Decarbonization strategies for SMBs in your portfolio

This article is co-authored by Sander Jansen, Director, ESG, KPMG in Canada and Christine Morris, Senior Consultant, Deal Advisory, ESG & Sustainable finance, KPMG in Canada.

Business leaders, economists, and intergovernmental organizations such as the UN and World Economic Forum (WEF) are increasingly citing climate change as one of – if not the greatest risk to the global economy.¹ It has the ability to wipe out up to 18% of the global GDP and 6.9% of the Canadian GDP by 2050, and can impact a company’s income statement, cash flow and balance sheet.²

To address this growing risk, it’s generally agreed that the world needs to strive for a warming cap of 1.5°C above pre-industrial temperatures – a more ambitious target than the 2°C threshold set forth by the Paris Agreement. However, at our current pace, we’re instead heading for a rise of 2.7 to 3.2°C.³

Getting on track demands timely action, and global efforts are under way by the public and private sector to achieve net zero greenhouse gas (GHG) emissions by 2050 to help limit and mitigate the impacts of climate change.

Given its potential to erode – or create – company value, private equity (PE) and venture capital (VC) firms should have a vested interest in corporate efforts to restrict climate change and reduce emissions. PE and VC firms can also have a critical role to play. By assessing and analyzing the emissions profiles of the companies that make up their substantial investment portfolios, PE and VC firms can drive meaningful climate initiatives that push the world closer to its emissions targets while simultaneously enhancing and protecting a company’s value.

To discuss what PE and VC firms can do, the Canadian Venture Capital and Private Equity Association (CVCA) devoted a recent Invest Canada webinar to decarbonization strategies for PE and VC firms, led by sustainable finance specialists Sander Jansen and Christine Morris from KPMG in Canada.

A live poll taken during the webinar revealed that most PE and VC leaders are in support of our collective climate goals – 60% of respondents already consider climate in their investment strategies. As for portfolio assets, 75% said that their investment companies incorporate climate into their business model. Still, the road to carbon reduction across diverse portfolios can present a challenge as climate regulation frameworks are proliferating.

The World Economic Forum (WEF)’s Global Risk Report lists climate change as the number one risk to the global economy. A report by Canada's Parliamentary Budget Officer indicated that emissions-related climate change is estimated to lower Canada’s Gross Domestic Product (GDP) by 5.8 per cent by 2100.⁴ Severe weather and climate events can interrupt cash flows, wipe out balance sheets and severely impact economies.

To address the role corporates play in furthering the climate crisis, stakeholders and regulators have ramped up scrutiny to ensure companies aren't just talking the talk but walking the talk when it comes to reducing carbon emissions. Still, Jansen and Morris emphasized that given current climate projections, PE and VC firms need to implement carbon reduction initiatives sooner than later and demonstrate a roadmap to meaningful results.

An increasing number of global regulatory frameworks are coming into effect stipulating financial reporting and risk management requirements for companies and investors, such as the Task Force on Climate-Related Financial Disclosures (TCFD), the United Nations’ Principles for Responsible Investment (PRI) and the International Sustainability Standards Board (ISSB). In the European Union, the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy regulate greenwashing and standardize disclosure requirements for investments tied to high emissions.

With many climate commitments being made by institutional investors effectively placing a net zero target on the emissions being produced by their portfolio companies on the volume of emissions a company can produce, carbon has become a liability to a business’ bottom line. Further, Investment firms need to focus on reducing emissions from their own operations as well as their portfolio companies.

A company’s GHG emissions fit into one of three categories:

Scope 1: Direct emissions from operations (e.g., emissions from company buildings, gas burned in company vehicles)

Scope 2: Indirect emissions from purchased electricity, steam, heating, and cooling

Scope 3: Value chain and portfolio emissions, including emissions related to capital provided to portfolio companies (investment, lending, and underwriting), also known as financed emissions

While companies will generally have some mix of all three types, a significant amount of emissions that PE organizations are accountable for fall into category 3. In order to reduce their Scope 3 financed emissions burden, there are several levers PE and VC firms can pull. These include:

• Reducing the emissions of existing portfolio companies: PE and VC firms can leverage their position as investors to encourage entities to reduce their emissions
• Altering their portfolio composition: to reduce carbon liability exposure, PE and VC firms can move away from investing in high-carbon sectors and towards low-carbon and carbon-reducing sectors
• Advocacy: PE and VC firms can engage in policy advocacy for government incentives, knowledge sharing, and industry-wide initiatives related to carbon emissions and climate change.

While PE and VC firms will need to balance their priorities between core value creation activities and new climate-related initiative, decarbonization brings added benefits, including:

• Access to capital through government grants, preferential tax rates, and other avenues, with global investment in low-carbon energy initiatives reaching $1.1 trillion in 2022
• Cost reductions through operational and resource efficiencies
• Competitive advantage through an enhanced value proposition
• Customer relations and brand perception benefits.

Another benefit for PE and VC firms to consider is the value of portfolio companies at the exit stage. As carbon increasingly implies direct and indirect costs, portfolio companies that manage climate risks and opportunities well may command a better price or be favourably positioned when it comes time to exit. In fact, the climate performance of portfolio companies will increasingly impact the field of buyers available to sell to.

Jansen and Morris introduced a five-step phased strategy to help PE and VC firms understand the financed emissions that exist within their portfolio, and operate as a climate centre of excellence for their portfolio companies by offering the tools, knowledge and roadmaps companies will need to set emissions targets and effectively decarbonize. The approach focuses on establishing and communicating targets, developing, and implementing a roadmap of specific solutions, and measuring and reporting to gauge success.

1. Calculate inventory of greenhouse gas (GHG) emissions

This step identifies where the sources of GHG emissions are in their portfolio companies’ value chains.

Firms need to collect all relevant data for scope 1, 2, and 3 emissions, calculate a firm’s GHG baseline for each category, determine reporting boundaries, and confirm their consolidation approach. For example, if 40% of the firm’s total emissions are in scope 3, the organization will need a specialized plan to comply with Science Based Target (SBTi) standards. Firms should allow sufficient time and budget for this step and work closely with portfolio companies and data owners.

2. Train leadership in climate risks and strategies

This step focuses on who is responsible and accountable for implementing and achieving the decarbonization strategy. It focuses on comprehensive, tailored climate and carbon transition training for portfolio company boards and management teams.

A successful approach will identify carbon transition ambitions, risks, and opportunities early on and gain stakeholder alignment at early stages in the process. It will focus on foundation setting as well as long-term sustainability. Leader upskilling is then based on concrete GHG inventory and Key Performance Indicators (KPIs) that are tailored to industry and peer trends.

3. Develop and implement a forecasting model

PE and VC firms need to do detailed forecasting to ascertain precisely what emissions they can eliminate and where to reduce in day-to-day operations and within the portfolio. Since business expansion can lead to emissions growth, forecasting should focus on concrete means of achieving decarbonization alongside growth.

The outcome should be an emissions inventory forecasting model that handles business-as-usual and incorporates meaningful reduction scenarios and initiatives.

4. Set targets and identify workable transition initiatives

Steps 1-3 set the baseline for target-setting, where concrete objectives are stated and carbon transition initiatives are identified and prioritized. Too often, companies make commitments without articulating how to achieve them. This step sets ambitious and reachable targets, alongside credible, climate-related KPIs.

Achieving success in this phase relies on collaboration. PE firms need to establish and maintain communication channels with portfolio company leadership and with on-the-ground operations teams that have hands-on experience with high-emissions equipment and processes. Deal teams and portfolio companies can collaborate to identify de-carbonization opportunities, assess their feasibility, and quantify the costs.

Some things companies might do to decarbonize include:

Scope 1: Shift to zero-emissions vehicles, adopt lower-carbon fuel alternatives, shift from natural gas to zero- or low-emissions heating systems

Scope 2: Purchase renewable energy, develop renewable power on-site, increase energy efficiency (LED lighting, insulation, newer HVAC), install energy efficient computer systems

Scope 3: Reduce employee travel, conserve virgin resources, reduce energy waste, produce longer lasting products, reduce partnerships with high-emitting companies, sell excess renewable energy to partners, develop policies to encourage supply chain partners to adopt zero- and low-carbon equipment and processes.

The outcome of this stage is a concrete target that states the scope, target type, target year, and the extent of the reduction as a percentage. It should be expressed as follows: [COMPANY] commits to reducing Scope 1, Scope 2 and Scope 3 emissions by [##]% by [2030] from [YEAR].

The percentage target gives portfolio entities a concrete objective to meet, and a firm measurement to assess performance. The net-zero vision needs to reflect the ambitions of key stakeholders, the reduction capacity of identified GHG initiatives, and should be tied to business growth.

5. Create a carbon transition roadmap and set it in motion

The final step commits to a timeline and addresses when carbon transition will be fully operationalized inside a given portfolio company. The crux is a detailed carbon transition roadmap that fully operationalizes the strategy and targets.

The roadmap should be tied to metrics and set out a timeline of prioritized carbon transition initiatives based on financing and capacity to deliver. It should identify any internal operational changes that are needed and reflect continuing impact even in a post-exit scenario.

The professional consultants in KPMG’s Deal Advisory and Environmental, Social and Governance (ESG) practices are positioned to assist VC and PE firms develop and implement carbon reduction strategies across their portfolios. Our specialists are deeply familiar with the intricacies of evolving emissions-related legislation and data, as well as industry practices, standards, and norms. Our approach helps bring carbon-related knowledge to private equity activities across the deal lifecycle, with a focus on building stakeholder trust and growing value for the business.

For assistance designing and launching a phased approach that’s tailored to your portfolio, supports your firm’s mission, and meets climate targets credibly, tangibly, and measurably, connect with us to start the conversation.