd April 2023

Investor focus shifts to climate risk

As impacts from climate change become more severe and frequent, climate risk is no longer just an emerging interest for investors, but an expectation. Investors now recognise how a changing climate has the potential to affect the financial performance of their investments over the long term, while new regulatory requirements and evolving ESG practices are reinforcing the importance. At Anthesis, we have seen a steady increase in interest from private equity and infrastructure asset managers seeking to advance how they assess and manage climate risk.

Overall, this heightened attention is driven by several factors:

  • increasing value at risk and the recognised need to integrate climate resiliency into investment strategies;
  • the implementation of mandatory disclosures and guidance on climate-disclosure reporting by regulatory bodies such as the Securities Exchange Commission (SEC), Sustainable Finance Disclosure Regulation (SFDR), Corporate Sustainability Reporting Directive (CSRD), and UK Department for Energy Security and Net Zero (DESNZ);
  • the integration of TCFD reporting requirements into popular voluntary reporting frameworks like PRI;
  • guidance on reporting for climate-related disclosures by organisations like Initiative Climat International (iCI) and International Sustainability Standards Board (ISSB);
  • and the growing investor demand for transparency as exemplified by organizations like Net Zero Asset Owner Alliance (NZAOA), Net Zero Asset Manager Initiative (NZAMi), and Net Zero Investment Framework (NZIF).

New guidance on TCFD implementation for private equity establishes common principles

In response to the increased interest, the British Venture Capital Association (BVCA) and iCI, in partnership with KPMG and their membership (including Anthesis Group), have produced a comprehensive guide to assist private market firms in implementing the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD). The guide offers practical suggestions, highlights existing tools, and provides a banded approach for different firms’ characteristics and priorities. The aim is to promote comparable disclosures across firms and it should give managers that may have been unsure about market expectations the confidence to begin addressing climate risk.

Consideration for climate risk should be embedded throughout the deal cycle, from pre-acquisition engagement to operational management of the portfolio. Private equity firms can benefit from developing tools and processes to identify, prioritise, and mitigate risks and engage with portfolio companies. To get started, firms should define what they believe success looks like and create buy-in among their portfolio companies. This buy-in is crucial to ensure all parties can manage climate risks and opportunities effectively, which includes prioritising climate change, building a foundational level of climate literacy, conducting in-depth analysis, and identifying responses and implementation.

By doing so, investment managers can ensure that climate considerations are integrated into the investment decision-making process, which reduces climate-related financial risks and positions the portfolio for potential opportunities.

Effective engagement with portfolio companies is a key place to start

For General Partners starting to consider climate risks, one of the most important practices is to effectively engage with portfolio companies. Not only can it add depth and context to the process of screening climate risks and identifying mitigation strategies, but it also helps to build internal capacity within the management team.

The threat of climate change is certain, but the response from the global landscape and the potential impact on business strategy and financial performance is uncertain. The COVID-19 pandemic highlighted the importance of having mitigation and adaptation strategies in place to minimise financial and operational damage from unexpected events. We recommend facilitating regular climate-focused forums with portfolio companies as a way to continue to drive progress and share best practices.

Scenario analysis and reporting frameworks unlock greater value

For General Partners looking to take the next step, scenario analysis can yield greater insights. Firms should look beyond their holding periods and explore possible futures their buyers might face to uncover risks and opportunities. Scenario analysis can help to illuminate the extent of climate risk and the effectiveness of mitigation practices in building resilience. The greater value of climate scenario analysis lies in its ability to identify and assess a wide range of potential risks and opportunities associated with various warming scenarios. This enables companies to develop robust strategies, invest in adaptive measures, and drive innovation to ensure business continuity and maintain a competitive edge in the face of uncertainty.

In addition, regulatory compliance standards are increasingly requiring scenario analysis. For instance, the EU SFDR is leading the way in this regard, and EU Taxonomy-aligned Article 8 and Article 9 funds will have to report the alignment of their investments periodically. Also, the ISSB has confirmed that companies need to include climate-related scenario analysis in their disclosures.

Meaningful integration of TCFD is vital for private equity firms, as it not only facilitates the identification and management of climate risks within portfolios but also showcases for limited partners a commitment to ESG principles. By effectively managing climate risks and disclosing relevant information, firms can gain a deeper understanding of the potential consequences of climate change on their investments, empowering them to adopt sustainable practices or divest from/avoid high-risk assets. These considerations will encourage investments in sustainable and resilient businesses, which can ultimately lead to enhanced financial returns and contribute to a more robust, environmentally responsible economy.