Abdulla Zaid, Burgiss

Amid the global rise in carbon reduction ambitions, institutional investors with net-zero pledges are contending with questions about whether using negative screening strategies to achieve net zero could impact returns. In this article, we explore this pressing topic and provide insights into the environmental and financial aspects of low-carbon asset allocation in private capital.

Key Takeaways:

Approximately 26% of the financed emissions in private equity and private debt funds are concentrated in the top 5% of the most carbon-intensive funds, by count.
The exclusion of up to 20% of the most carbon-intensive funds (by count) appears to have a limited impact on returns, as the change in quarterly and since inception internal rate of return (IRR) is within a -/+ 1 percentage point range.

The Path to Net Zero

In our previous blog “Climate Engagement Guide for Investors in Private Assets,” we discussed the various aspects of active engagement and materiality as part of a climate investing strategy to achieve net zero.[1] In this article, we explore negative screening as another climate investing strategy to reduce a portfolio’s carbon footprint. Negative screening is the process of identifying and excluding carbon-intensive companies whose operations are deemed “pollutive.”

This strategy can be implemented more feasibly in the public markets, where investors invest directly into public companies and can avoid or divest from carbon-intensive companies. However, in private markets, Limited Partners (LPs) invest in private funds that in turn invest in private companies. Thus, negative screening in private capital is most actionable at the fund level, where LPs with emissions reduction targets may choose to either avoid funds or sell their positions in carbon-intensive funds in the secondaries market in order to reposition their private portfolios toward achieving net zero.

Burgiss and MSCI ESG Research provide financed emissions estimates[2] for private investments in over 55,000 private portfolio companies within Burgiss’ data. Financed emissions[3] are defined as the greenhouse gas emissions that are attributed to or financed by an investor. By aggregating a portfolio’s financed emissions, investors can more easily implement climate investment strategies that are quantifiable and accessible when analyzing the portfolio’s emissions reduction and performance outcomes.

The following analysis is based on a sample of 3,899 private equity and private debt funds with an aggregate holdings valuation of USD 3.1 trillion, sourced directly from the Burgiss Manager Universe (BMU).

*Table 1: Understanding the Data by Asset Class*
Data as of Q1 2023. Carbon intensity and financed emissions estimates are only calculated for companies within Burgiss’ data. Therefore, properties, natural resource investments, and infrastructure assets generally do not have available estimates yet. Source: Burgiss, MSCI ESG Research

Adjusting the Carbon Thermostat in a Private Capital Portfolio

Under a negative screening strategy, private funds can be sorted based on their Scope 1+2 investment carbon intensities[4] within each asset class. The most carbon-intensive funds may subsequently be excluded from the investment pool, eliminating some of the financed emissions tonnage from the portfolio. The size of the marginal tonnage reduction depends on whether the emissions are concentrated or evenly distributed across the portfolio of funds. Figure 1 outlines the reduction in financed emissions when excluding the top 5–20% of carbon-intensive funds (by count) between Q1 2022 and Q1 2023.

*Figure 1: Reduction in Financed Emissions at Various Exclusion Levels*
Data as of Q1 2023. The black dotted line represents the percentage change in financed emissions compared to the “All Funds” portfolio in Q1 2023. The blue labels indicate the cumulative reduction in financed emissions in Q1 2023. The gray ribbons represent the maximum/minimum percentage change in financed emissions during all four quarters in 2022. The purpose of including the ribbons is to examine the consistency of the results across different time periods. Source: Burgiss, MSCI ESG Research

In Distressed Debt, there is a significant level of emissions concentration within a small percentage of funds. By negatively screening the top 5% of the most carbon-intensive funds, almost 40% of the asset class’s financed emissions are removed. Expansion Capital shows a similar level of emissions concentration, as the top 5% of funds account for 35% of the underlying financed emissions. The marginal reduction in emissions generally diminishes when excluding the next 10–20% of the carbon-intensive funds. Meanwhile, in the case of other asset classes, emissions are distributed more evenly across funds, which results in a relatively more gradual decline of the carbon footprint at the various exclusion levels.

A follow-up question is whether the concentration of financed emissions is driven primarily by the fund’s net asset value (NAV) or by the fund’s carbon intensity. In aggregate, the top 20% of funds by count represent only 13.4% of the total NAV but are responsible for 54% of the financed emissions or approximately 44.4 million tons of CO2e.[5] These percentages clearly demonstrate that the emissions concentration is largely influenced by the carbon intensity of the funds, not by the NAV.

The Portfolio's Carbon Diet: How Do Exclusions Impact Returns?

After exploring the environmental aspects of negative screening, the other side of the coin is to examine how returns may be impacted by the same levels of fund exclusions. Figure 2 shows what happens to the quarterly pooled IRR when excluding the top 5–20% of funds based on their carbon intensities, as of Q1 2023. While divesting from carbon-intensive funds could possibly come with transaction costs and discounts that might impact IRR, we consider private asset prices in the secondaries market to be out of scope for this article. Instead, we only examine how returns are impacted at various levels of exclusion, as compared to the “All Funds” portfolio within each asset class.

*Figure 2: What is the Quarterly Return/Cost of Low-Carbon Investing?*
The black dotted line represents the change in the quarterly pooled IRR compared to the “All Funds” portfolio, as of Q1 2023. The gray ribbons represent the maximum/minimum change in IRR during all four quarters in 2022. The purpose of including the ribbons is to examine the consistency of the results across different time periods. Source: Burgiss, MSCI ESG Research

There are two main takeaways from figure 2; the first one is that as of Q1 2023, the various exclusion levels have not resulted in significant volatilities in quarterly returns, as the change in IRR has generally remained between -1 and +1 percentage points across all asset classes (as illustrated by the black dotted line).

The second takeaway is that the uncertainty around the change in IRR increases as we move to the right side of the chart toward higher exclusion levels (as illustrated by the gray ribbons). This increased uncertainty suggests that at higher exclusion levels, the quarterly IRR behaved differently from one quarter to another in 2022. The changing macroeconomic environment and its impact on private asset valuations could be a factor in the uncertainty equation. Also, higher exclusion levels could meaningfully alter the portfolio’s sector composition, which may differ from one quarter to another.

The since inception IRR provides a long-term perspective on how negative screening may impact performance. While the change in quarterly IRR shows the impact of excluding carbon-intensive funds, the change in since inception IRR captures how performance might have been had the carbon-intensive funds never been selected.

Figure 3 shows that the change in since inception IRR is also in the -/+1 percentage point range. However, a few asset classes steadily exhibit a growing change in IRR as more funds are excluded, which could be caused by the changing sector composition. For example, under a 20% exclusion level, Buyout, Expansion Capital, and Venture Capital funds increased their exposures to Information Technology by 2.8, 2.7, and 2.1 percentage points,[6] respectively. Meanwhile, Distressed and Senior debt funds reduced their exposure to Energy, Materials, and Utilities by 5.3 and 3.6 percentage points,[7] respectively.

*Figure 3: What is the Since Inception Return/Cost of Low-Carbon Investing?*
The black dotted line represents the change in the since inception pooled IRR compared to the “All Funds” portfolio, as of Q1 2023. The gray ribbons represent the maximum/minimum change in IRR during all four quarters in 2022. The purpose of including the ribbons is to examine the consistency of the results across different time periods. Source: Burgiss, MSCI ESG Research

Climate Investment: A Breath of Fresh Air for Portfolio Performance

Thus far, our findings indicate that implementing negative screening strategies to curtail emissions may not lead to substantial impacts on returns. Specifically, the IRR changes lie within a narrow range of -1 to +1 percentage points when excluding up to 20% of the most carbon-intensive funds. However, it is imperative to acknowledge that this analysis does not factor in the possible transaction costs or discounts that might be associated with the sale of an LP’s interests in these funds on the secondaries market.

When evaluating the returns of low-carbon strategies, separating the carbon factors from the sector factors could prove challenging given that carbon-intensive companies tend to be in specific sectors such as Energy, Materials, and Utilities. Therefore, excluding carbon-intensive funds from a portfolio may be an unintended exercise in changing the portfolio’s sector composition.

While acknowledging this potential recomposition, we have noticed evolving low-carbon solutions in traditionally high-emissions sectors (e.g., renewable electricity in the Utilities sector) as well as growing carbon reporting initiatives in private companies. Both trends may allow investors to better separate the carbon factors from the sector factors when assessing the returns of low-carbon asset allocation in private capital.

The Science of Selection: An Appendix

[1] For more details, read the Climate Engagement Guide for Investors in Private Assets.

[2] Carbon intensity and financed emissions estimates are only calculated for companies within Burgiss’ data. Therefore, properties, natural resource investments, and infrastructure assets generally do not have available estimates yet. Source: Burgiss, MSCI ESG Research.

[3] Financed Emissions = (Investment Carbon Intensity x NAV)/1,000,000. At the portfolio company level, investment carbon intensity is measured in tons of carbon dioxide equivalent (tCO2e) per USD 1 million of enterprise value including cash (EVIC). A fund’s carbon intensity is the average carbon intensity of the underlying portfolio companies, weighted by the holdings’ NAVs.

[4] Carbon intensity is measured in tCO2e/USD 1 million EVIC.

[5] The 44.4 million tCO2e is equivalent to the annual emissions from approximately 9.7 million passenger cars, which would take approximately 1.9 billion trees to absorb. Calculations are based on estimates from the United States Environmental Protection Agency (EPA) and Arbor Day Foundation. According to the EPA, the average annual emissions of a typical passenger vehicle is 4.6 metric tons of CO2. This assumes that the average gasoline vehicle travels 11,500 miles per year at 22.2 miles per gallon. In addition, approximately 8,887 grams of CO2 are emitted from burning a single gallon of gasoline. https://www.epa.gov/greenvehicles/tailpipe-greenhouse-gas-emissions-typical-passenger-vehicle. According to the Arbor Day Foundation, a mature tree absorbs more than 48 pounds of CO2 in one year. https://www.arborday.org/trees/treefacts/.

[6] Exposure to Information Technology increased from 24.5% to 27.2% in Buyout, from 30.8% to 33.4% in Expansion Capital, and from 43.9% to 46% in Venture Capital.

[7] Exposure to Energy, Materials, and Utilities decreased from 14.2% to 8.9% in Distressed Debt and from 4.4% to 0.8% in Senior Debt.

From Greenhouses to Greenbacks: Does Negative Screening Impact the Returns of Private Capital Portfolios?