Prospective investors now routinely ask searching questions about a private equity firm’s approach to environmental, social and governance (ESG) issues, and many firms have developed detailed policies that address these investor requests. However, in Europe at least, policy-makers are catching up. Since the launch of the European Commission’s Action Plan on financing sustainable growth in 2018, European regulators have taken steps to put responsible investment principles on a legislative footing. This year we have seen significant progress towards the adoption of specific legislation and the first concrete changes are likely to be effective in 2021.

From a private equity perspective, the Disclosure Regulation – now agreed to by the EU’s various law-making institutions – will have the most immediate impact. This will require all fund managers to publish the methods they use for incorporating sustainability risks on their websites. The Regulation makes a distinction between sustainability “risks,” which could impact the value of an investment, and sustainability “impacts,” those factors with wider societal consequences which may reach beyond specific investments to affect society at large. All managers are required to disclose their approach to value items, while smaller fund managers will have the option to say that they do not take account of wider societal consequences (and clearly explain their reasons for not doing so). The requirement to make these disclosures will, inevitably, catalyze a behavioral change for some.

Private equity fund managers – including those outside of Europe who may not be directly affected by this change – will also be indirectly affected because of the regulations that affect their investors. Many significant European investors in private equity funds, such as EU-based occupational pension schemes, are covered by the Disclosure Regulation. This will increase the attractiveness of private funds that themselves comply with these disclosure rules, or are at least those that are able to satisfy the investors’ enhanced due diligence requirements. EU-based insurers, also significant investors in private equity, are subject to a separate initiative that will mandate consideration of sustainability risks in their investment processes. Changes to the Solvency II Directive will clarify that the “prudent person” principle that underlies insurers’ investment decisions can take into account sustainability risks such as climate change.

Under the Disclosure Regulation, firms that launch “sustainable” products – broadly, products that explicitly aim to have a positive impact on ESG issues as part of their objective – will be required to make enhanced disclosures. In particular, where firms designate an index as a suitable benchmark for the product’s objectives, the firm will need to justify the choice of index, while firms that do not use a benchmark index will need to explain why they do not. Products that aim to reduce carbon emissions must benchmark themselves to the Paris Climate Agreement’s global warming targets.

Recent work on the Taxonomy Regulation revealed significant differences of opinion between EU countries regarding which activities should be considered environmentally sustainable, with nuclear energy being particularly contentious.

This year also saw work on the Taxonomy Regulation, another initiative of the Action Plan. The Taxonomy Regulation is an ambitious attempt to establish a classification system and common language for describing economic activities that are considered environmentally sustainable for investment purposes. However, a recent publication by the Council of the European Union, which represents the member states, revealed interesting political differences regarding which of the activities should be considered to be environmentally sustainable, with some member states strongly arguing against the inclusion of nuclear energy. It is now unclear when the Taxonomy Regulation will be finalized, since the Council has pushed the target date back to 2022. However, if ultimately adopted, the EU’s taxonomy could become the basis for investor mandates and may be used as a global reference point.

The European Commission says that its Action Plan is aiming to refocus the financial services industry on financing the European and global economy “for the benefit of the planet and our society.” With their focus on disclosure, these reforms may not lead to wholesale changes in investor or manager behavior, but are likely to focus the minds of many market participants focused on the ESG issues that arise from their investment activity, and will at least ensure that investors consider these issues when making investment decisions.

The Private Equity Report Fall, 2019, Vol 19, No 2