A private-equity portfolio with the energy sector excluded had a higher Scope 1+2 carbon intensity than a private-equity portfolio with high-carbon-intensity funds excluded. This was also true for Scope 3 carbon intensities.
The comparison between the two portfolios’ intensities underscores the value incorporating carbon-based solutions had, as opposed to employing broad sector-wide filters in portfolio construction.
The tracking error for both portfolios versus a private-equity universe was similar once we accounted for fund weightings.

Among the array of climate investing strategies, negative screening remains one of the most prevalent methods used by investors.[1] Yet, there are several ways of building portfolios using negative screening, including sector and carbon filters. A useful way to evaluate both options in private equity may be to assess which of them can provide the lowest carbon intensity with the lowest tracking error.

To examine this, we looked at the carbon footprint and tracking error of an ex-energy portfolio (sector-based exclusions) compared to a low-carbon portfolio (carbon-based exclusions) — both built using private-equity funds. The ex-energy portfolio excluded funds with any active investments in the Global Industry Classification Standard (GICS®) energy sector,[2] while the low-carbon portfolio excluded the most carbon-intensive funds based on carbon intensity estimates from MSCI ESG Research.

Constructing ex-energy and low-carbon portfolios
The analysis that follows is based on a subset of private-equity funds, henceforth referred to as the “universe” or “sample,” sourced from the Burgiss Manager Universe. As of Q2 2023, the sample includes 4,724 funds with an aggregate investment valuation of nearly USD 3.8 trillion.

Of these funds, 4.3% had at least one active investment in companies in the energy sector, equivalent to about 7.6% of the universe’s net asset value (NAV). Excluding these funds to construct an ex-energy portfolio may lower the portfolio’s carbon intensity and its direct exposure to the extraction and refinement of fossil fuels. To accurately evaluate the ex-energy portfolio’s carbon intensity and tracking error, we compared it to a low-carbon portfolio that excluded the same number of funds, but based on the criteria of filtering out the top 4.3% of the most carbon-intensive funds.[3]

Did the ex-energy portfolio offer the biggest carbon savings?

Carbon-intensity estimates are only calculated for companies within the MSCI Private Capital Solutions data. Therefore, properties, natural-resource investments and infrastructure assets generally do not have available estimates yet. Carbon estimates are available for 96% of the underlying aggregate holdings’ valuation, as of Q2 2023. Source: MSCI ESG Research, MSCI Private Capital Solutions (formerly Burgiss)

By excluding 4.3% of funds, Scope 1+2 carbon intensity decreased by 11% in the ex-energy portfolio, compared to a 38% reduction in the low-carbon portfolio. The gap between the two portfolios narrowed significantly for Scope 3, as the reduction in carbon intensity reaches 10% and 14%, respectively. It is worth noting that a substantial portion of the carbon risk for the extraction and production of fossil fuel may be concentrated within the supply chain (Scope 3), which could be largely captured by the energy-sector filter.

Portfolio returns under the carbon lens

To examine the exclusionary filters’ impact on the tracking error of the ex-energy and low-carbon portfolios, we calculated the difference between each portfolio’s since-inception internal rate of return (IRR) versus the private-equity universe.[4]

As the next exhibit demonstrates, the ex-energy portfolio had a larger tracking error compared to the low-carbon portfolio. A significant portion of this differential may be attributed to the size effect of the excluded funds. For instance, while both portfolios excluded 4.3% of funds in Q2 2023, the reduction in NAV was 7.6% for the ex-energy portfolio and only 3.5% for the low-carbon portfolio.

Tracking errors versus universe

This analysis does not factor in the possible transaction costs or discounts in the secondary market. Tracking error is the difference between the ex-energy and low-carbon portfolios’ since-inception IRRs versus the private-equity universe. Data as of Q2 2023. Source: MSCI ESG Research, MSCI Private Capital Solutions (formerly Burgiss)

Untangling tracking-error threads

To examine the role of fund size in the tracking-error equation, an equally weighted IRR is calculated. This neutralizes the relative sizes of the underlying funds, which could be relevant for limited partners who may commit the same amount of capital across private-equity funds, regardless of size. Results in the next exhibit suggest that the excluded funds in the ex-energy portfolio were overweighted, while the ones excluded from the low-carbon portfolio were underweighted. Neutralizing the weights of the underlying funds significantly reduced the ex-energy portfolio’s tracking error, limiting them to a narrow range of 12 to 17 basis points (bps), compared to the 15 to 41 bps in the previous exhibit. Conversely, the tracking error of the low-carbon portfolio slightly increased to reflect the increased weights of the excluded funds.

The effect of fund weights on tracking error

Paving the path to net-zero: From good intentions to effective strategies

The comparison between the ex-energy and the low-carbon portfolios’ carbon intensities underscores the value that incorporating carbon-based solutions had as opposed to employing broad sector-wide filters in portfolio construction. This may be particularly pertinent for companies with novel climate innovations within the traditionally high-emissions sectors (e.g., renewable electricity in the utilities sector). In this instance, sector-wide exclusion strategies designed to curtail emissions may inadvertently impede the flow of private capital to the very companies that are at the forefront of addressing climate challenges. The growing climate-related reporting initiatives in private markets and improved carbon-estimate models may increasingly allow investors to actionably integrate climate-based measures in private-asset allocation.

[1] Negative screening entails the identification and exclusion of industries or companies whose operations are considered environmentally detrimental.

[2] GICS® is the industry classification standard jointly developed by MSCI and S&P Global Market Intelligence. The GICS energy sector includes the following sub-industries: oil & gas drilling, oil & gas equipment & services, integrated oil & gas, oil & gas exploration & production, oil & gas refining & marketing, oil & gas storage & transportation and coal & consumable fuels.

[3] A fund’s carbon intensity is the average carbon intensity of the underlying portfolio companies, weighted by the holdings’ NAVs. Within private assets, carbon-intensity estimates are calculated only for private companies within MSCI Private Capital Solutions data. Therefore, private properties, natural-resource investments and infrastructure assets generally do not have available estimates yet. Source: MSCI ESG Research and MSCI Private Capital Solutions (formerly Burgiss). More details on carbon-based exclusions: Abdulla Zaid, “From Greenhouses to Greenbacks: Does Negative Screening Impact the Returns of Private Capital Portfolios?” MSCI Private Capital Solutions (formerly Burgiss), Aug. 10, 2023.

[4] This analysis does not factor in the possible transaction costs or discounts in the secondaries market.

Private Assets Can’t Hide from SEC’s Proposed Climate Rule

Understanding Private Capital’s Exposure to Carbon-Intensive Sectors

New Frontiers in Carbon Footprinting: Private-Equity and -Debt Funds

Emissions Exclusion in Private Equity: How Is Tracking Error Taking It?