“Private equity GPs need a robust framework to assess climate-related risk and to help guide them through the transition.”
In March 2020, the UN Principles of Responsible Investment (PRI) launched a technical guide on implementing TCFD for private equity general partners (‘the Guide’).
The Guide sets out the actions that GPs can take to address the four-pillar framework of the recommendations proposed by the Task Force on Climate-related Financial Disclosures (TCFD), and was contributed to by a range of private equity General Partners (GPs), Limited Partners (LPs) and advisors.
Why Have a Guide?
Non-financial disclosures associated with climate change have been discussed for years, but to date, there has been limited uptake by private equity GPs. According to the PRI Climate Snapshot Report 2016-2019, only 2% of signatories are fully reporting on climate risk including TCFD disclosure. This mirrors Anthesis’ own market experience; for every GP we are working with to meaningfully evaluate climate risk, implement climate risk strategies and/or carbon footprint portfolio companies, there are multiple firms we are helping in far earlier stages in their overall ESG programs.
Launched in 2017, the TCFD is the most widely recognised international initiative to examine climate change in the context of financial stability. Although technically a voluntary initiative (albeit mandatory for PRI signatories), the TCFD mirrors a general trend for governments and central banks to increasingly require the disclosure of specific climate and wider sustainability-related metrics and information. It considers the physical, liability and transition risks to an organisation and its assets associated with climate change and what constitutes effective management, measurement, response and financial disclosures of these.
The Guide aims to help GPs better understand how to implement the TCFD.
A Simple Approach to a Complex Topic?
The PRI identified that the reasons why GPs have been slow to adopt TCFD and climate risk management and reporting include:
- A lack of climate-related knowledge within investment teams
- Constrained resources and capacity limitations
- Difficulty in obtaining climate-related data and identifying metrics
- The scale of addressing climate change for an entire portfolio
The Guide goes a long way to addressing these concerns, with a clear, practical and pragmatic approach. This includes many real-world examples and suggestions for how GPs can approach the implementation of a TCFD aligned climate strategy and get down to understanding how climate change, its physical effects and the regulatory and market changes associated with the transition to a low carbon economy will impact portfolio companies in terms of sales, Opex and Capex.
A key part of the Guide is outlining a series of priority actions for GPs addressing each pillar of the TCFD:
- Governance – including conducting training for key personnel, participating in cross-industry workshops on climate integration, and defining responsibilities.
- Strategy – identification of macro-level risks and opportunities and development of an implementation plan.
- Risk Management and Metrics & Targets – beginning to integrate climate considerations into pre and post acquisition due diligence and engaging with portfolio company management teams to define climate targets.
By presenting the practical steps and deliverables, the Guide can start to galvanise and stimulate a standardisation of TCFD disclosure and climate risk reporting. The practical examples help to give a real perspective on the process. They also illustrate that specialist knowledge, for example climate-related knowledge, is not necessarily required within investment teams, and that the TCFD does not expect in-depth, detailed analysis for each invested company within a fund.
The Guide’s Recommended Approach
The Guide recommends a three-phase approach to implementing the TCFD’s recommendations:
Phase 01 – Governance and Strategy.
- Raise climate awareness throughout the organisation.
- Define a climate-dedicated governance.
- Develop a simplified implementation plan.
Phase 02 – Strategy and Risk Management.
- Conduct materiality analysis on current portfolio holdings to identify climate risk exposure.
- Define key climate performance indicators for each portfolio holding.
Phase 03 – Risk Management and Metrics & Targets.
- Fully integrate climate considerations within the investment process.
- Support holdings with tools and recommendations to address climate risks.
- Conduct yearly reviews of portfolio holdings to assess progress towards climate objectives.
- Raising climate awareness within a GP is a key first step, which requires senior management buy-in and effective communication across the firm. Different levels of training, for example, starting with simple workshops lasting a few hours, can be put in place for different individuals within a firm to raise that awareness and embed knowledge throughout the investment team.
- It may not be necessary, or practical, to develop the deepest level of understanding on climate risk inhouse. Even within a sustainability consultancy like Anthesis, climate change is a specialism, and an inhouse ESG professional, already needing to keep abreast of circa 40 topics that fall under the ESG umbrella, may not have the bandwidth to become an expert on all its elements. The use of a specialist allows the leveraging of broader experience.
- Building the governance structure to manage climate risk should be considered alongside the rest of the ESG management process. When considered in isolation, the decisions made could be unwittingly detrimental to other ESG goals. Where firms already have ESG frameworks in place requiring very little change, this may require simply reviewing and defining new climate-dedicated governance procedures and then defining additional climate KPIs for portfolio holdings. By implementing climate risk assessment and strategy within a firm’s wider ESG approach, these will likely bolt on to existing tools and processes. However, the practical steps, such as conducting materiality analysis to identify climate exposure, will require specific focus and could be more involved than many other ESG assessments.
- The most critical element is getting the initial materiality assessment right. The Guide’s phased approach allows for a gradual introduction and a pragmatic approach to the more complex requirements such as portfolio materiality and scenario analysis, for example by recommending focusing on those holdings with the greatest climate risks and opportunities. To date, much of the discussion has been around how and on what assets to undertake the deeper scenario analysis, where an asset is evaluated in the context of a number of future scenarios, including a 2-degree future. But by highlighting that this should be reserved only for those assets considered at greatest risk, it has heightened the importance of getting this initial materiality assessment right. The assessment of which portfolio holdings represent the most material risks and opportunities is crucial, both for maximising the benefit from the climate risk reporting process, but also potentially when it comes to exit scrutiny. Therefore, a robust and repeatable materiality assessment process is needed when identifying which companies and assets are most exposed to climate-related risks.
- The guide is not particularly detailed on how to conduct thorough scenario analysis on the most at-risk companies. This is not surprising given the obvious diversity of investments across the PRI’s GP signatory base and the technical nature of the process. In reality, such guidance would take as many pages again. This is perhaps where we expect to see further requests for specialist input; so, the challenge then becomes selecting a suitably qualified and experienced advisor and/or increasingly, a software solution.
- Carbon footprinting is a fundamental requirement of TCFD’s Metrics & Targets phase. This provides the essential benchmarking and evidence platform from which climate decisions and action plans can be made and implemented. As one LP was quoted in the Guide, only 25% of their GPs have footprinted their portfolios to date; albeit they noted that carbon emissions are not material for all types of companies. Through many discussions with clients, we note that carbon footprinting is routinely perceived as a massive challenge, however, whilst it can be a sizeable task when first undertaken, subsequent years are always significantly easier. In addition, in some jurisdictions, carbon footprinting has recently been elevated from a ‘nice to have’ to a regulatory requirement for many companies, for instance under the UK’s Streamlined Energy and Carbon Reporting (SECR) scheme.
- Responding to TCFD and climate reporting requirements can seem complex and unwieldy. Yes, forecasting the impact of climate change on a diverse set of investments and understanding value at risk and potential exposures is challenging, but with the right steps and support, it can just become part of ‘business as usual’.
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