Private Capital Findings, Issue 21

Digging deeper

Taken together, the papers suggest that market forces and regulation are effective in ensuring that LPs can invest in ways that align with their own and their stakeholders’ views and values. However, as anyone who has  attempted to get their heads around ESG topics can attest, positive and negative outcomes are often far from cut and dried in what is a massively complex area. There can frequently be unintended consequences to regulations and to investor actions and decisions, for example.

A third paper highlights the potential for these when making what, on the face of it, may look like straightforward choices. Against the backdrop of negative headlines about PE’s investment in fossil fuel power plants, Mayank Kumar decided to examine the industry’s involvement in the sector. “Some people have formed the opinion that PE is buying fossil fuel assets as an arbitrage opportunity and that this is prolonging the lives of dirty assets,” he says. “I wanted to see what the scientific evidence showed by examining why PE firms were buying these assets.”

His findings are perhaps counterintuitive at first glance. Taking into account the amount of sunlight around fossil fuel plants in the US and looking at investment patterns before and after the 2005 implementation of tax credits for solar development, he finds that PE firm investment has increased since 2005 in fossil fuel power plants where solar irradiance is high. He also finds that new solar development increases in and around these sites relative to other fossil fuel power plants, suggesting that PE investment is facilitating the energy transition. “PE firms are more likely to own fossil fuel power plants in sunny areas than in other places – but this has been the case only since the policy change that offered incentives in 2005,” says Kumar. “I was surprised by how quickly PE identified this as an opportunity, because we start to see a big PE expansion in this space from 2007.”

Part of the reason for this is that fossil fuel power plants already have much of the infrastructure that renewable plants require. “Renewable assets face a lot of transmission problems – there are significant delays to grid connections, for example” says Kumar. “The advantage of coal and gas plants is that they are already connected.”

It’s a finding that chimes with Coller Capital partner and head of ESG and sustainability, Adam Black. “Many energy funds have a mix of oil and gas, nuclear, solar and wind assets,” he says. “There are good reasons for this beyond diversification, such as the grid connections and technical expertise. Many of the skills needed to operate and maintain fossil fuel plants are transferrable to renewable energy assets.”

One key takeaway from the research, therefore, is that simply blacklisting certain sectors can achieve the opposite of what an investor might intend. “Exclusionary policies don’t work financially or for the environment,” says Kumar. “They are not helpful from an investor perspective, because you are limiting the pool of investments. And from an environmental perspective, you are just substituting one owner for another.”

As ESG and responsible investment programmes have developed over time, many investors have started to agree on this point. Exclusionary policies still exist, but there appears to be a greater appreciation of the need for engagement, as opposed to divestment, when it comes to the potential for driving change.

“There has been an evolution,” says Maksym Konevshchynskyy, senior strategy consultant at Indefi. “Many investors started out with exclusionary policies, but over the past few years, we’ve seen a shift as people recognise that this is not the only way to go, especially if they want to aid the energy transition, for example. Companies need capital to transition, and so that has led investors to prioritise stewardship and engagement initiatives rather than simply withhold capital from sectors critical to the transition.”

This greater appreciation is leading to more “brown to green” strategies in PE, where firms invest in companies that underperform in E&S, perhaps because they are in legacy industries or energy-intensive sectors – concrete or glass manufacturing, for example – with the intention of putting them on a more sustainable footing or supporting them in the energy transition. Yet this can still be a challenging proposition for those LPs that may have little tolerance in their policies for, say, an increase in carbon intensity in their portfolios, even if the rise is temporary.

“It can sometimes be difficult for LPs to reconcile ambitious climate objectives on one hand with helping companies transition on the other, which often means investing in businesses that remain carbon-intensive in the short term,” says Konevshchynskyy. “LPsare concerned about  this and are thinking it through, but there is no easy answer to it yet.” He points to the European Commission’s review of the Sustainable Finance Disclosure Regulation (SFDR) as one measure that might help LPs to square the circle.

Indeed, the SFDR as it currently stands is another example of the potential for unintended consequences in the sustainability arena. The regime as designed to improve disclosure, but it is often perceived and used more as a labelling and marketing tool.

“There is a preference among some LPs for Article 8 or 9 funds,” says Black. “Yet we often see Article 6 funds that are considering and managing sustainability in portfolio companies just as well. This is why it is so important for LPs to do their homework and look beyond what has become a label to understand exactly what is going on.”

So, while the first two papers are encouraging for investors that care about E&S factors – LPs clearly have a voice in what happens in their portfolios and regulations are helping them to determine where to allocate their capital – the third provides a salutary lesson about being wary of unintended consequences of both ESG investment policies and directives from rule-makers. “One of the main lessons from this is that LPs should take a deeper look at their PE portfolios to see what kind of assets their GPs own and determine whether there  are decarbonisation opportunities – it doesn’t have to be binary as to whether an asset is dirty or clean,” says Kumar.