ESG for Private Equity – A Lens for Finding and Developing Hidden Value

By: Bob Pickert, Senior Compliance Specialist

Environmental, social, and corporate governance (ESG) is a lens through which private equity companies can identify and develop hidden value. This article explores ESG and considers some tools to simplify and manage the ESG journey through the merger & acquisition (M&A) process of acquisition strategy and planning, due diligence, and integration and development. Along the way, we will examine a metric – ESG Maturity – that measures how well an organization manages ESG risks and opportunities by integrating ESG into its business strategy.

Do you know where your organization stands on the ESG Maturity scale?Figure 1               ESG Maturity Scale

What is ESG?

ESG issues are increasingly important to an expanding universe of stakeholders with changing expectations, including general partners (GPs), limited partners (LPs), and other lenders and investors. ESG issues are symptoms of inefficiency and inequity. These unsustainable imbalances represent a risk, but they also create opportunity. There is a growing awareness that there is an economic gradient toward a more efficient and equitable world. It is enlightened self-interest that public and private organizations understand their stakeholders’ expectations for a clearer view of their business-related risks and opportunities. Traveling the path to ESG success is an active, iterative, and creative process that takes place over time. More than just a consideration at due diligence, ESG can be built into the Private Equity firm’s existing strategy and planning process, M&A criteria and toolkit, and integration and development approach.

The ESG timeline is both generational and urgent. Sustainable development was first defined in the 1987 Brundtland Commission report – Our Common Future – as “Development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” The awareness grew that organizations had a “triple bottom line” that included environmental and social obligations as well as its fiduciary responsibility to its stockholders. At the same time, a variety of reporting standards and initiatives around corporate social responsibility; environmental, health, and safety management systems; and global sustainable development goals emerged and grew. Around that time the concept of socially responsible investing joined the lexicon as some investors recognized that efficiently run companies were more profitable than their less efficient competitors, and cleaner technologies did not have the compliance and legacy burdens of legacy technologies. They saw hidden value in more sustainable business models. That thinking has accelerated.

Climate Change Takes Center Stage

The COVID-19 pandemic has accelerated many trends. Among them is the need to face existential risks, including climate change.

While not everyone agrees on the details, governments and organizations around the world are already committing to carbon-neutrality to avoid the most extreme impacts from climate change. This transition is likely to completely transform the entire economy creating disruption, risk, and opportunity. The adage that “necessity is the mother of invention” acknowledges that need drives innovation. The need for a more efficient and equitable world will help drive a new wave of innovation affecting all sectors of the economy, but especially energy, transportation, resource management, and industrial productivity.

There are current and emerging requirements to disclose material financial risks to investors including United States Securities and Exchange Commission (SEC) requirements to report material financial risks, and the European Union (EU) Do No Significant Harm (DNSH) and related “green taxonomy” requirements that codify the relative sustainability of various business activities. While many of these requirements do not apply directly to private equity, they are influencing the expectations of financial stakeholders and creating de-facto requirements and voluntary guidelines for Private Equity firms. As the transition to a carbon-neutral economy gains traction, non-regulatory pressure from investors – inspired by the recommendations from the multi-national Task Force on Climate-Related Financial Disclosures (TCFD) – is driving organizations to understand and report on climate-related risks and opportunities, resilience, and risk management processes.

Greenhouse Gas Emissions and Carbon Strategies

Climate change risk assessments include the use of models and datasets to understand an organization’s exposure to extreme events such as coastal and inland flooding, extreme heat or precipitation, wildfires, landslides, drought, and water scarcity. A risk assessment reviews the impacts from acute risks (extreme weather events) and chronic risks (e.g., drought and water scarcity), as well as impact chains (such as secondary risks, e.g., socioeconomic effects like migration, conflict, and public health shocks). The United Nations Financial Initiative published a review of climate change risk assessment tools and data sources.2 Industry standards such as ISO 14091 Adaptation to Climate Change – Guidelines on Vulnerability, Impacts and Risk Assessment can help ensure assessments are conducted in accordance with standard practices and are consistent and transparent.

Many organizations have taken steps to inventory their carbon footprint. Inventories of greenhouse gas emissions include emissions from combustion of fossil fuels on-site and fleet fuel consumption (defined as Scope 1 emissions), indirect emissions associated with the purchase of electricity, heat, or steam from a utility provider (Scope 2 emissions), and indirect emissions associated with upstream sources from suppliers and downstream emissions from the distribution, use, and disposal of products (Scope 3 emissions).

Energy audits can help organizations identify easy changes to improve their carbon footprint and cost-effective carbon strategies. Energy audits are an important part of developing carbon management strategies to blunt the impact of emerging carbon taxes, cap and trade schemes, and restrictions on carbon offsets circulating in Washington D.C. Many companies, including big technology firms, are purchasing renewable energy credits to offset their carbon footprints. Organizations need to assess and understand their climate-related risks and opportunities, and develop adaptation, mitigation, and business strategies to manage those risks and embrace future market opportunities.

Environmental Footprint – Social Handprint

Of course, there is more to ESG and sustainability than climate change. Regulators and stakeholders are demanding that organizations report on their environmental footprint – including the transition to a circular economy that uses renewable and recyclable products, materials conservation, pollution prevention, the protection and restoration of water and marine resources, biodiversity, and ecosystems.

Stakeholders are recognizing that sustainability has social elements including employee diversity, health & safety; human rights, community relations, customer privacy and data security; and green marketing of products and services. Issues like diversity and inclusion are not necessarily altruistic, but they provide a 360-degree view of perspectives that help organizations recognize and manage risks and embrace opportunities.

Organizations recognize their governance or internal controls over ESG elements are under the constant watchful eye of social media and are taking proactive steps to ensure they optimize the impacts of their environmental footprint, social handprint, and their control or influence over their supply chain, products, and services. There are a variety of ways to engage suppliers on ESG, including communicating your organization’s code of conduct, screening suppliers for high risk to drive corrective action, or identifying high ESG performance for collaboration. Supplier ESG risk screening, surveys, or questionnaires can help focus this effort.

Standards for assessing and reporting an organization’s sustainability performance are published by organizations such as the Global Reporting Initiative (GRI) (https://www.globalreporting.org), the Sustainability Accounting Standards Board (SASB) (www.sasb.org), and the United Nations Sustainable Development Goals (SDGs) (https://sdgs.un.org/goals). They all provide standards and criteria to help organizations plan and manage their ESG programs. One of the important contributions of the SASB has been the development and publication of a sustainable industry classification system (SICS) across 11 industrial sectors and “materiality maps” that highlight priority issues, standards, and metrics for each of the 77 industries. These materiality maps help organizations prioritize the ESG issues that are most relevant for them and over which they have some influence or control. SASB materiality maps are a good place to start when comparing or benchmarking ESG programs. Another good source of inspiration for ESG programs is to see what your competition or other organizations are considered best-in-class for a particular industry. The SDGs provide a useful guide for aligning an organization’s ESG goals with global priorities. Proactive organizations are increasingly aligning their reporting on sustainability programs with these standards. Along the way, organizations need ESG data management solutions to organize, store, and report ESG data and information to stakeholders.

ESG Maturity – A Metric Whose Time Has Come

Organizations need a system and tools for prioritizing, managing, and comparing their ESG programs, and managing ESG data. Enter the ESG Scorecard. Often based on the standards referenced above or on proprietary ESG criteria, or a combination of the two, ESG Scorecards are a useful way to simplify, focus, measure, monitor, compare, and communicate ESG programs.

The process of assessing the maturity of an organization’s ESG program begins with an understanding of the organization or project under review including the context, scope, and organizational profile. Existing and available information and reports on the organization or project’s ESG programs (such as existing ESG, sustainability, corporate social responsibility, and environmental health and safety reports issued by the organization) can help provide these general disclosures. Benchmarks such as the SASB materiality maps and comparisons to competitors, best-in-class, or analogous businesses can provide useful information and perspective. An assessment of an organization’s ESG programs might include interviewing executives with responsibility, authority, and/or direct knowledge of ESG management systems, as well as physical site visits or reconnaissance.

The assessment of ESG maturity often includes reviewing the following:

  • ESG management approach (e.g., policies, planning, and commitments)
  • Program deployment (e.g., procedures, operational controls, and verification audits)
  • Results achieved (e.g., metrics, monitoring, and management reviews)

Implementing ESG programs ensures they are part of the organization’s ability to adapt to changing circumstances, identify risks and opportunities, and drive ESG performance improvement. It is important to have objective scoring criteria to prepare consistent and comparable ESG scores that can be monitored over time for improvement. Managing ESG issues is an active, iterative, and creative process. Scores can be developed for relevant ESG exposure risks, the organization’s ESG maturity/ability to manage ESG exposure risks and identify and take advantage of ESG opportunities, and the resulting adjusted or net risks to identify unmanaged risks. For example, an organization might want to conduct a baseline assessment of its ESG Maturity or ESG net score to compare against a potential acquisition to see how the acquisition would impact its ESG score or programs (see Figure 2).

Figure 2 – ESG Benchmark Comparison

Over time, an organization may pass through stages where it complies with regulatory and ESG-related requirements, sets and achieves ESG performance improvement goals, and integrates ESG into its business strategy. ESG starts with taking the first step and requires a deliberate, focused, and sustained effort. If focused deliberately and systematically, ESG criteria can offer GPs and LPs a competitive advantage in acquisition strategy and planning, due diligence, and integration and corporate development to identify blind spots, business development opportunities, and develop hidden value across the portfolio. A simple metric – ESG Maturity – can help an organization understand where it is on the ESG Maturity Scale and how well it is positioned to minimize risks and take advantage of opportunities.

1 Private Equity Ties Pay to Social Goals, Wall Street Journal, June 2, 2021, B11.

2 Charting a New Climate: State-of-the-Art tools and data for banks to assess credit risks and opportunities from physical climate change impacts. UNEP Finance Initiative. September 2020.

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