Private Equity Path in Transforming “Grey Assets”

Today, a lot of private equity investors see “grey” assets, including high emitters, as potential stranded asset risks that should be avoided by using exclusionary screens or divesting. The world’s problems with long-term decarbonization won’t be resolved by that strategy, though. In addition, there is a risk (actual or perceived) that private equity may take on the role of the de facto owner of high-emitting assets as public markets put more pressure on companies to sell them off. If this were to happen, the industry would be subject to regulatory and reputational damage. Instead, private equity companies may and must enhance these assets’ sustainability performance, turning them “from grey to green”. Because of its full ownership model (which provides operational control and reduces action impediments) and longer time horizon than public markets, the sector is well-suited to fill this function. Despite these structural benefits, the industry isn’t yet taking use of this potential to a significant degree. Capability gaps, measurement constraints, and holding periods that are too long have all been mentioned as obstacles to effective engagement in sustainable transitions in conversations with industry players. 

Three additional obstacles to the decarbonization of heavy emitters stand out

  1. Lack of sustainability knowledge to analyze the market for chances to alter sustainability and carry out ambitious plans
  2. Investors are subject to “headline risk” due to a lack of measurement standardization that makes it difficult to communicate progress towards goals.
  3. Longer time to get benefits from sustainability, maybe longer than the standard holding period, which discourages ambitious plans

Additional obstacles specific to the decarbonization of heavy emitters

  1. Targets for “levels-based” portfolio emissions reductions discourage the purchase and decarbonization of high emitters.
  2. Investors that are concerned about the environment and would decarbonize or retire their assets are outbid by funds looking to make money from heavy polluters.
  3. Due to the lack of societal agreement and supportive policies about the retirement or decarbonization trajectories of heavy emitters, there is a risk that assets will get stranded over the holding period.

“As investors and partners, our job is to improve all aspects of a business to drive growth and improve how they operate over the long haul,” said Kewsong Lee, Carlyle’s CEO. “In a world that is changing quickly, that increasingly involves working with businesses to help them perform better on ESG problems. We are ideally suited for this role given our ownership stakes, investment horizon, and knowledge. Five key steps for paving the path to sustainability for private equity are listed below; 

  • Invest in competencies and culture: For LPs and GPs today, a capability gap is one of the main obstacles to action. One of the most important initial steps in developing institutional capacities is to make sure that the leadership team consists of individuals with relevant operational and conventional investment knowledge as well as a sustainability mentality.
  • Maintain attention on the long-term plan: Creating capabilities and bringing about a culture shift may need some false starts along the way. To maintain momentum, private equity leadership must make use of the larger time horizon flexibility in private markets and optimize for the long-term result, not simply short-term gains, by taking actions like embracing experimentation and extending hold periods.
  • Share the strategy: along with specific targets along the way: Given the extensive time horizon needed to achieve benefits at the asset and portfolio levels, it is essential to secure and retain buy-in by clearly articulating the long-term objective and progress towards it to all stakeholders. Both standardized metrics and customized reports should be used in this.
  • Don’t simply divest; transform: The private equity industry should be able to transform sustainability-laggard assets due to its complete ownership model and flexibility to have a longer-term perspective than the public markets, but so far it has not taken advantage of this opportunity.
    Diversification and sector switching provide immediate gains for a single investor, but they do not exclude assets with low sustainability performance from the global portfolio. By investing money to change these “grey assets,” sustainability problems must be tackled head-on.
  • 5-Work together to overcome major obstacles: It is impossible to solve measurement problems and provide the correct incentives on your alone. Industry-wide LPs and GPs must keep working together to establish standards and guidelines.

Private equity investors must adapt to the quickly changing public expectations and aspirations for sustainability. This creates opportunities for long-term value development in addition to financial, reputational, and regulatory concerns that must be managed. To take advantage of this opportunity, private equity needs to act. These five “Monday morning” priorities can be used by private equity leaders as a starting point to ensure that their firms fully understand the significance of their involvement in decarbonizing difficult-to-abate sectors.

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