Decarbonizing Portfolio Companies: How Science-Based Targets Empower Private Equity Leadership on Climate

The Science Based Targets initiative (SBTi) enables companies worldwide to set greenhouse gas (ghg) reduction goals aligned with climate science. Over 6,000 businesses have joined SBTi, signaling a seismic shift towards urgent, coordinated climate action across sectors.

Among SBTi’s 14 sector-specific resources, the expanded guidance for financial institutions provides a targeted framework for private equity firms to drive urgent decarbonization across their portfolios.

With trillions in assets under management, private equity firms are uniquely positioned to drive urgent decarbonization across their portfolios and the broader economy. However, many face barriers in measuring emissions and setting ambitious, science-aligned targets.

In order to enable meaningful adoption, the SBTi has developed tailored guidance for private equity investors. This framework aims to equip firms to overcome common challenges and accelerate portfolio-wide emissions reductions.

The guidance provides methodologies optimized for private equity business models and asset classes. This assists in developing robust emissions inventories and science-based targets aligned with 1.5°C and 2°C climate scenarios.

Unlocking Portfolio Decarbonization: Inside SBTi’s Private Equity Approaches.

To empower wide emissions reductions, the SBTi private equity guidance provides three complementary approaches:

• Sectoral Decarbonization: it involves setting intensity targets benchmarked against the decarbonization rate of the specific sectors as a whole,  it outlines methods for high-impact sectors like electricity generation and real estate.

For electricity generation, science-based targets take a portfolio view of investments across renewables, fossil fuels, and other generation technologies. Targets address the overall carbon intensity of energy output, incentivizing shifts from coal or gas toward solar, wind, and other low-carbon sources. Though this method is focused on Scope 1 and 2 emissions, not Scope 3.

For real estate holdings, targets encompass emissions reductions per square meter of floor area. This drives decarbonization across portfolios as firms improve building efficiency and adopt renewable heating and power.

• Portfolio Coverage: If the investing firm has more than 25% of the equity in the business, then portfolio coverage is the most suitable approach. Beyond sector-specific guidance, the portfolio coverage approach enables broad private equity decarbonization. Portfolio coverage sets overarching emissions targets based on the proportion of assets with approved science-based targets. This incentivizes broader engagement across varied sectors. Firms must guide portfolio companies to develop 1.5°C-aligned targets suited to their operations within five years of making an acquisition.

Control and governance levers like board seats allow private equity to steer portfolio companies in target setting and decarbonization execution. By cascading targets through significant ownership positions, private equity can propagate ambitious climate action throughout the global economy.

• Temperature Rating Approach: For minority stakes or private debt, the temperature rating approach enables science-based target setting. This applies when firms lack control over portfolio companies’ climate strategies.

The temperature rating approach measures portfolio emissions and then models alignment with 1.5°C or 2°C scenarios. SBTi provides temperature tracking tools that determine the reductions required for science-based decarbonization, and firms set top-down targets to decrease portfolio emissions on the necessary trajectory by 2050.

With less influence over individual assets, private equity firms steer decarbonization through financing incentives and conditions. Debt covenants or minority board seats allow engagement on emissions measurement, disclosure, and reduction initiatives.

The temperature rating approach empowers ambitious target setting despite limited governance control. By embedding climate objectives in investment decisions and portfolio management, private equity can catalyze decarbonization across the broader business landscape.

Setting the Targeting Stage: Foundational Steps for a Robust Emissions Baseline.

To set robust science-based targets, private equity firms first require comprehensive emissions inventories encompassing their operations, financing activities, and portfolio company holdings.

As the parent organization, the private equity firm accounts for emissions from its direct and indirect business operations, categorized as Scope 1 and 2. They may be excluded if the private equity business represents less than 5% of total emissions.

Critically, a private equity firm’s portfolio company investments fall under Scope 3, Category 15 “financed emissions”, as they are financed by limited partner investor capital outside the PE firm’s control.

However, the operational emissions of a portfolio company from their supply chains and operations would be considered Scope 3, category 1-14 for the individual portfolio companies.

Regardless, the PE firm must still comprehensively measure and aggregate all portfolio company emissions to set science-based targets for their overall assets under management.

In summary, robust Scope 3 emissions accounting, including Category 15, is critical for private equity firms to have visibility into total portfolio emissions and decarbonize through their governance influence over funds and holdings.

Streamlined Science-Based Target Setting for Private Equity.

The SBTi process enables private equity firms to set ambitious, science-aligned emissions reduction targets through several key steps:

1. Compile a greenhouse gas inventory covering all direct and indirect emissions sources, which provides a comprehensive baseline.
2. Calculate total Scope 1 and 2 emissions then apply SBTi’s portfolio coverage, sectoral decarbonization, or temperature rating tools to determine the target reduction by 2050. These cover direct operations.
   For Scope 3, categories 1-14 are recommended but not mandated. However, category 15 for investments is required. This includes portfolio company emissions.
3. Identify the target-setting approach for Scope 3, category 15 based on the level of control over assets – either sectoral decarbonization, portfolio coverage, or temperature ratings.
4. Collect and combine portfolio company emissions data to model overall reductions required for science-alignment. This top-down target cascades down to guide portfolio companies.
5. Establish a public, SBTi-validated target for 2023-2050 and execute decarbonization initiatives to meet the goal.

The Winding Road to Decarbonization: Current Challenges in Private Equity SBT Adoption.

Private equity firms face numerous challenges in adopting SBTi, especially regarding data quality. Scope 3 emissions from portfolio companies rely heavily on third-party data that is often incomplete. Firms must aggregate emissions across all holdings, but tracking progress against targets across myriad assets with varying decarbonization timelines proves difficult.

Implementation barriers arise from diverse investment styles and levels of active management influence over portfolio companies. However, the biggest obstacle is the pragmatics of driving emissions reductions through ownership levers amid competing business priorities. Despite motivations to lead, private equity has structural hurdles to overcome in achieving portfolio decarbonization through science-based targets.

The Coming SBT Transformation in Private Markets.

By addressing typical adoption obstacles, SBTi seeks to unlock private equity’s outsized potential for portfolio decarbonization. Widely embraced, science-based target setting can drive a step change in ambition across private markets.

Combined with stringent governance, the guidance offers a pathway for private equity to lead as responsible stewards. This not only manages climate risks but forges resilient portfolios fit for a net zero future.

Expectations are rising rapidly, as asset owners like pension funds and insurance companies set their own science-based targets and pressure private market managers to follow suit. Moreover, masses in managed capital are demanding urgent, credible decarbonization plans from private equity funds.

This top-down accountability will accelerate target adoption and transparency. Increasing standardization and third-party validation of portfolio emissions data will also enable smoother target setting and progress tracking. With mounting external pressures and improving data systems, private equity will increasingly use SBTs as a vital tool to maximize returns in a carbon-constrained world. Firm commitments to science-based portfolio decarbonization will soon become the norm rather than the exception.