Converting high-issue assets is difficult, but private equity could help

Institutional investors are under tremendous pressure to commit to net-zero greenhouse gas emissions by 2050 – and many are doing so. According to a recent survey, nearly half of all institutional investors have either publicly committed (31 percent) or are in the process of making a commitment (16 percent) to achieve net-zero emissions from their investment portfolio by 2050.

While many are still exploring what net-zero means for them, private equity could help decarbonize high-emission assets. Image: Robeco Global Climate Survey 2022

However, after a commitment, the following questions must be answered: “How do we get there?” and “What do we do with the assets with the highest emissions?”

Transformation versus divestment

One of the hottest topics for sustainable investing today is the debate between selling or converting such assets. According to the previously cited survey, investors say they will sell around a fifth of their total portfolios over the next five years to reduce exposure to high-issuance assets. This could help these organizations achieve their net zero goals, but does it really solve the core problem?

While it’s easy to see this transformation versus divestment debate through a binary lens, the answer could lie somewhere in between. While divestment offers investors and the world short-term quick wins, in reality it merely transfers ownership and does not remove sustainability-delayed assets from the global mix. It also clearly penalizes emerging markets. Such regions may be big issuers today, but an exit could deprive these markets of the capital needed to move to net zero.

On the other end of the spectrum, decarbonizing high-emission facilities is difficult (and expensive). It requires rethinking processes from the ground up and redesigning existing sites through remodeling or retrofitting. Many cannot be fully decarbonized and also require investment in future breakthrough technologies.

All this is not easy and often associated with high costs. It also requires tolerating temporary spikes in issuance across the portfolio rather than a steady downtrend towards 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 contribute to the decarbonization of high-emission assets?

So what can private equity do? This is where the industry has the opportunity to exert a disproportionate influence. With its full-ownership governance model and relative freedom from short-term pressures, private equity funds can achieve a lucrative early mover advantage by developing differentiated decarbonization capabilities.

Four strategies can be used, which are described in more detail in the World Economic Forum’s white paper, Creating Value through Sustainability in Private Markets. These are:

• Improve asset-level visibility with proactive communication against a clear transformation plan to mitigate “headline risk”
• Investing in capacity building for deal teams to credibly engage portfolio companies on transformation opportunities and create sustainability playbooks
• Increase flexibility in hold times where needed to execute ambitious transformation programs and capture value created at the end of a transaction
• Advocating emissions targets to be “rolled over time” to complement level-based targets and allow for active adoption and conversion of strong emitters.

That doesn’t mean it’s easy. Even if the private equity industry meets all four points, the key to the success of such a sustainable transformation strategy will be tolerance for assets that may have higher issuance in the short term.

Investment funds themselves, as well as their limited partners (the institutional investors), need to consider that hard-to-reduce sectors such as aviation and shipping will take longer to reach long-term emission reduction targets. In the meantime, they must clearly communicate the decarbonization strategy and withstand pressure from politicians and other stakeholders to move faster.