Achieving Net Zero

Private equity and venture capital can play an outsized role in the economic transition that is unfolding. What progress is the industry making?

A central aim of the COP26 Climate Change Conference is to rally finance in support of achieving global net zero by 2050. Private equity (PE) and venture capital (VC) may not have been quick to engage with this goal, but now the industry is mobilising, it is able to translate ambition into action in the real economy. “Perhaps the PE industry was slower to engage than others, but as the industry maintains its current pace of engagement, we will be able to deliver faster change because we have direct involvement with the boards of the companies that we invest in, unlike public markets,” says Graeme Ardus, Head of ESG at PE firm Triton Partners.

Where PE firms like Triton have a controlling stake in a company, they are educating management teams on the why and the how of ESG, and helping them to reduce their impact on the environment.

“Typically the companies that PE investors are investing in, especially mid-market, don’t have big sustainability teams,” says Peter Dunbar, Private Equity Senior Specialist at Principles for Responsible Investment, a UN supported network of investors that promotes sustainable investment.

“If you have a company that has a good product and just doesn’t happen to have strong ESG credentials, that’s an opportunity”

“They’re probably not even tracking their carbon emissions at the time the PE funds invest, so there’s a ton of work for the PE firms once they’re onboarded.

“That process of putting the business case to them, getting things like baseline greenhouse gas emission data and ongoing reporting in place, getting buy-in from other investors if you’re a minority, can take more than a year.”

By embedding ESG within companies that have not got to grips with the issue, responsible investors are performing an incredibly important function in the journey to net zero.

While most investment firms thinking about climate change are motivated by concern for the environment, there are a multitude of push and pull factors driving ESG up the agenda within private markets. On the push side, pressure from limited partners (LPs), regulation, consumers and employees is building, climate change poses risks to supply chains, and the broader backdrop of an economy transitioning to net zero will leave laggards with stranded or less valuable assets. But, more importantly to an industry that thrives on funding innovation and finding operational improvements within portfolio companies, the risk is the opportunity.

“You can’t expect small businesses that have grown very rapidly, with probably a handful of staff, to be on top of ESG, because it’s relatively new and there is a lot to digest. We’re all grappling with materiality and what it means to each individual business,” says Maria Carradice, Managing Director at Mayfair Equity Partners. “If you have a company that has a really good product or service and just doesn’t happen to have strong ESG credentials, that’s potentially a huge opportunity for you, as a GP, to influence management and really make a difference.”

Reducing the carbon emissions of a portfolio company can often result in efficiencies, making it more profitable. And given the wider economic transition to net zero, companies that are on top of their data and reporting are more attractive. “When we come to exit these companies, they are more valuable assets,” says Ardus.

Carbon-intensive sectors

However, not all companies are easy to decarbonise. Some sectors, such as energy and transport, will be fundamentally remodelled, much as the advent of electricity redefined the factory in the early 20th century. In these sectors it is not just VC that has a role to play by bringing climate tech to market. PE is also getting involved in the transition of companies in carbon intensive sectors.

One example is Cadent, the UK’s largest gas distribution network operator. In 2017, a consortium of investors led by Macquarie Asset Management acquired the company. Since then, the asset manager has been working with Cadent to decarbonise and support the UK’s transition to a net zero economy.

“For some companies there are some very obvious things they can do to reduce their carbon footprint. For others, it’s less a matter of quick wins and more a matter of innovation,” says Mary Nicholson, Head of Responsible Investment at Macquarie Asset Management. “Cadent is working hard to embed the use of hydrogen technology, which will play a big role in securing a low emission future.

“Cadent is exploring blending hydrogen with natural gas, which reduces the emissions intensity of heating. But also, more strategically, it’s part of a working group looking at establishing the hydrogen supply chain in the UK. Perhaps one day its network won’t be transmitting natural gas, it may be transmitting hydrogen or synthetic natural gas,” she says.

“It’s a real privilege in the asset management space to work closely with our portfolio companies to explore these technologies and to provide hands on support to help them achieve their decarbonisation objectives.”

Macquarie Asset Management has committed to align its financing activity with net zero by 2040. The decision was driven by both a responsibility to be part of the transition and the opportunity it presents. As a large investor, it is keen to get moving quickly. “If we are transitioning our businesses then frankly, the earlier we start, the easier the process will be,” says Nicholson.

Shifting fundamentals

The IMF estimates that an additional US$6–10 trillion in global investments, both public and private, are needed in the next decade to mitigate climate change.

“Climate change and net zero is having an impact across our portfolio, it’s affecting nearly every sector in all sorts of different ways,” says Mike Sibson, Head of Aberdeen Office at BGF. “There are lots of businesses that you wouldn’t consider to be really concerned with the net zero drive. In areas like food production or clothing or tourism, industrial processes, the impact of climate change and our desire to reduce that impact are having a big effect and people are making big changes.”

BGF has set up a Clean Growth Advisory Board to provide a strategic view of how net zero will transform the economy. “As a lot of investors would appreciate, we can sometimes look at the most interesting lessons that we find in a certain sector. What the Clean Growth Advisory Board does is allow us to raise our sights and look at what’s happening overall and where the best investments might be,” says Sibson.

A natural ally

On the VC side, important work is being done on the carbon footprints of portfolio companies (see page 48). However, it also has a big role to play in funding the 40% of emissions reductions that will come from technologies not yet commercially deployed on a mass-market scale.

“The climate crisis will only be solved with effective innovation. New technologies and services need to be deployed very rapidly and VC funding plus know-how will be essential if this is to happen successfully” says Patrick Sheehan, Co-founder of ETF Partners. “We can already see VC being deployed to good effect, and in fact we and some other pioneers have been doing this for years already. More recently, it has been great to see others begin to recognise both the huge need and the equally huge opportunity.”

So, the VC sector is taking up the challenge. PwC found that early stage venture funding for climate tech companies increased from US$418 million in 2013 to US$16.1 billion in 2019, a jump of more than 3,750%. To put that into context, in an investment class known for its focus on technology, this is in the order of three times the growth rate of VC investment into artificial intelligence.

Dama Sathianathan is Partner at Bethnal Green Ventures (BGV), an early-stage ‘tech for good’ VC that invests in founders using technology to tackle big social and environmental problems. “Tech for good is quite well positioned, working across different domains that are geared towards a net zero future,” she says. BGV has been working on projects that explore how we get food from farm to fork (see page 55), as well as zero pollution in urban areas, smart mobility and access to affordable green energy, among many others.

One example is Fairphone, an ethical modular smartphone that not only reduces electronic waste going to landfill but aims to provide customers with long-lasting smartphones that are made with ethically sourced material.

Momentum from the majority

While impact investors and firms focused on responsible investment are leading the way, it is a shift in the practices of the majority that will bring about the biggest change. Momentum has been building significantly in recent years. The Principles for Responsible Investment (PRI) has 920 signatories that invest in PE or VC to some degree, with 120 PE firms joining in the first half of this year.

Signatories commit to incorporating ESG issues into their investment decision-making process and to seeking disclosure of ESG issues from their portfolio companies, among other things. Importantly, they are also required to report on how they incorporate ESG and who within the firm is responsible. Some of that reporting is made public and some is available privately to LPs. “In an asset class that isn’t too well known for transparency, it brings a bit of accountability,” says Dunbar.

While mandatory Task Force on Climate-related Financial Disclosures (TCFD) reporting will bring more regulatory pressure to bear on the ESG agenda within PE and VC, the industry has been convening on the issue for some time.

“The idea that something needs to be done is mainstream and I think the private equity industry and the investment industry generally is trying to figure out what that should mean in practice,” says Sheehan.

Carradice at Mayfair agrees: “Some of the larger houses have been looking at ESG for a while, and some of us in the mid-market are starting to think, what’s the best thing to do? And that’s all with a background of wanting to do the right thing but not actually being clear on what the right thing is. With all the different regulations and general lack of standardisation, it’s quite difficult to determine what we should be doing across the funds to make a real difference.”

The industry is tackling this issue by pooling knowledge and resources through bodies such as the Initiative Climat International (iCI) on the PE side and VentureESG and ESG_VC.

“Members of the iCI make certain commitments when they join,” says Dunbar, “from fairly basic stuff like recognising that climate change will have adverse effects on the global economy, which presents both risks and opportunities for investments, to committing to doing work with their portfolio companies to help them reduce their emissions.”

Clarity for investors

However, the real engine of transformation comes from the working groups housed within the iCI. “It brings firms together to agree a consistent framework by which we can gather data and communicate around this crucial topic,” says Ardus.

Carradice highlights the challenge faced by firms trying to gather data from young companies that have not started reporting yet. “One iCI working group is developing methodologies that enable you to make good estimates and use proxy data if you are not able to get actual data initially, so you can at least start to get an idea of baselines and then can work to capture the relevant data going forward. The working group is looking at how we can make that data collection process easier and give people that starting point so it isn’t too overwhelming,” she explains.

Another working group is exploring the World Resources Institute’s Science-Based Targets initiative (SBTi). “We’re trying to establish methodologies for PE firms that will give guidance to them on how to set net zero targets that are aligned with science-based targets,” explains Dunbar. “People can set a net zero target of their own, but the science-based targets initiative validates them. It brings a high degree of credibility to net zero commitments.”

Other organisations facilitating knowledge-sharing include the Institutional Investor Group for Climate Change (IIGCC), the European membership body for investor collaboration on climate change. The IIGCC has more than 300 members, mainly pension funds and asset managers, and aims to drive real progress towards net zero by 2030. US-based Ceres, a non-profit organisation working towards a sustainable economy, also convenes 200 institutional investors with more than US$47 trillion in assets through the Ceres Investor Network.

PE and VC firms that have established systems for ESG are able to perform a similar function within their own portfolio companies. Macquarie Asset Management, for example, hosts workshops with the management teams at its portfolio companies to set expectations and provide tools to help them begin their decarbonisation journeys. “We’re able to take learnings and experiences from one asset and share them with others. As part of that, some of the businesses who are more advanced than others can showcase what they’ve been doing,” says Nicholson. This provides a shortcut for companies within portfolios that operate in similar sectors, so that they do not need to reinvent the wheel on decarbonisation.

Carradice says portfolio companies have been very responsive to the support offered to them from GPs, “even to the point where we’re having meetings with the non-executives and CEOs of the businesses, who typically don’t get involved in these kind of things until you’ve worked them through. They’re really interested in learning what they should be doing and what their competitors are doing.”

The big commitment

Some PE and VC firms have made a commitment to net zero, such as sustainable investor Earth Capital, which joined the Net Zero Asset Managers Initiative this year. “We’ve signed up with a view to making our entire portfolio net zero — as a business we’ve been net zero now for two years,” says Co-founder Gordon Power. “What we haven’t committed to yet is the formal date of that. The reason is that different businesses will have different dates on which they can make that net zero commitment. We are spending time going through each of our businesses to look at what date we can physically put on each one of the companies.”

Carradice says Mayfair is also preparing for a net zero strategy. However, the industry broadly has not been as quick as others to make public commitments. “I think there’s a certain psychology at play in PE,” says Dunbar. “They don’t want to commit to things and then figure it out afterwards. They want to figure it out first, then commit. That’s why the iCI project is important, because that guidance and methodology will help the GPs say, ‘this is how we can go about setting these targets’. It helps them understand whether they can do it or not.”

Ardus agrees: “You could say that the PE industry has been slower in publicly communicating than the listed companies who have already gone out and made commitments, but that’s the nature of the industry. When we make commitments, our investor base can hold us accountable against them, so we’re perhaps more cautious to make public statements, but there is action happening.”

Part of the challenge is figuring out how net zero works in the context of the private investment cycle. “A net zero science-based target is 10 or 20 years out, but during that period, companies will come in and out of our portfolio. Just because we exit from one company, which perhaps is a much more energy-intensive business, does that make our footprint materially better or worse? No, we just exited that business,” says Ardus. “We’re different to a large multi-national business where they can say how they will evolve over time. At a PE level we are trying to establish some credible guidelines through iCI which establish a way of measuring your footprint — we’re trying to work out a consistent way of comparing apples with apples.”

Where next on the journey?

As the industry starts to get to grips with the fundamentals, it is also looking at next steps. Some of the challenges it is thinking about are how to ensure subsequent owners come good on net zero targets once companies are sold on, and how net zero commitments can become a priority alongside pricing in negotiations. There are also questions over how minority investors can make best use of the influence they have over board decisions.

“In time, we would like to have conversations with portfolio companies about linking an element of remuneration to ESG outcomes”

Once Mayfair has helped portfolio companies establish ESG strategies that are benchmarked and where progress is reported, it is considering an even more progressive step. “In time, we would like to have conversations with portfolio companies about linking an element of remuneration to ESG outcomes,” says Carradice.

The PE and VC sector is starting to play its part in driving change in the real economy. When it has established standards that work for private markets, its potential to turn words into action is huge.

Until then, the eyes of the industry are on COP26 and what it will mean for the economy. As Carradice says, “I’m hoping that COP26 will culminate in a sense of joined-up government responses to the global climate challenges, and I’m hopeful that we’ll be able to play a very significant role in that as an industry.”

This article is from the BVCA Journal Autumn edition, published October 2021. BVCA members can access the full publication here.

In this autumn edition, we explore the role of PE in achieving net zero; the current momentum behind ESG initiatives across the VC space; the factors driving an ever-increasing number of firms to certify as B Corps; showcase a selection of BVCA members working on the most viable solutions to the many problems presented by climate change, and much more.

www.bvca.co.uk