Development of SBTi in the Financial Sector
The Science Based Targets initiative (SBTi) regards the financial sector as a crucial part in promoting the global decarbonatization and green economy transition. Through lending and investing, they have the power to reallocate resources to sustainable solutions and the preparation for a net-zero emission economy of companies in their portfolios. In October 2020, the SBTi launched its first net-zero transition guidance for financial institutions, followed by recommended criteria and methods in April 2021. In addition, the SBTi is developing a Net-Zero for Financial Institutions Foundations and expects to publish it in 2022 to help the sector standardize and drive financial climate action.
Release of New SBTi Guidance for Private Equity Firms
The SBTi keeps expanding its reach deep into each participant of the financial market. The organization launched tailored guidance for private equity (PE) firms to assist them in taking a science-based approach to reducing greenhouse gas (GHG) emissions on November 8. The SBTi authored this new guidance with the support from the UN Principles for Responsible Investment (PRI) and signatories of the initiative Climat International (iCI). It required the private participants to set their decarbonization goals for their operations and portfolios in line with the one urged in the COP26 summit. During the COP26, leaders worldwide highlighted the urgency of limiting the global temperature rising under 1.5 °C rather than just below 2 °C.
Together with the introduction of the new guidance, SBTi announced the first six PE firms with validated green targets. The first batch of eligible companies are Astorg, Bregal Investments, FSN Capital, Hg, Intermediate Capital Group (ICG), and Investindustrial, managing over USD133tr worth of assets under management (AUM). Afterward, the next day after the release of the guidance, five more firms pledged to have their own SBTi targets approved within two years. These candidates are Altor Equity Partners, Eurazeo, Montagu Private Equity, Tikehau Capital, and Triton Partners.
Methods for PE Companies to Apply
The guidance divides different asset classes covered in PE firms. Following that, the guidance requires direct PE investments, including electricity generation, real estate, buyouts, growth capital, and venture capital, to set out their decarbonization targets in a science-based way mandatorily, while the rest of the asset classes in the private market can decide whether to establish and disclose their targets.
Figure 1 illustrates that firms possessing electricity generation or real estate assets should use the Sectoral Decarbonization Approach. Firms engaged with growth capital or buyouts should adopt the Portfolio Coverage Approach, while PE firms managing venture capital assets should set their goals using the Temperature Rating Approach. If a PE firm is a multi-strategy firm with several of the above asset classes, such as real estate and venture capital, it will have to adopt two methods, one for each of the asset classes: Sectoral Decarbonization Approach and Temperature Rating Approach, respectively. The PE firm will then need to set a science-based target (SBT) for each asset class and disclose the language concurrently and consistently using the Guidance.
Method 1: Sectoral Decarbonization Approach (SDA)
The SDA belongs to the traditional SBTi methods and is accepted widely across corporates that have approved SBTs. Once the targets come into practice, it means companies should take aggressive decarbonization mitigation action to achieve the absolute reductions required.
Method 2: Portfolio Coverage Approach (PCA)
The Portfolio Coverage Approach (PCA) is an engagement-based approach. When adopting this approach, a PE firm is required to set a five-year target by using a selected metric, GHG emissions (SBTi’s preference) or financial, to sufficiently make portfolio companies set their own SBTs, in line with a linear trajectory to 100% of portfolio companies having SBTs by 2040.
Another case when using the PCA is that if PE firms acquire listed firms with existing approved SBTs, the PE firms should integrate these approved targets of listed companies in percentage into their own SBT establishment. Such acquisitions will directly contribute toward the achievement of the PCA. This encourages PE firms to acquire listed companies with approved SBTs that will help their progress toward their portfolio coverage of SBTs.
Method 3: Temperature Rating Approach (TRA)
The Temperature Rating Approach (TRA) ranks all portfolio companies with temperature scores. The calculation of the temperature rating is based on their GHG footprints and any existing GHG targets. In the absence of an existing GHG target, the SBTi gives a default score of 3.2°C to each portfolio company. Then, the PE firm is required to set a target to reduce its aggregated temperature score across all portfolio companies, to a minimum temperature below 2°C scenario regarding the portfolio companies’ scope 1, 2, and 3 emissions by 2040.
The method provides an online tool to interpret any existing GHG emission reduction targets into temperature scores at a portfolio company or borrower company level. For each of these companies, there is a requirement to obtain GHG emissions data for the temperature rating tool. If the data is unavailable, companies can purchase proxy data from some data vendors such as the Carbon Disclosure Project (CDP).
Reason for Launching PE Firm Guidance
Expansion of PE
According to the McKinsey Global Private Markets Review 2021, PE has outperformed other private asset classes and experienced less volatility after the financial crisis in 2008. This has attracted more investors to invest in PE and won more confidence. In 2020, the total investable PE amounted to USD 502.9bn globally. Besides, the number of active private capital firms reached the peak of 11,000 in 2020, where three quarters were PE companies. The growth rate of PE companies is 9.1% per year, which is even 1.1% higher than that of the entire private market. With the expansion of PE, investors will also stress on these firms and portfolio companies to set climate change targets and disclose their performances.
The increasing influence of PE
According to IEA’s latest report, spending on clean energy is the largest proportion in sustainable investment, accounting for 37.3%. The current funding structure shows that governments and public funds are major players in this field. In terms of PE firm’s contribution, more and more private funds would flow in global energy projects if governments take the lead. Hence, this leaves great room for private actors to increase their influence in the green transition.
Inherit issues in PE
Most companies still prefer private fund sources rather than going listed due to relatively lower interests and compliance costs than being a listed company. This means PE firms face influencing portfolio companies to take the bigger step to sign up to and disclose in compliance with SBTs. Another issue is that the business model of PE focuses more on increasing the value of the portfolio companies but seldom cares about the post-acquisition stage. In other words, it is more likely to be short-termism rather than keep long-run sustainability.
The new guidance argues that there is a general immaturity of GHG footprint disclosures in the private investment market. Only less than 0.03% of private companies report to the CDP, and only 37% of these have emission reduction targets. Compared to the case in public corporations, the public investment market has a relatively higher carbon maturity, where 10.2% of 41,000 public investable companies report to the CDP.
The key pre-requisite step to setting an SBT is to commit to the SBTi within a two-year conducting period. However, when it comes to practice in reality, there still exists some challenges for PE firms in setting and achieving the SBT. The guidance is quite huge and complicated for companies to digest and then put into effect. The entire process needs more educational support from the SBTi and some other professional organizations. Moreover, GHG emission target-setting and planning require a large amount of data while PE firms are immature in terms of recording and tracking their GHG footprints, regardless of high-quality GHG data. Therefore, there is still a long way for PE firms to align with the SBTi guidance and to integrate decarbonization into their investing strategies.
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