Institutional investors are facing immense pressure to commit to achieving net-zero greenhouse gas emissions by 2050 — and many are doing so. According to a recent survey, almost half of all institutional investors have either made a public commitment to achieve net-zero emissions from their investment portfolio by 2050 (31 percent) or are in the process of making this commitment (16 percent).
While many are still investigating what net zero means for them, private equity might help with decarbonizing high-emitting assets. Image: 2022 Robeco Global Climate Survey
Once a commitment has been made, however, the following questions must be answered: "How will we get there?" and "What do we do with the highest emitting assets?"
Transformation versus divestment
One of the hottest sustainable investing topics today is the debate between either divesting from such assets or transforming them. According to the previously cited survey, investors say they will divest around a fifth of their overall portfolios in the next five years to reduce exposure to high-emitting assets. This might help these organizations achieve their net-zero targets, but is it really solving the core problem?
While it is easy to see this transformation versus divestment debate through a binary lens, the answer may lie somewhere in between. Divestment does offer short-term quick wins for investors and the world, but in reality, it simply transfers the ownership and does not remove sustainability-laggard assets from the global mix. It also puts emerging markets at a distinct disadvantage. Such regions may be high emitters today, but divestment could starve these markets of the capital needed to transition to net zero.
On the other side of the spectrum, decarbonizing high-emitting assets is hard (and expensive). It demands reimagining processes from scratch and redesigning existing sites with rebuilds or retrofits. Many are impossible to decarbonize completely and will also require investment in future breakthrough technologies.
All of this is not easy and, more often than not, comes at a high cost. It also requires tolerating temporary spikes in emissions across the portfolio, rather than a steady downward trend toward net-zero. For institutional investors, in particular, this requires clear communication with stakeholders and the ability to withstand other political pressures in the meantime.
How can private equity help in decarbonizing high-emitting assets?
So what can private equity do? This is where the industry has the opportunity for disproportionate impact. With its full ownership governance model and relative freedom from short-term pressures, private equity funds can earn a lucrative early mover advantage by developing differentiated capabilities when it comes to decarbonization.
Four strategies can be used, which are mapped out more fully in the World Economic Forum’s whitepaper, "Creating Value through Sustainability in Private Markets." These are:
- Enhancing asset-level transparency, with proactive communication against a clear transformation plan to mitigate "headline risk"
- Investing in capacity-building for deal teams, so that they can credibly engage portfolio companies on transformation opportunities and build sustainability "playbooks"
- Increasing the flexibility in holding periods where necessary to undertake ambitious transformation programs and capture the created value at the end of a deal
- Advocating for "change-over-time" emissions targets to supplement levels-based targets, allowing for active acquisition and transformation of heavy emitters.
This doesn’t mean it’s easy. Even if the private equity industry executes on all four points, the key to the success of this kind of sustainable transformation strategy will be the tolerance for assets that may have higher emissions in the short term.
Investment funds themselves, as well as their limited partners (the institutional investors), must consider that hard-to-abate sectors such as aviation and shipping will need more time to achieve long-term emission reduction targets. They will need to clearly communicate the decarbonization strategy in the meantime, withstanding political and other stakeholder pressure to move faster.