By Paul Davies and Michael Green

dsc20050604_133440_3421In December 2015, world leaders met to negotiate the Paris Agreement. Setting aside whether the Paris Agreement goes too far, not far enough or is just right, one cannot dispute that government commitments to limit an increase in the global average temperature to well below two degrees Celsius will almost certainly impact private equity funds. In particular, regulatory and investor demand are likely to change the way climate-related risks are assessed. As Blackrock notes, “…carbon-heavy industries are not immune from disruption, nor are asset prices from regulatory efforts to mitigate climate change risk. We believe investors should thoughtfully consider these dynamics in order to build sustainable portfolios and take advantage of investment opportunities as we move towards a low-carbon economy”.

The private equity sector is in general paying closer attention to Environment, Social and Governance (ESG) issues throughout the investment cycle, whether voluntarily (for example, KKR’s Green Solutions Platform) or in response to investor pressure. French private equity firms Apax Partners, Ardian, Eurazeo, LBO France and PAI Partners committing to reducing greenhouse gas emissions Private equity goes green across their portfolio companies is perhaps the most recent illustration of this shift in focus.

While the Paris Agreement clearly sets governments’ aspirations and goals, the real key to climate change risk mitigation will turn on implementation. To date, the EU has been a leader in terms of regulation in this area with the EU Emissions Trading Scheme and Article 8 of the Energy Efficiency Directive (requiring non-SMEs to undertake energy audits). The UK has also been proactive, with national goals set out in the Climate Change Act 2008 and the implementation — through the CRC Energy Efficiency Scheme and climate change levy — of a tax on UK businesses’ carbon footprint (the UK will abolish CRC from 2019 as the government seeks to simplify carbon-related regulation). Going forward, we anticipate further tightening of existing laws and also the emergence of new controls, particularly in jurisdictions that have previously been less proactive (including China, which will in 2017 launch the largest emissions trading scheme in the world).

This rapidly changing regulatory landscape is also impacting investment behaviour with carbon-intensive assets increasingly considered stranded assets. The World Bank, along with analysts at Citigroup, HSBC and the Carbon Tracker Initiative have all warned of the financial risk that climate change poses to such assets. Indeed, the Portfolio Decarbonization Coalition, a coalition of institutional investors committed to mobilizing financial markets to drive economic decarbonization, is overseeing the reduction in carbon emissions across US$600 billion in assets under management.

Other investors see stranded assets as a significant opportunity, particularly given concerns over the lack of capacity in the energy market. Whatever your view, there will likely be more volatility in this sector. The question yet to be answered is whether these are ‘stranded assets’ or ‘undervalued assets’, or perhaps a combination of both.