Comment: Climate-related risks and opportunities – what does PE need to know?

The role of finance in the fight against climate change is now clearer than ever.

Private equity and private market industries have a unique role to play. With an active investment model that supports so many businesses with significant global capital, the industry can leverage its influence to drive meaningful change, while also creating shareholder value.

By investing and engaging with portfolio companies to drive climate action, private equity firms can respond to regulatory and investor pressures, grow their value while mitigating risk and, ultimately, contribute to global environmental ambitions at pace.

To do this, private equity firms need to embed environmental sustainability into their organisation at every level and develop the ability to effectively analyse and report on climate-related risks and opportunities across all their activities.

A consistent approach to climate
The Financial Stability Board (FSB) set up the TCFD in 2015 to develop consistent climate-related financial disclosures, and it has already had a huge market impact, transforming how asset managers think about and prioritise climate change. And while the TCFD’s recommendations are being rolled out by various regulatory bodies around the world, many firms are also aligning to the recommendations voluntarily, to stay market competitive and up to date with investor expectations.

Several countries and regulators have begun to mandate climate-related disclosures using TCFD recommendations as the foundation of their rules, and many others are looking to the International Sustainability Standards Board and the Taskforce on Nature-Related Financial Disclosures for their expected recommendations in 2024. We expect several other countries and regulators to follow this lead in the coming years.

In the UK, FCA-regulated asset managers with more than £50bn AUM will have to present detailed climate-related disclosures by June 2023, followed by those with between £5bn and £50bn by June 2024.

There is also a clear financial imperative for disclosures. We’re operating in a market where climate change affects portfolio businesses over time, not just during hold periods but also long afterwards. Environmental sustainability is now inextricably linked to value, so understanding climate risks and opportunities is, therefore, key to firms’ investment, value creation and exit strategies.

Industry-specific guidance
While the TCFD has published guidance on its recommendations for asset managers, it does not always capture some of the nuances of private equity firms, including their hold period, the significant changes in portfolio composition over the life of a fund, and the requirement to disclose at firm and portfolio company level.

To help address this lack of private equity-specific guidance, KPMG (together with initiative Climate International and the British Private Equity & Venture Capital Association) prepared a guide with practical steps for firms at every stage of their climate journey to implement, to produce disclosures aligned to the TCFD recommendations’ four core pillars – governance, strategy, risk management, and metrics and targets – illustrated with case studies, methodologies and best practices.

Summarising that guidance, the three key takeaways would be:

1) Climate risks and opportunities are starting to be considered in valuations
The TCFD recommends that firms assess the climate-related risks and opportunities they have identified in their portfolio over the short, medium and long term. As investment businesses, private equity firms need to consider these risks even before the investment has been made.

Incorporating climate considerations into investment decisions can help firms understand and quantify the climate-related risks and opportunities impacting the value of a business across the investment lifecycle. Starting prior to acquisition, during the hold period and in the post-hold period, investment strategies can drive efforts towards a lower-carbon economy, and strengthen the resilience of our financial systems collectively.

As disclosures and modelling capabilities develop over time, climate risk will be incorporated with other financial risks monitored by private firms, and will therefore be considered in business valuations, both for target portfolio company acquisitions and exit models.

Part of the focus of this guide is to explain how climate analysis capabilities, structured around the recommendations of the TCFD requirements, can be used as a strategic tool for the benefit of private equity firms and their investors.

2) The time is now…
It’s not just the regulatory environment that is driving the adoption of TCFD recommendations. While the TCFD is being implemented at scale, with several countries and regulatory bodies now expecting it, so too are investors. With the increase in available data and comparability, stakeholders and investors are increasingly using climate-related metrics and targets to benchmark, assess and strategise their investments.

Disclosing the metrics and targets used to assess climate-related risks and opportunities – as per the TCFD’s recommendations – helps firms demonstrate to stakeholders that their long-term climate ambitions are aligned and risks are mitigated.

This can not only help to protect investor capital from climate risks but lead to financial benefits and returns from the opportunities that the transition presents. Failing to align your climate approach to the regulation and market, as well as investor expectations, could pose increasing risks to capital flows for private market firms.

3) Helping the planet – and creating value
Private market firms control trillions of assets worldwide and therefore have a significant role to play in the decarbonisation of our global economy and the long-term protection of our planet.

There is the opportunity for private market firms to not only benefit commercially from developing their climate expertise, but to fulfil a stewardship role in the journey to decarbonisation.