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The inevitable policy response to climate change

It is highly likely investments made now will be exited in a world with vastly different regulation around climate change. Private equity firms should take note, write Debevoise's Simon Witney and Wendy Miles.

More than 400 private equity and venture capital fund managers have signed the UN Principles for Responsible Investment – together with around 250 of their investors – and it is quite clear that pressure to invest responsibly is ratcheting up across all asset classes. In most areas, the changes needed are manageable and evolutionary: a better and more effective approach to anti-corruption; more investment in health and safety and supply chain due diligence; and seeking and implementing expert advice on cyber-security, for example.

At the moment, climate change risk is often put in the same category. Relatively small adjustments are being made to investment policies and processes, and to governance mechanisms in portfolio companies. But there is a strong argument that climate risk should be in a category of its own, and that revolution, not evolution, is coming. Just as many laggard companies were driven out of business by the digital revolution in the last decade, those who are not prepared for the “climate revolution” of the next decade may face a similar fate.

That, at least, is the UN PRI’s view. A series of technical papers, launched in September under the banner “The Inevitable Policy Response”, have laid out the case for sudden policy changes at some point during the next decade. The thesis is simple enough: there is a global consensus – even if the current US federal administration is an exception – that policy-makers must act to restrict average temperature rises to between 1.5°C and 2°C; that various measurement points along the way will check progress towards that goal; and that current policy responses and national commitments fall way short of what is required. Therefore, at some point in the next several years, when regulators wake up to the severe shortfall – perhaps around 2025 – there will be an “inevitable policy response”. That response will cause serious disruption to the financial system.

The UN PRI believes that such a shock to the system could be avoided if governments dramatically step up their intervention now, but at the moment there is no sign that their efforts will go anywhere near far enough to achieve their stated goals. The longer it takes for that to change, the bigger the shock will be.

Investors who can afford to take a very short-term view may think that they can postpone worrying until their governments wake up to the challenges sometime in the 2020s. They may get caught out, of course, but private equity investors will be acutely aware that they cannot afford to adopt that approach. Many of the companies into which they invest now will be ready for exit in the middle of the next decade. At the time of investment, investors have to imagine what the world will look like to a prospective buyer in five to seven years’ time. Predictions of a radical shift in policy during that time frame cannot be ignored.

Climate change, and the inevitable policy response to it, create both risks and opportunities. The opportunities to invest in technologies that will help solve the problem are well known, and many sector specialist firms are ahead of the curve. But the risks are, perhaps, less easy to spot. The UN PRI’s papers lay out some expected legislative changes that investors have to bear in mind now. These include: steeply increasing carbon prices; new performance standards for power and transport; and dramatic changes to regulations for consumer goods, among many others.

Imagining the exit environment of the future is an integral part of private equity investing. The impending policy responses to climate change must be integrated into models of the future and, if the UN PRI’s prediction of a policy shock are correct, could even be a key driver of future fund performance.

Simon Witney is special counsel and Wendy Miles QC is a partner at Debevoise & Plimpton.

This is part of a series: European Funds Comment.