4 Essential Environmental KPIs Private Equity Investors Need to Know: Going Beyond Carbon

Understanding Carbon Metrics: Beyond the Basics

Ok, so I said we’d go beyond carbon - and we will, however, carbon is still the number one metric investors must get a handle on before even considering other environmental factors.

The categorization into Scopes 1, 2, 3, and the emergent concept of Scope 4, provides a comprehensive framework for understanding a company's direct and indirect carbon emissions.

• Scope 1 emissions are direct emissions from owned or controlled sources. This includes, for example, emissions from combustion in owned or controlled boilers, furnaces, and vehicles.
• Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating, and cooling consumed by the reporting company.
• Scope 3 emissions, often the most challenging to estimate, encompass all other indirect emissions that occur in a company's value chain, including both upstream and downstream emissions. Scope 3 can often represent the largest share of a company's carbon footprint, but its estimation is fraught with complexities due to the reliance on external data and assumptions.
• Scope 4, a nascent idea, proposes the concept of "avoided emissions"—emissions that are not released into the atmosphere due to the company's products or services. While intriguing, Scope 4 metrics are still under development and pose significant measurement challenges.

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This distinction highlights the importance of a nuanced approach to carbon accounting, recognizing the varying degrees of control and influence companies have over their emissions across these scopes. Especially for Scope 3, investors need to understand the estimation difficulties and consider methodologies and transparency in reporting.

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Climate and Transition Risk: A Holistic View

This approach encompasses both the physical risks associated with climate change (such as floods, wildfires, and storms) and the transition risks related to the shift towards a low-carbon economy.

Innovative methods, including satellite data analysis, can map out a company's physical assets globally—factories, shops, warehouses—and assess their vulnerability to climate change-induced events. This dual analysis enables investors to gauge the "double materiality" of climate risk: the financial impact on the company and its operations' effect on the surrounding environment. Understanding these risks is crucial for investors aiming to build resilient portfolios that can withstand the challenges of climate change and transition.

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One tangible example of a company significantly impacted by climate-related wildfires is Pacific Gas & Electric Co. (PG&E), a utility company based in San Francisco. The role of climate change in exacerbating the severity and likelihood of wildfires in California played a material role in the company's bankruptcy. Due to climate change, conditions such as diminished autumn rains, increased winds, and higher temperatures have made the landscape more susceptible to fires. These conditions, coupled with electrical equipment failures during extreme weather conditions, have led to devastating wildfires. The 2018 CampFire, one of the most destructive in California's history, was sparked by PG&E's equipment.

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'The W's': Water and Waste

Water and waste management are pivotal elements in assessing a company's environmental stewardship. Recent droughts in the United States and other parts of the world highlight the critical importance of sustainable water use. A business's vulnerability to water scarcity can significantly impact its operational capacity, cost structure, and overall sustainability.

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Again, investors can use key KPIs as opportunity flags. For example, Texas, facing one of the hottest summers on record, has taken legislative action to address its water supply challenges. Lawmakers agreed on a plan to spend a billion dollars on new water projects and repair aging infrastructure. This ambitious plan, encapsulated in Senate Bill 28 and Senate Joint Resolution 75, aims to significantly expand the state's water supply by 2033. The focus is on fortifying Texas against droughts and keeping up with a growing population that strains the state’s water resources. The legislation earmarks funds for upgrading water infrastructure and jumpstarting major water supply projects, such as marine desalination and the treatment of produced water from oil fracking processes.

Conversely, waste management practices reflect a company's efficiency and its potential environmental impact. The generation of waste, if not properly managed, can harm ecosystems, contribute to pollution, and incur regulatory penalties. Investors should scrutinize companies' strategies for minimizing waste production and their policies for recycling and disposal.

By focusing on 'The W's', investors gain insight into a company's resource efficiency and its commitment to reducing its environmental footprint. These KPIs, alongside carbon metrics and climate risk, form a comprehensive framework for evaluating suitability in investment decisions.

Next week we’ll look at social KPIs, and shed light on the often undervalued ‘S’ from ESG.

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