The evidence that humankind is putting the planet on a path to disaster has become increasingly difficult to ignore. The UN’s Intergovernmental Panel on Climate Change concluded its latest report with a haunting warning that “any further delay in concerted global action will miss a brief and rapidly closing window to secure a livable future.”

At least until recently, however, the US private equity industry has largely been reluctant to put its full might behind efforts to decarbonize the economy.

“European private fund managers certainly moved earlier in setting net-zero commitments and engaging with portfolio companies on climate issues,” says Liqian Ma, head of sustainable and impact investing research at Cambridge Associates, an investment firm that provides management services to institutional investors. Indeed, it was a group of French private equity firms that led the way in establishing the project now known as Initiative Climat International in 2015. The iCI plays an important role in helping global PE firms collaborate on climate mitigation and reduction strategies.

Similarly, US buyout firms have mostly remained on the sidelines of the Science Based Targets initiative, which validates that the commitments made by companies are consistent with keeping temperature rises within 1.5C or 2C thresholds. Each of the seven PE firms that received validation from the SBTi in 2021 are headquartered in Europe, although several have North America-focused funds.

Nate Aden, finance sector lead at the SBTi, says that the difference in approach reflects the reality that “Europe has more robust climate policies than the US.” This in turn is a consequence of both political and economic differences. “The US is not only a large consumer but a large producer of a lot of fossil fuels, so that creates very different vested interests,” he says.

Growing momentum

But there are clear signs that the tide is beginning to turn. Climate change has become a key focus of the US government under the Biden administration. Private equity firms have taken note of the shifting political currents.

“Momentum is picking up in the US,” says Ma, who points to the fact that the iCI established a North America chapter in March. Some 23 firms have joined the chapter; although not all of these have formally issued a net-zero commitment, the members will collaborate to standardize climate disclosures and target-setting.

Meanwhile, multiple US-headquartered PE firms (though by no means all of the largest players) have signed-up to the Net Zero Asset Managers initiative, which does require a commitment to achieve net-zero alignment by 2050. In February, The Carlyle Group became the first of the major publicly traded US private equity firms to commit to a 2050 or sooner net-zero target. Megan Starr, Carlyle’s global head of impact, told Buyouts that it was important for the firm to “put the line in the sand” by making its long-term pledge.

Hamilton Lane is another member of the North American iCI chapter that has made a 2050 net-zero pledge. Paul Yett, the firm’s head of ESG, says that with undeniable evidence of the climate crisis, “it wasn’t a hard discussion at all, internally, around the pledge to net zero. It was universally accepted from our CEO on down to our analysts.”

Firms that have not yet signed up to net zero can expect more scrutiny from their LPs. “Net zero and sustainability more generally are rising up the agenda for US investors and so US fund managers will naturally need to step up their game to meet evolving client expectations,” says Chris Leslie, a senior managing director at Macquarie Asset Management in New York.

Indeed, Ma says that Cambridge Associates has “incorporated several standard diligence questions related to fund managers’ net-zero strategy, including target-setting, methodology to determine net-zero alignment, and engagement strategy with portfolio companies on science-based targets.

“Over time, we expect fund managers will take net-zero commitments seriously as they see net-zero questions and engagement from allocators become commonplace.”

Next steps 

Making a 2050 pledge is one thing but following up with concrete actions is a considerably more complicated task. While the most obvious route to decarbonization is to divest from the most highly polluting assets, particularly fossil fuel investments, doing so risks throwing up unintended consequences.

“As an asset manager, there’s an easy way to go to net zero and there’s a hard way to go to net zero,” says Starr. “If you want to do it quickly and you want to do it in a way that lends itself to an easy press release, the easy way is portfolio allocation decisions.”

She tells us that if Carlyle divested from around a dozen of the approximately 300 companies in its portfolio, the firm could reduce its Scope 1 and 2 emissions by as much as 95 percent. But, says Starr, “that does not change a molecule of carbon dioxide in the atmosphere.

“What really matters is the individual trajectory of a given company or asset – where the company starts when you invest in them and where they are when you exit. The highest decarbonization potential is actually frequently in the most carbon intensive companies, because they have the most impact to be had if you’re able to decarbonize them over your hold period.”

“The highest decarbonization potential is actually frequently in the most carbon intensive

Megan Starr

Vista Equity Partners provides an example of a firm that has started to flesh out its strategy for requiring portfolio companies to reduce emissions. The software, data and tech investor committed last year to reaching net zero by 2050, but David Breach, Vista’s president and chief operating partner, tells us that it “quickly decided that 2050 was too far off.”

As such, Vista announced in May that each of its majority-owned portfolio companies would be required to “measure GHG emissions, set a GHG reduction target and offset GHG emissions on an annual basis.”

Mid-market challenges

Taking this kind of approach depends on a GP being able to collect reliable data on emissions across its portfolio. The complexity of this task means that some firms are holding off from making a long-term commitment until they have finessed the details of their strategy.

“Those GPs that are actually making net-zero commitments have probably already gone through a multi-year path that they’ve trodden to get to that point where they’re comfortable in committing,” says Peter Dunbar, head of private equity at the UN-backed Principles for Responsible Investment. “It’s not something that just happens overnight.”

Developing carbon reduction policies, and then measuring and managing emissions at the portfolio company level, is likely to appear even more daunting for firms without large sustainability functions. Adam Heltzer, head of ESG at Ares Management Corporation, says that he sees many GPs grappling with the challenge.

“In our private credit business, we engage with a lot of midsized private equity firms that often do not have the resources or expertise to measure emissions,” he says. “We’re observing that a lot of mid-market firms are racing to hire heads of ESG as they seek to build the in-house capability for measuring and managing the carbon footprint of their portfolio.”

Ares itself is taking a caution approach. “We are evaluating a net-zero commitment but want to ensure that when we make that commitment it is backed by a substantive plan,” Heltzer tells us.

“Measuring emissions across our entire platform is a tremendous endeavor and we have to get it right.”

“The first step is to actually measure emissions and then increase accuracy year over year. Some companies in our portfolio already measure their carbon footprint, but most middle market companies that we partner with today do not.”

This is a common challenge for smaller buyout firms that focus on the mid-market. “The companies you’re investing in are not as mature, therefore they’re not as sophisticated around their management of carbon and
climate-related risks and opportunities,” says Dunbar. “They probably don’t even have carbon footprints at the point at which the GP invests. There’s then a lot of work to do with those companies to try to explain to management the need to do those things.”

Aden acknowledges that the finance sector is in a “Cambrian explosion moment” on its route to net zero. The wide range of initiatives, metrics, targets and measurements is disorienting for fund managers that lack experience in climate science. “There’s a lot of confusion and a lack of consistency and clear understanding of how things fit together or what may be more or less credible over time,” says Aden.

But almost all advocates of decarbonizing the financial sector make a similar point – that the uncertainty around measurement and reporting cannot be an excuse for inaction. As Ma from Cambridge Associates points out, “validation of targets does not guarantee real-world decarbonization.”

He advises firms to “overcome the urge to over-analyze” and says managers should simply “start measuring baseline emissions in what you own today and concentrate on the companies and assets where you can generate the most emissions reductions the

Aden agrees. “One of the conversations we have with financial institutions is that the data are imperfect,” he says. “Well, if we waited for the data to be perfect, we’d surpass 3C very quickly. We have to act now.”

Regulation and validation

So far, US buyout firms are not exposed to the same level of regulatory scrutiny as their European counterparts on ESG, including in relation to climate risks. That, however, could be starting to change. 

In March, the US SEC proposed a rule that would require listed companies to disclose various types of climate-related information, including Scope 1 and 2 emissions.

The rules, if they survive criticism from Republican lawmakers, would not necessarily have direct impacts on most US PE firms. Some knock-on effects would be inevitable, however. A portfolio company that prepares for an IPO, for instance, would need to ensure it can meet the SEC’s requirements. And it may not be long before regulators start to focus on the climate claims made by PE funds, similar to how private funds in the EU are covered by the Sustainable Finance Disclosure Regulation.

“I do believe the SEC will turn its attention on the private markets and start asking questions and requiring certain information from companies,” says Hamilton Lane’s Paul Yett. “It behooves us in the private markets to get ahead of that, to the extent that we can begin to make sure that we’re capturing the information that will be required, both from the government, but also from all stakeholders.”

For the time-being, however, in the absence of regulation, US firms that make climate pledges are likely to face some suspicion of ‘greenwashing’ unless they submit their commitments to third-party validation.

This brings us back to the SBTi, which is regarded as the gold standard in verifying climate claims. Carlyle’s Megan Starr says that “we really like SBTi and we encourage a lot of our portfolio companies to get validated.” Carlyle itself does not plan to seek validation, however. “We work across those frameworks and have found the parts that work best for us, because there isn’t one that fits well with how we invest in our organization,” says Starr.

Similarly, David Breach of Vista confirmed that his firm is in the process of developing a framework that will “align with [the SBTi’s] methodology but will not require validation through the initiative itself.”

One factor behind the apparent reluctance of many firms to seek validation is the SBTi’s insistence that it will only validate financial institutions or corporates, rather than specific funds. “Our scope of coverage has to be the whole target-setting entity, whether it’s a company in the real economy or a financial institution,” says the SBTi’s Nate Aden. 

The organization will not allow GPs to ringfence part of their portfolios and “try to ignore the parts that aren’t compliant with climate stabilization,” Aden adds. “We’ll never achieve climate stabilization with just part of the portfolio, we need to have everything all-in – in fact, we have to have the whole economy transformed to achieve this.”