How Private Equity Investors Are Backing the Energy Transition

“We need to be fully committed to address both risks and opportunities. Climate change brings both.” 

CalPERS’ stance echoes the sentiment of many global capital heavyweights. Addressing climate risks has become a cornerstone of fiduciary duty for many allocators — only 18% of LPs disregard climate as a material investment risk. 

And the financial stakes have become impossible to ignore. Transition costs stand to impact carbon-heavy businesses via enhanced regulatory costs and the threat of leaving investors with ‘stranded assets.’ Further, as the true cost of carbon drives up input prices, profit margins, and valuations at these GHG intensive companies could take a hit. 

Extreme weather events also pose growing physical risks, holding the potential to damage infrastructure, disrupt supply chains, and in turn, cut into revenue. Deloitte projects that without stronger policies, the current global warming trajectory could wipe out $178 trillion from the economy over the next 50 years. 

However, CalPERS’ statement highlights the dual nature of the energy transition: alongside financial risks, there are massive investment opportunities. The Climate Policy Initiative (CPI) estimates the world needs $8.1 trillion annually in climate finance — rising to $9 trillion by 2030 to hit net-zero by 2050. And the potential upside is huge. The same Deloitte analysis projects a $43 trillion economic gain if climate targets are met, offering allocators a chance to profit while driving progress.

Institutional investors are increasingly committing to net-zero goals as they navigate climate-related opportunities and risks. Leading universities, including Harvard and Stanford, have pledged to align their endowments with net-zero targets, joining major philanthropic organizations such as the Rockefeller Foundation and Russell Family Foundation. Meanwhile, pensions and sovereign wealth funds worldwide are also adopting net-zero strategies, reflecting the widespread adoption of carbon emission reduction targets among LPs. 

But the road to net-zero is far from straightforward. Tracking emissions in layered private equity vehicles and holding managers accountable on climate targets remain tough obstacles. Climate goals must also align with risk appetites, return expectations, and asset allocation limits. To make matters more challenging, US allocators are grappling with policy uncertainty and the growing politicization of climate efforts.

Addressing Net-Zero Goals in Private Equity Portfolios

As LPs worldwide commit to net-zero targets, three key objectives emerge: cutting portfolio emissions, increasing exposure to net-zero-aligned companies, and financing and scaling critical climate technologies.

While private equity isn’t always the biggest emissions driver in LP portfolios, it is playing a growing role in achieving these goals. LPs are pursuing multiple strategies within the asset class — each presenting its own set of challenges and opportunities.

Divestment and Portfolio Allocation Changes

One strategy for investors to meet portfolio-level emissions targets is to divest from high-GHG emitting companies or shift their allocations away from carbon-intensive industries. Take Sweden’s AP4: The fund has slashed emissions by 65% across its $20 billion global and domestic equity allocation. However, Tobias Fransson, the fund’s Head of Sustainability estimates that about two-thirds of this reduction stems from portfolio reallocation rather than actual corporate change. 

Some large LPs have taken a similar approach with private equity, creating mandates to block new private investments in fossil fuels or divest from asset managers unaligned with their climate goals. For example, PME Pensioenfonds, a Dutch pension fund, recently announced plans to divest from BlackRock because of its departure from the Net-Zero Asset Managers Initiative. 

Further, some states and jurisdictions are creating mandates to block pension private equity investments into fossil fuels. This month, the state of Oregon introduced legislation that would create a five-year moratorium on state investments in private equity and other private market funds that pursue investments in fossil fuel portfolio companies. 

However, while divestment reduces emissions exposure, it doesn’t drive real-world emission reductions. Moreover, divesting from high-emitting assets often means those assets end up with new owners who may have no intention of improving their carbon footprint.

Achieving emissions reductions in the ‘real economy’ will require transitioning high-emitting industries to net-zero pathways. Some investors are already leading the charge. For example, as part of its climate strategy, the Caisse de dépôt et placement du Québec (CDPQ) has allocated a portion of its portfolio specifically to decarbonize high-emitting industries — a strategy several other pension funds are now adopting.

Driving Asset Level Emission Improvements  

Given the challenges of divesting from high-emitting sectors, many LPs are working towards driving emission reduction at the asset level by increasing their portfolio coverage of underlying companies that are “net-zero aligned” or have clear decarbonization targets. 

To achieve these asset level improvements, LPs are increasingly scrutinizing how GPs address emission targets during due diligence, negotiating climate goals through side letters, and partnering with GPs who explicitly link decarbonization levers to value creation. 

This demand from LPs has led to an increasing portion of GPs using sustainability improvements to achieve multiple uplift. For example, according to a recent Boston Consulting Group Analysis, private companies with lower emission intensity increase revenues faster than those with higher intensity. 

However, driving asset-level improvements in private market portfolios aren’t without challenges. For one, most private equity managers setting decarbonization targets for portfolio companies mostly operate within low-emitting sectors.

A GP’s ability to drive emission reductions also varies by their stake in the company. Fund managers with board control can advocate for emissions cuts through 100-day plans, value creation strategies, and linking management remuneration to climate KPIs. Setting ambitious climate goals is more complex with minority stake investments, requiring extensive engagement and education from both the GP and LP with management.

LPs also face constraints on their ability to influence investment decisions based on their timing, role, and scale within a fund. Those investing at a fund’s launch, serving as anchor investors, or contributing a significant portion of the fund’s capital are more likely to secure seats on LPACs and exert greater sway over investment strategies. LPs accessing private equity via secondaries or funds-of-funds typically wield far less influence. 

Creating Allocations to Finance Climate Solutions

LPs can also create allocations to finance the companies and technologies essential to the net-zero transition, like renewable energy, carbon capture and storage, and waste management technology, etc. 

For example, many large institutional investors have mandates to invest a certain amount of the total portfolio into climate solutions. The New York State Retirement Fund and CalPERS have set climate solution targets of $40 billion and $100 billion, respectively, integrating them into existing asset allocation strategies. Similarly, the Washington State Investment Board has grown its exposure to renewable energy companies by encouraging investment into these opportunities as part of its existing tangible asset and innovation allocations. 

But investing in climate solutions isn’t without challenges. Some investors argue that climate solutions don’t fit neatly into traditional asset classes or risk profiles, as they can involve exposure to high-risk emerging technologies, capital-intensive infrastructure projects, and shifting policy landscapes. Take the IRA, for example: its subsidies boosted renewable project economics, but its future remains uncertain under the current administration.

With this in mind some investors have carved out separate allocations for climate solutions within their broader portfolios. CalSTRS, for instance, launched its SISS portfolio to invest more flexibly in low-carbon solutions that don’t neatly fit within the risk/return profiles of its umbrella strategic asset allocation (SAA) targets. The portfolio invests across strategic areas in private markets: opportunistic climate infrastructure, venture capital and growth equity, and hybrid or innovative climate solutions.

Similarly, Border to Coast set up a separate $1.6 billion private climate program, distinct from its main private market strategy, to tap into opportunities that don’t align with the core strategy’s risk-return objectives. About 20% of this program is earmarked for venture investments in emerging climate technologies. Harvard’s endowment climate solutions investments are similarly concentrated in venture and growth capital funds and companies. 

Another trend in LP’s climate solution efforts is the rise of co- and direct investing. For example, CalPERS has allocated $600 million of its climate solutions budget to co-investments. However, while co-investing has emerged as a popular tool in climate solutions portfolios it’s not absent of risk, as seen in the collapse of battery provider Northvolt, which impacted several co-investors. 

Ultimately no matter how LPs are integrating climate solution goals across asset classes, one thing is clear: private markets are taking center stage. 

“Those are the ones [private market assets] that have very evident climate investment opportunities. “We’re expecting [private markets will] represent more than half of the $53bn. It’s pretty significant.”

Peter Cashion, Managing Investment Director, Sustainable Investments, CalPERS in a Financial Times interview

Data and Reporting Challenges of Assessing Net-Zero Impact in Private Equity

Limited partners face significant hurdles in achieving net-zero goals, regardless of their approach. Sector visibility, data collection, and reporting pose major challenges in measuring portfolio impact. For example, even establishing a baseline exposure to high-emission sectors or understanding financed emissions at the company level within private capital vehicles demands extensive data aggregation.

Tracking net-zero progress is also challenged by the lack of consistent, reliable emissions data in private equity. Without standardized reporting requirements, securing emissions data from private companies is a challenge, often requiring a resource-intensive process. Further, an LP or GP’s influence over a company can play a key role in whether data is disclosed at all.

Even when private companies do report Scope 1, 2, and 3 emissions, inconsistencies in calculation methods are common, leading to unreliable data and complicating efforts to track real progress. Scope 3 emissions pose the biggest challenge. As the largest source of emissions for many companies, they are also the hardest to factor into investment analysis since they originate outside a company’s direct control. 

Tracking these emissions across private equity portfolios is complex, relying on assumptions and estimates that introduce errors. One major issue is widespread double counting, as emissions are often recorded multiple times across business-to-business supply and demand chains. 

Additionally, two of the primary metrics LPs typically use GHG emission data to assess climate risk — total financed emissions and weighted average carbon intensity — must be tied to their ownership in an underlying company and a company’s revenue, respectively. Often, integrating emissions data alongside financial metrics to calculate these insights entails a significant data aggregation. 

Adding to the complexity, ESG disclosures often lag behind financial statements, making it difficult to ensure accurate and timely calculations. These challenges are partly behind CalSTRS decision to delay disclosing its 2023 carbon footprint until this year. 

Despite the challenges, LPs continue to push forward in aggregating carbon insights within their private equity portfolios. The Public Sector Pension Investment Board (PSP) is one example of an LP who has started to collect and report on emission data in the private market portfolio at a more granular level. 

As LPs continue to look for ways to refine their emission data collection, processing, and reporting, leveraging technology to help bridge the gap between financial and ESG data will become increasingly important for monitoring progress against net-zero goals. 

Learn how LPs can use Chronograph to help position their ESG insights alongside underlying portfolio financials and operating metrics.