Eurazeo

The future is now upon us. A summer of natural disasters has shone a harsh light on the need for investors to assess whether their portfolio companies are equipped to be resilient in the face of demands of profound climate-induced volatility. Sophie Flak and Mathieu Teisseire call for urgent action to establish a common and coherent ESG benchmark to guide institutional investors as we move into the adaptation economy.

Act to adapt, or simply disappear

Wildfires, heatwaves, storms, and drought – if the alarming catalog of recent natural disasters has taught us anything, it’s that time has run out for discussion.

Climate change is upon us. The only choice we face now is whether to act to adapt, or succumb to the vagaries of a frighteningly unpredictable new world.

For the investment community, the urgent question this poses for us today is how to ensure that the companies that we back are not only future-proofed but will continue to perform profitably in this new age of the “adaptation economy”.

The demands of this new economic era are profound. Real change, not marginal tinkering, is essential if we are to reverse the dramatic consequences of climate change and biodiversity loss, allowing us to live within the nine “Planetary Boundaries” that define the limits of human impact on a self-regulating and sustainable environment.

The recent spate of natural catastrophes has brought us face-to-face in every sector with the vulnerability of many companies to the potentially lethal impact of changes in the physical world. The ramifications of these physical changes are so far-reaching as to threaten multiple aspects of a company’s business, be it in terms of food and water supplies, employee safety, consumer demand, or even accessibility of trade routes and resilience of supply chains.

Every company has to assess its vulnerability to new physical challenges

The big change for investors is that any review of a company’s ESG considerations is no longer guided by hypothetical or potential risks, but by real vulnerability. This means that the investment industry needs to move fast to determine which criteria are the most relevant to determine a company’s ability to survive - and thrive - under the new conditions.

Within the private equity industry, we have already observed how institutional investors, on whose behalf we invest in our portfolio companies, have raised their game in recent years and are today well-versed in ESG considerations. Five or so years ago, many institutional investors’ interest in ESG matters appeared to reflect the need to check off a limited number of routine questions.

Today, one rare piece of good news is that almost all the major institutions fully understand what is at stake. Now, private equity firms like ours are facing tough and very pertinent questions from their limited partners about how ESG criteria have guided our investment choices. LPs drill down to assess not only how “responsible” our companies are, but how well-adapted they are, and even urge us to go still further in our approach.

There now is a deep understanding among investors that any company’s future performance is related to its awareness of - and ability to adapt to – present and future risks. Will the company still be able to operate, will it be able to access its suppliers, will its business even be relevant in coming years under such rapidly changing conditions?

No time to waste in establishing a common ESG benchmark

But – and it’s an important “but” – our industry must now move even faster to establish a clear, coherent, and relevant system to assess and benchmark the non-financial ESG criteria that indicate how well-adapted a company is to the new world.

As things stand today, there is a confusing plethora of literally hundreds of Key Performance Indicators related to ESG criteria that different stakeholders refer to.

This has to change, and fast. Admittedly, it took decades for the investment industry to align on a small number of universally accepted financial KPIs, with a common methodology allowing investors to benchmark corporate performance.

We don’t have the luxury of such a lengthy time span for all the various players, including regulators, to converge on a commonly agreed set of standardized ESG KPIs. We must move fast.

There are some promising initiatives. The One Planet Sovereign Wealth Fund Summit, which brings together the largest asset managers, sovereign wealth funds from across the globe and innovative private equity firms, including Eurazeo, have adopted a common ESG framework for climate data disclosure from private market participants. Another initiative to be applauded is the EU’s Sustainable Finance Disclosure Regulation, which provides a useful outline of the most significant 20 ESG-related KPIs, even if the calculation methodology of certain indicators remains to be settled. The urgent call to action, for all of us in the investment industry, is to seize such an opportunity to converge around those criteria, using them to establish an actionable ESG performance benchmark to assess the extent to which individual companies and, indeed, entire industries are “future-proofed”, and where they need to make progress in their ability to adapt to present and future conditions.

The temptation that we must resist is a fragmentation of KPIs, as each industry association or national regulator, for example, pleads for its own disparate set of criteria reflecting some local specificity. Such complexity would make benchmarking impossible, and without benchmarking, investors will have a tough time taking a realistic view of how to assess a company’s resilience and potential within the new “adaptation economy”.