From ESG risks as buzzwords to tangible implementation

From ESG risks as buzzwords to tangible implementation By Eric Jan-Vink and Tim van der Weide, PGGM Introduction Environmental, social and governance (ESG) factors are on the agenda of many LPs and GPs alike, yet there remains a lot of confusion about what exactly ESG means and why it warrants extra attention in the private equity world. This chapter takes ESG factors beyond the theoretical buzzwords by providing examples of how GPs can measure, manage and mitigate ESG risks in practice. It focuses, in particular, on how to manage ESG risks rather than more topical considerations such as the moral ethics of investing in tobacco or weapons. It is also worth noting that taking ESG factors into account is not only a means to reduce risk, but it can also create financial value for companies by, for instance, reducing energy dependency or prompting new product development. ESG risks and why they are relevant The term ESG is, in essence, a blanket term encompassing a wide variety of environmental, social and governance-related risks (Table 1.1 gives an inexhaustible overview of such risks). There are two ways to approach ESG risk: strategically and operationally. Risks such as ecosystem decline or social inequality are classified as strategic risks for companies. Workplace safety violations, corruption risk or hazardous waste, among others, are classified as operational risks. As we shall discuss below, both require a different approach to risk management. Strategic ESG Strategic ESG risks are increasingly recognised at the international level. In its global risks report, for example, the World Economic Forum highlights both the failure to adapt to climate change and water supply crises as risks that are likely to occur in the next ten years and have a high impact on society. If measures are not put in place to mitigate the potential effects of a four-degree Celsius temperature rise, it could lead to increased instances of tropical storms, rising sea levels impacting coastal cities and more droughts. In turn, this will have an impact on economic growth, cause rising food shortages and also impact water supplies. As a consequence, consultants such as McKinsey have warned of the growing pressure on resource systems. For companies that are dependent on natural resources (such as those operating in the food or industrials sector), these risks cannot be ignored or underestimated. To use a hypothetical example, a large food retailer analyses its supply chain to determine where its products are grown and if there is any threat to future supply in the event of climate change. With that information, the retailer could then analyse its product portfolio and determine whether a change in its portfolio would make it more resilient to future supply shocks. The fishing industry, for example, already has to deal with over exploitation and pollution of the seas in which they operate. Rising temperatures affecting surface water and rising sea- levels will impact many fish species and could lower available fish stocks. To lessen the impact, the food retailer could, for instance, look at the tuna salads it is selling and offer its customers a wider selection, including plant-based salads. By doing this, it could limit its exposure to changing fish stocks while also introducing products with a potentially higher profit margin and that is responsive to megatrends like healthy eating. The food retail company has therefore strategically positioned its portfolio to limit supply chain risk and, at the same time, found a new driver for value creation. Operational ESG Some ESG risks relate more to the in-house operations of a company than its strategy. When speaking about ESG risks, private equity GPs often tend to highlight operational risks, which include looking at a target company s com pliance with local environmental law, the health and safety procedures in place and levels of energy efficiency. In some jurisdictions, environmental law may be up to the standards of international best practice and as a consequence GPs may expect there not to be any ESG risks. However, for example, for expansion projects, an environmental impact assessment may be needed, although actually implementing the measures to mitigate the risks identified in the environmental impact assessment (for example, steps to avoid leakage of hazardous substances in ground water) may be inadequate. 1 From ESG risks as buzzwords to tangible implementation

In a climate where there is little actual enforcement, failure to implement these actions may not result in any current liability for a company eg fines, but if future governments change or increase legislation, compliance costs may then rise and so too the liability. In China and India, where environmental enforcement used to be inadequate, examples can be found of companies having to limit their production capacity because they did not have control over hazardous waste leaking into rivers when the governments in those countries eventually stepped up enforcement. An example is the air pollution controls that China is now establishing and the impact this is having on companies that do not have air emission controls in place. Another example is energy efficiency; although still a looming risk, if governments follow up on their climate change commitments, this may mean a carbon tax or a carbon-trading scheme, which will affect the price of energy. For an industrial company (for example, an LCD manufacturer), energy costs may be 50 percent of its product s costs. For such companies, focusing on energy efficiency will be a no-brainer once future liabilities are taken into account. If a company sets targets to lower its energy use, it will result in energy cost savings, reduced exposure to energy price volatility and a lower environmental footprint with greater potential for positive marketing opportunities for the company. Reputational risks are also a factor. For instance, the Bangladeshi clothing factory collapse was a reputational issue for companies using these production facilities. Although, so far, no evidence has been found that it affected the sales performance of these companies, it was a risk they did not want to expose themselves to. Moreover, companies that did not produce in these factories were able to quickly differentiate themselves publicly by showing their supply chain auditing standards and by signing up to international initiatives to improve working conditions in these factories. This meant that the brand value of those companies were not negatively impacted and, in fact, may have helped improve it. It is also important to note that for GPs investing in companies operating in OECD countries, non-compliance with the OECD Guidelines for multinational enterprises increasingly incurs reputational risk for both GPs and limited partners (LPs). International complaints have been filed against investors at their local OECD contact points. In one case, a number of investors had to respond to a complaint with regards to the operations of a listed company in which they were minority investors. These investors have had to respond publicly to the complaints of NGOs (Non-Government Organisations) at the OECD contact point. This also raised the question of how far the investment and supply chain responsibility of a firm goes. This is hard to answer, but underlines the need for GPs and LPs alike to have processes in place to identify the risks. Analysing ESG risks is regarded as a socially responsible exercise. However, as shown, many of these risks are considered business risks when taken in the proper context. So even without the socially responsible label attached, all these risks can be material depending on the geographical region and type of company and are, therefore, relevant for all private equity investors. Analysing ESG risks is not a tick-boxing exercise (that is, they cannot be applied uniformly across all companies in all sectors) For instance, biodiversity loss may be more relevant to a mining company than a software company. Without taking the context into consideration (such as geography and sector) ESG risk management can be a tick- boxing exercise with little relevance and has the potential of just being a marketing exercise. Table 1.1: Common ESG risks ESG integration Social risks Corporate governance risks Climate change Health & Safety Bribery and corruption Water scarcity Employee turnover Shareholder rights Biodiversity loss and ecosystem collapse Hazardous waste Social instability Food safety Measuring, managing and mitigating ESG risk After determining what ESG risks are, the next question is how a GP can measure manage and mitigate them. Measuring risk A GP first needs to measure ESG risks before deciding on the appropriate way to manage and mitigate them. There are two ways to approach this: from a strategic perspective and from an operational perspective. First, a GP should review its current portfolio and poten tial new investments for any inherent strategic ESG risks. For instance, it could measure the carbon footprint of its portfolio companies to determine where the highest regulatory risk or exposure to energy cost volatility is with regards to climate change. By mapping the exposure to different ESG risks at the portfolio level, a GP can also determine if its portfolio is diversified enough or has a concentration of, for example, water scarcity risk. A GP can also share what it has learned from one portfolio company with others. This encourages the dissemination of best practice throughout the portfolio and ESG risk management, therefore, becomes an integral part of portfolio management. 2 From ESG risks as buzzwords to tangible implementation

A GP may also measure ESG risks for every potential investment as part of its due diligence and monitoring processes. To set a standard for measuring ESG risks, a GP could apply a definition or baseline against which to measure ESG risks. To do this, there is a wide variety of sources available for GPs to use. The starting point is that a portfolio company should comply with all relevant legislation. This includes environmental law and legal worker rights. At a higher level, a company should comply with international best practice. Organisations such as the International Financial Corporation (IFC) and European Bank for Reconstruction and Development (EBRD) provide environmental, health and safety guidelines per sector that can be accessed publicly for this purpose. The OECD Guidelines for multinational enterprises and the UN Global Compact may also be useful frameworks. Moreover, tools such as the Transparency International Corruption Perception Index provide insight into potential geographic exposure to corruption and bribery. A GP could also create its own sector and geographic risk checklists or notes and communicate these to its investment professionals. Table 1.2: Illustration of a risk-rating system High risk Medium risk Low risk Transactions typically involve clients/investees with business activities that have significant adverse environmental and social impacts that are sensitive, diverse, or unprecedented. A potential impact is considered sensitive if it may be irreversible (such as loss of a major natural habitat), affect vulnerable groups or ethnic minorities, involve involuntary displacement and resettlement, or affect significant cultural heritage sites. Transactions typically involve clients/investees with business activities that have specific environmental and social impacts that are few in number, generally site-specific, largely reversible and readily addressed through mitigation measures and international best practice. Potential adverse environmental impacts on human populations or environmentally important areas are less adverse than those of High Risk transactions. Transactions typically involve clients/investees with business activities that have minimal or no adverse environmental and social impacts. Source: First for Sustainability at: http://firstforsustainability.org/risk-management These frameworks, however, do not provide a tick-the-box approach to measuring risks, since ESG risks may differ per sector and location/geography. A scoping exercise is therefore usually needed to determine which of the risks in the framework are relevant. This scoping exercise can also help determine the amount of ESG due diligence required. For instance, an industrial company that uses raw materials to fabricate machinery may require more ESG due diligence than a services company. Many banks use a risk-rating system to determine the potential ESG risk they face and the amount of due diligence they are required to undertake. GPs could consider adopting a similar process in relation to their portfolio companies. Table 1.3: Illustration of an ESG risk-materiality matrix High Financial value at risk Energy use Corruption Chemicals Water scarcity A risk-rating system usually has labels, such as high, medium, low (see Table 1.2) or A, B, C. IFC, FMO, a Dutch Development Financial Institution, and EBRD provide online tools for GPs to help them undertake a risk-rating exercise when performing due diligence on portfolio companies. High ESG risk is usually defined as an environmental or social impact that goes beyond the company s location and that has wide-reaching repurcussions, which cannot easily be mitigated. Examples include hazardous waste operations or companies using hazardous chemicals. GPs may also choose to score all the risks that have been identified in an ESG risk register. These risks can then be plotted on a matrix in order to determine the priority in which ESG factors should be considered for a particular portfolio company. Table 1.3 provides an example how such a matrix may look like. Thus, using a risk-rating process early in the investment process can save time and money since it helps determine the degree of attention that different ESG issues need in the due diligence process. Low Low ESG risk impact Using internationally accepted standards as a benchmark can also assist a GP to clarify its ESG risk management approach to its LPs. Often GPs refer to local law when applying minimum standards, but for LPs coming from different geographic backgrounds, it is hard to gauge what that means as laws often differ from country to country and often are not stringently enforced in every country. Once a GP has procedures in place to measure ESG risk at the portfolio and individual investment level, it is able to manage them effectively. High 3 From ESG risks as buzzwords to tangible implementation

Managing ESG risks There are several steps a GP can take to create an ESG risk management system including setting out how: ESG risks are to be identified and categorised. ESG due diligence is to be performed. The decision-making process works. Areas for improvement are to be communicated to and monitored with portfolio companies (discussed further below). There are different ways in which a GP may perform ESG due diligence. Commensurate with the degree of risk, a desk-top review may suffice or a site visit to the target company may be required. A first step in any due diligence process is to screen the transaction against any ethical exclusions. A second step is to review the industry in which the company operates, and the environmental and social issues associated with it. A third step would be to take this analysis to the portfolio company and survey the extent to which it is following applicable ESG law and dealing with the identified ESG risks. For instance, has the portfolio company identified the same risks as the GP and what mitigants does it have in place? In an ideal situation, a GP should document this analysis and be part of the investment decision-making process. For high ESG risk industries, the specialist knowledge of an external expert may also be helpful. Either due to the scale of the GP s firm or the lack of specialist ESG knowledge, this can be warranted. For instance, an investment professional could be expected to flag up risks associated with involuntary resettlement, but may not be able to determine the seriousness of the risk or the need to remediate. For this purpose, an in-house expert or external consultant may be hired. To understand if ESG risks are properly managed, the GP could have residual ESG risks analysed. This can be expressed as follows: Potential ESG risk Managed ESG risk = Residual ESG risk A GP should be comfortable with any remaining ESG risks, either by being confident that the management of risks can be improved at the portfolio-company level or that the GP is appropriately compensated for the remaining risks. When ESG risks are identified at a target company, it is important that the GP has a decision-making process in place that clearly sets out the responsibilities and accountability at the GP level. For instance, this may be helpful in determining which ESG risks need to be escalated to senior management or which could be resolved at the investment professionals level. GPs should determine the following: Who has responsibility for the overall ESG risk management framework. Who should drive implementation of the framework. Who should own individual ESG risks at the transaction level. Who will perform ESG risk due diligence and monitoring. To support its risk management, a GP may train investment and risk professionals on its ESG risk framework. Outspoken commitment from senior management is often seen as helpful for implementation across a GP s operations. Mitigating risks ESG risk are sometimes approached as a showstopper. In other words, it is sometimes reasoned that if a company faces serious ESG risk, a deal should not be closed. However, often ESG risks are an area where GPs can prove their value-add and create value by bringing a company up to best practice standards. A lack of ESG management at company is then not a showstopper, but a value creation opportunity. For instance, oil and gas companies looking to acquire oil services companies, or to hire them, often have stringent health and safety policies. Bringing portfolio companies up to the standards in these markets may improve exit opportunities. To mitigate ESG risks, it is helpful to first quantify them during the ESG due diligence phase (although not all risks can be quantified). Many environmental risks can be quantified however(for example, CO2 emissions, water usage and energy efficiency). Social risks, such as work force diversity and employee turnover are also quantifiable. A universal baseline against which to benchmark a company may not be present so in such circumstances a GP could look for industry figures to set a relative target or aim for a zero target (eg zero lost time injuries or zero CO2 emissions). A GP should try to secure a company s commitment to actually improve a perfor mance indicator before closing the deal and could make these indicators part of the 100-day plan. ESG risks that are not measured will be harder to monitor and therefore mitigate for a GP. A GP with a seat on the board of the portfolio company could also discuss any improvement at the board level periodically. 4 From ESG risks as buzzwords to tangible implementation

Communicating ESG risks to LPs LPs are increasingly interested in understanding the ESG risks in their portfolios and the ways in which they are managed by GPs. Three drivers can be identified for this. 1. LPs such as pension funds are increasingly under public scrutiny and have to defend their investments publicly. Knowing how they are invested gives them more control over any reputational risk. 2. LPs in Europe also cite their social responsibility. They invest for beneficiaries that want to retire in a world that is livable. 3. LPs understand that a lack of ESG risk management may translate into losses in the investment portfolio and in wasted opportunities for value creation. For GPs, LP requests to report ESG risks can be an opportunity to showcase best practice. GPs often start with reporting anecdotal evidence such as case studies. When a GP integrates ESG risks more structurally, this is often followed by reporting relevant ESG metrics per portfolio company against a baseline or public benchmark. ESG reports may be offered as standalone reports or integrated in a fund s annual report. For LPs, ESG reports may hold the most value if they are concise and specific to the fund they are invested in. In the future, ESG reporting may be replaced by more integrated forms of reporting, where value at risk is communicated. This refers back to the two levels of ESG risks, strategic and operational. Currently, it is mostly operational risks that are communicated to LPs. One last note on reporting. There is much discussion about whether a company with low ESG risk will have a higher financial value. Although, as discussed above, some ESG risks can be quantified and, as a consequence, can often be traced back to cost savings, some ESG risks are intangible. Lowering supply chain risks on human rights violations, for example, may raise brand value but to put a specific number on this will be subjective. At the same time, few will argue against the positive effects this measure can have on the value of a company. Conclusion LPs. LPs and GPs looking for further guidance are recommended to look at the following additional resources: PEI s The Guide to Responsible Investment: Creating Value in Private Equity with Effective ESG management (2011). Principles for Responsible Investing (PRI), Integrating ESG in private equity A guide for general partners (2014). British Venture Capital Association (BVCA), Responsible Investment: A guide for private equity and venture capital firms (2014). ESG Disclosure Framework for private equity (2013). CDC Group, Toolkit on ESG for fund managers (2010). Authors biographies Eric-Jan Vink, Head of Private Equity, PGGM Investments Eric-Jan joined PGGM in July 2011, and chairs the PGGM Private Equity Investment Committee. He is a member of the PGGM Private Markets Management team and oversees private equity investments for PGGM s clients. Prior to joining PGGM, Eric-Jan was a partner at Gilde Buyout Partners where he worked for 13 years. While based in Utrecht and Paris, he led and was involved with a broad range of investments in mid-market buyouts in Western Europe. He studied Business Administration at the Rotterdam School of Management (MSc). Tim van der Weide, Advisor Responsible Investment, PGGM Investments Tim joined PGGM in 2008. He is an internal consultant for PGGM s investment teams on the integration of ESG factors into investment decisions in asset classes such as private equity and infrastructure. He chairs the PRI steering committee for the private equity work stream, and participated in the creation of the ESG Disclosure Framework for private equity. Prior to joining PGGM, he was as an interim banking professional working for Dutch retail and merchant banks. Tim holds an MA in American Studies from the University of Groningen. The intention of this chapter is to offer tangible examples of how ESG risks are implemented. It has focused both on what ESG risks mean for portfolio companies and on how GPs can deal with such risks. This takes the confusion out of the blanket term ESG risks and may support meaningful discussions between GPs and their 5 From ESG risks as buzzwords to tangible implementation

PGGM Noordweg Noord 150 Postbus 117, 3700 AC Zeist Telefoon (030) 277 99 11 www.pggm.nl 14-6548 juni 2014 6