BCG Investing in the Future

bcg.comAugust 2020

Xinyi Wu, Rina Su, Mengya Lin

Investing in the Future——Being a Climate-Smart Private Equity Investor in China

Contents

1. Global Warming Is the Greatest Threat to Our World Today 1

2. Climate Change Is Becoming a Primary Focus for PE Investors 32.1 LPs Are among the Front-Runners on Climate Topics, and Require Commitment

from GPs 42.2 Industry Stakeholders Set Low-Carbon Operation Principles for Portfolio Companies 52.3 The Carbon Price May Potentially Impact PE Investors’ Financial Returns 6

3. Call for PE Investors to Take Action on Climate Change 9

4. BCG Is a Partner Helping PE Investors Fight Climate Change 10

Boston Consulting GroupAugust 2020

1. Global Warming Is the Greatest Threat to Our World Today

When you think of ‘global warming’, what is the first image that comes to your mind? The thunderous ice calving? Or a forlorn polar bear standing on a shrinking ice floe? The level of carbon dioxide in the atmosphere today has reached its highest point in 25 mil-lion years. If this unprecedented increase in greenhouse gas (GHG) emissions continues unabated, the average global temperature will rise more than 5°C by 2100, which would be a disaster for the human society: grain yields would diminish by 50% causing mass star-vation. As history has repeatedly shown, an inadequate food supply often leads to migra-tions, conflicts, wars, and eventually the collapse of civilizations.

Knowing that they had to come to grips with these dire consequences, 196 countries pledged to limit the increase in global average temperature to below 2°C by signing the 2015 Paris Agreement. Under this scenario, net-negative global emissions will be achieved, carbon concentration will be limited to 430-480 ppm1, and sea levels will rise less than 0.6m (Exhibit 1).

However, given that most countries have not been taking enough action to meet their targets since the 2015 Paris Agreement, the global temperature is still likely to increase by 3°C (or more) by 2100: At this rate, coral reefs would become extinct, the majority of tropical rainforests would disappear, the Greenland ice sheet and summer Arctic sea-ice would melt, and floodwaters would flow through the streets of coastal cities for ten months each year. Before approaching “the point of no return”, countries must increase their commitments to cut greenhouse gas emissions at least threefold, and up to fivefold, if the world is to meet the goals set in the 2015 Paris Climate Agreement.

1 Ppm=parts per million.

Investing in the Future——Being a Climate-Smart Private Equity Investor in China

Boston Consulting Group August 2020

Investing in the Future: Being a Climate-Smart Private Equity Investor in China2

-20

0

20

40

60

80

100

20601980 21002000 2020 2040 2080

2019 Estimate

Net-negative global emissions

Gt

<0.6 m 10%-20%430-480 ppm<2°C 5%

0.6-0.9 m 20%-40%720-1000 ppm2-4°C 15%

0.9-1.8 m Up to 50%>1000 ppm1>5°C 75%

Net CO emissions

Sea levelrise

Grain yieldreduction

Temperatureincrease

Speciesbecoming

extinctUnprecedented GHG emissions

Paris agreement

Moderate efforts

Carbonconcentration

Exhibit 1 | The Paris Agreement Limited the Global Average Temperature Increase to 2°C, Aiming to Achieve Net-Negative Global Emissions

Source: Carbon Brief; IPCC; BCG analysis.1 ppm=parts per million.


Investing in the Future: Being a Climate-Smart Private Equity Investor in China 3

2. Climate Change Is Becoming a Primary Focus for PE Investors

As the largest GHG emission country (contributing 28% of total global emission), China is pivotal to saving the human race from extinction. Private Equity (PE) investors are import-ant force to drive China economy growth, what’s the impact of their investment activities? A BCG study revealed that PE backed companies in the last five years generate an estimated 410 Mt CO2e of GHG annually2 (including both direct and indirect emissions along the value chain), which is greater than UK’s total GHG emissions in 2019 (Exhibit 2). As a result of the country’s investment environment, companies backed by PE generate 3.3% of China’s annual GHG emissions, while PE investors contribute 4.4% of the country’s total capital investment.

Industrial-level benchmarks (Exhibit 3) showed that rare investment activities in high-emission industries (mining and metals, construction, utilities, manufacturing and other traditional heavy industries with an emission intensity of more than 0.5Kt per USD

2 Scope 1: Direct GHG emissions from combustion of fossil fuels in self-controlled sources and from production activities, including chemical reactions; Scope 2: GHG emissions from the generation of purchased or acquired energy resources; Scope 3: Other indirect GHG emissions that occur in an organization’s value chain. BCG only included activities that a company could have controlled if it made efforts to do so.

CHINA

UK

Mt COe

UK’s total GHG1 emissions in 2017

(~350 Mt COe)

China’s total GHG emissions

(~1300 Mt COe)

Passenger vehicles per year in China generate GHG emissions (more than current car ownership in China)

Shanghai Centers in weight

More than

~3.3%

~2402 Mn

~330~410

Total annual GHG emissions of PE backed companies3

(investments from Jan 2015 – Jun 2020)

Exhibit 2 | PE Backed Companies in China Generate an Estimated ~410 Mt CO2e of Green-house Gases Annually

Source: Eikon database; AVCJ; Pitchbook; Preqin; Literature research; BCG China Carbon Emission Intensity Tracker.1 UK’s greenhouse gas emissions in 2019, including CO2, NH4 and N2O.2 Assuming compact passenger vehicles utilizing #93 gasoline with 16.47 mpg travel at 31km per day (2019 Beijing avg.), 365 days per year with a carbon emissions intensity of 2.925 kgCO2e/kg gasoline.

3 The calculation includes publicly announced 1,770 companies backed by PE from Jan 2015 to Jun 2020.



in revenue), as these industries are highly restricted by the government. Most of the in-vestments are in sectors with high ROI and mid-to-low emission intensity, such as the medical industry, computer-related industries, and information technology.

While GHG emissions are becoming one of the primary focuses in China, PE investors, although they currently cause limited emissions, still have to face three pressures:

• Limited Partners (LPs) are among the front-runners on climate topics, and require the commitment of General Partners (GPs);

• Industry stakeholders set low-carbon operation principles for portfolio companies;

• The carbon price may potentially impact PE investors’ financial returns.

2.1 LPs Are among the Front-Runners on Climate Topics, and Require Commitment from GPs

Alliances such as Climate Action 100+, Investor Group on Climate Change (IGCC), Net-Zero Asset Owner Alliance, and Principles for Responsible Investment (PRI) were all founded by responsible LPs and non-governmental organizations (NGOs). Trillions of

241

5,284

3,283

1,35375219

883 71864238 211 201 183 141 114 99 95 86 44 39 25 14

Average CO equivalent emissions per unit of revenue(tCOe/Mn USD)

29 7 6 35103

267

82 49 28

156

5 21

245

45 968

7 13 685

347

157

Utilities

Construction

Mining and m

etals

Manufacturing

- Light

Transportation/ D

istribution

Financial services

Medical

Retail/W

holesale

Manufacturing

- Heavy

Consumer products/

services

Health care

Leisure/Entertainm

ent

Electronics

Conglomerates

Agriculture/Fisheries

Computer related

Infrastructure

Telecomm

unications

Textiles and clothing

Media

Information

technology

Services - N

on-Financial

Number of companies by industry

Low-emission industries39% of PE-backed companies

High-emission industries~10% of PE-backed compa-

nies

Medium-emission industries51% of PE-backed companies

Exhibit 3 | Most PE Investments Are in Sectors with Mid-to-Low Emission Intensity

Source: Eikon database; AVCJ; Pitchbook; Preqin; Literature research; BCG China Carbon Emission Intensity Tracker.



dollars of private equity assets under management (AUM) belong to LP signatories of these alliances.

In 2014, Harvard Management Company (HMC) became the first US higher education company to sign on to the PRI. In 2019, it joined the Climate Action 100+. At the time, Harvard University President Larry Bacow stated, “In joining Climate Action 100+, we create another significant channel for engaging with companies around the imperative to adopt sustainable practices and reduce greenhouse gas emissions.”

In 2019, as a part of the UN-convened Net-Zero Asset Owners Alliance, Oliver Baete, the CEO of Allianz, said, “Mitigating climate change is the challenge of our lifetime. We, as asset owners, will live up to our responsibility and, in dialogue with companies in which we invest, steer towards low-carbon business practices. We’ve already started, and by 2050 our portfolios will be climate neutral.”

When allocating capital, increasingly LPs are asking GPs to align climate change prin-ciples and practices with their own climate investment beliefs, as the approach of GPs in managing and disclosing climate issues directly reflects the commitment of their LPs. For example, in 2017, the UTAM3 included responsible investing approaches in its evaluation of various private equity funds. The other famous LP, Allianz, ensures its GPs focus on industries operating at low-carbon intensity, and requires GPs to have the veto right to block portfolio companies from pursuing high-emission projects. GPs are also re-quired to submit half-year energy consumption reports on portfolio companies to Allianz. Moreover, many NGOs have continued exerting pressure on companies in high-emission industries.

2.2 Industry Stakeholders Set Low-Carbon Operation Principles for Portfo-lio Companies

In acknowledging the irreversible consequences of global warming, an increasing num-ber of regulators around the world are bringing the topic of GHG emissions to the top of their priority list. French and UK governments have made climate reporting a prerequisite for listing: Article 173 of the French Energy Transition Law strengthened man-datory carbon disclosure requirements for listed companies. The UK’s Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 requires quoted companies4

3 University of Toronto Asset Management Corporation (re. University of Toronto Pension Plan).4 Quoted companies: UK incorporated and whose equity share capital is officially listed on the London Stock Exchange; or in the European Economic Area; or the New York Stock Exchange or NASDAQ.



to report their annual emissions and intensity ratio in their Directors’ Report. In China, more stringent restrictions on GHG emissions are expected to be included in the country’s 14th Five-Year Plan, and the implementation of Emissions Trading System (ETS) across all industries and across all regions will be put in place in the coming years.

In addition to government mandates, responsible leading companies are moving to-ward low-carbon operations, and pushing their ecosystem partners to make similar commitments. Apple launched the Supplier Clean Energy Program in October 2015 to reduce its overall emissions. Nike’s "Move to Zero" plan aims to reduce carbon emissions across its global supply chain by 30% by 2030.

2.3 The Carbon Price May Potentially Impact PE Investors’ Financial Re-turns

Today, 67 jurisdictions — representing about half of the global economy and more than a quarter of global GHG emissions — are putting a price on carbon (Exhibit 4). While Eu-ropean countries including Denmark, Sweden, Ireland, Iceland, and Norway are leading the market in this endeavor, China initiated its ETS in 2013 and will promote the platform further in the coming years.

NORTHWESTTERRITORIES

MANITOBA

ONTARIO

QUEBEC NEWFOUNDLAND AND LABRADOR

PRINCE EDWARD ISLANDNOVA SCOTIANEW BRUNSWICKMASSACHUSETTS

RGGI

VIRGINIA

ALBERTABRITISH COLUMBIA

WASHINGTIONOREGON

CALIFORNIA

RIO DE JANEIROSAO PAULO

Both ETS1 and carbon tax implemented or scheduled

Either ETS or carbon tax implemented or scheduled for implementation

ETS or carbon tax under consideration

JAPAN

EU

UKRAINE

TURKEY CHINA

THAILAND VIETNAM

REPUBLIC OF KOREA

AUSTRALIANEW ZEALAND

SOUTH AFRICA

CANADA

MEXICO

COLOMBIA

BRAZIL

CHILE

ICELAND

SINGAPORE

KAZAKHSTAN

Exhibit 4 | 67 Jurisdictions—Representing about Half of the Global Economy and More than a Quarter of Global GHG Emissions—Are Putting a Price on Carbon

Source: World Bank; BCG analysis.Note: The circles represent subnational jurisdictions. The circles are not representative of the size of the carbon pricing instrument, but show the subnational regions (large circles) and cities (small circles).1 ETS=Emissions Trading System.



Carbon price affects portfolio companies’ margins and shareholder returns. Al-though PE investors mostly invest in mid-to-low level emission sectors, portfolio companies with minimized carbon footprint are able to sustain competitive advan-tages. BCG studied two specific sectors to further illustrate different GHG performances between companies.

Medium-emission industry: apparel brand ownerFor apparel brand owners, the companies with the best carbon control practices generate a 50% lower GHG emission/revenue ratio5 than the industry average (Exhibit 5). More than 90% of the carbon footprint of brand owners comes from upstream and downstream activities not as part of their internal operation—including fabric dyeing and finishing, garment assembly, and inbound and outbound transportation. Brand owners could con-trol effectively by managing the supply chain. In addition, brands could initiate many

5 The company’s total GHG emissions divided by the company’s revenue (in US dollars).

Usage behavior

Sewing machine eff.

Lighting usage

Robot/system efficiency

Electricity Heat Gasoline/Diesel

Low-hanging fruit

A/C system

Lighting plan

Architectural design

Lighting usage

Long-term strategy

Retail store

HQ+Office

Distributioncenter

Assembly

Industry avg. Best practice

~200

70-80

~80-90

~60-80

~160

~50

~80-90

~50-60

Mix of rail/water/road

Avg. distance

Energy mix

Heat usage in productionDyeing &finishing

Transportation

~160-180

~220-230

~100-110

~150-160

Emissions (Kt COe)2

Best practice

Industry avg.

Mt COe

Mt COe

25%-30%

50%

On par

30%-40%

~60%

35%-45%

Activities Major typeof energy

Major source ofvariance

Emissionsvariance

equivalent toemissions of~180Kpassenger vehicles1

Difference inGHG emissions

40%-50%

0.9

0.6

Exhibit 5 | Apparel Brand Owner: Difference in Emissions Could Be 40%-50% if the Brand Adopts Carbon Friendly Processes along the Value Chain

Source: Expert interviews; National bureau of statistics; literature research; BCG Carbon Footprint Assessment Tool.1 Assuming compact passenger vehicles use #93 gasoline at 16.47 mpg, travel at 31km per day (2019 Beijing avg.), 365 days per year with a carbon emissions intensity of 2.925 kgCO2e/kg gasoline.

2 Assuming the company has 500 retail stores, with avg. floor area of 300 sqm; total 150k sqm office area; total 400k sqm distribution center; annual shipment of 100Mn garments which each would use 1kg fabric; transport 150k/day with avg. distance of 500km; Scope 1 emissions considered negligible as limited self-owned vehicles and facilities using primary.



policies through direct control of their retail stores and office areas, for example, about 5% of total GHG emissions could be cut by using efficient lighting and energy management systems.

Low-emission industry: Internet content providerThe GHG emissions/revenue ratio difference between the best performing company and the industry average could be 35%-40% for a large-scale internet company (Exhibit 6). The major discrepancy comes from data center operations, which accounts for a potential difference of approximately 30%-35%. Factors such as office building energy consumption, employee commuting and travel, and office waste are additional areas where emissions could easily be reduced under appropriate management initiatives.

Usage behavior

Usage behavior

Recyclable materials

Travel frequency

Power usage effectives

Electricity grid mix

Architectural design

Daily commuting

Data Center

Office building

Commuting

Office waste

Industry avg. Best practice

~2000

40-45

250-300

~10

~1500

25-30

180-200

~8

Emissions (Kt COe)2

Best practice

Industry avg.

Mt COe

Mt COe

Electricity Heat Gasoline/Diesel

Low-hanging fruit Long-term strategy

equivalent toemissions of~360Kpassenger vehicles1

Difference inGHG emissions

35%-40%

30%-35%

40%-50%

30%-40%

35%-45%

Activities Major typeof energy

Major source ofvariance

Emissionsvariance

2.4

1.8

Exhibit 6 | Internet Content Provider: Difference in Emissions Could Be 35%-40% for Com-panies with the Same Scale

Source: Expert interview; National bureau of statistics; literature research; BCG Carbon Footprint Assessment Tool.1 Assuming compact passenger vehicles use #93 gasoline at 16.47 mpg, travel at 31km per day (2019 Beijing avg.), 365 days per year with carbon emissions intensity of 2.925 kgCO2e/kg gasoline.

2 Assuming the company uses 48,000 server racks, with office GFA of 250k sqm and 40k FTE; Scope 1 emissions considered negligible as limited self-owned vehicles and facilities using primary.

The GHG emissions variance would introduce direct costs. If we apply the internation-al practice of setting carbon tax at ¥175/ton (or $25/ton), the two best practices shown in the charts above would save costs of ¥52 million and ¥105 million per year respec-tively, which increases the margins to approximately 0.6% and 0.3%.



3. Call for PE Investors to Take Action on Climate Change

All of these pressures call for PE investors to take leadership on climate resilience via both external investment activities and internal operations.

Deal sourcing: Investors need to have a clear understanding of industry-specific climate issues, and give more weight to climate-friendly industries. In the meantime, they can more proactively focus on impact investing, for example by investing in clean-energy-re-lated technologies.

Due diligence process: Investors need to be aware of the climate change regulations in their target business, and tailor their due diligence approach and evaluation method to include climate change risk factors.

Portfolio management: Investors also have an obligation to highlight and support the climate change initiatives of their portfolio companies. While portfolio companies contrib-ute their industrial expertise, PE investors can bridge resources/technologies to maximize value creation.

Internal operations: PE firms themselves can take a series of global initiatives to make a difference, such as recycling appliances and stationery, adopting energy saving office de-signs, reducing business travel, and training employees on climate issues etc.



4. BCG Is a Partner Helping PE Investors Fight Climate Change

BCG, as a leading voice on climate topics, supports PE firms along the full investment cycle with climate due diligence, climate portfolio strategy, and climate vendor due dili-gence. It also helps portfolio companies answer key questions about low-carbon business strategy, climate-proofed operations, and their engagement and narrative (Exhibit 7).

Drawing on the in-depth research by its Center for Climate Action, BCG has developed proven climate change tools and relevant technologies. Our China Carbon “EI-FA” Toolkits aim to put PE investors and portfolio companies on the right path, and to enable them to mitigate risks caused by their GHG emissions in China (Exhibit 8).

The unexpected outbreak of COVID-19 raises many unknowns on investors around the world. People have been talking about “how we can better prepare for future crises”. Cli-mate change is a threat similar to the pandemic, why don’t we take action now to slow down the progressing global warming process? BCG PIPE team is ready to help PE inves-tors achieve a balance in this game of short-term benefits and long-term value, and ulti-mately a sustainable future for all!

• Changes in value chain

• Opportunities and risks

• Mitigation measures

• Target's capabilities

• Profitability and impact multiple

• Climate scenarios and macro trends

• Risks, opportunities and impact

• Mitigation measures and value creation

• Existing climate initiatives and value

• Objective scrutiny of asset to decrease risk premium

• Decarbonization measures boosting asset value

• Goal, vision and target-setting

• Scenarios and portfolio resilience

• Low-carbon product and growth strategy

• Ventures, partnerships and ecosystem development

• Emission reduction program and measures

• Sustainable supply chain (Scope 3)

• Infrastructure resilience

• Financial management and carbon trading

• Low-carbon governance

• Shareholder narrative and engagement

• Financial disclosure

Climate due diligence Climate-friendly portfolio strategy Climate-friendly portfolio strategy

Low-carbon business strategy Climate-proofed operations Engagement & narrative

PEinvestors

Portfoliocompanies

Exhibit 7 | BCG Supports PE Investors and Portfolio Companies along the Full Lifecycle

Source: BCG Center for Climate Action; BCG analysis.



• Battery storage market size and value pools by country

• Business cases by application, business models and value chain opportunities

• Company-level key activities and energy consumption identification

• Scope 1, 2, 3 COe calculation and comparison

• Potential reduction evaluation

• CO reduction potential and total cost by technology type, with change over time

• CO technology assessment across 20+ countries and different industry sectors

• Worldwide database with benchmark of oil and gas players’ actions on climate change

• Techno-economic assessment of 30+ H-related technologies

• Solar PV model for both on and off-grid

• Onshore and offshore wind power market model: technologies, LCOE modeling etc.

• Carbon intensity benchmark table of 22 primary industries and 179 sub-sectors in China

Battery Storage Market Model H-COST Model O&G Players Database

GHG Abatement Matrix CCUS-COST Model

Renewable Energy Models

Carbon EmissionsIntensity Tracker

Carbon FootprintAssessment Tool

Carbon Technology Assessment Toolkits

Other Energy Analysis Tools

China Carbon "EI-FA" Toolkits

Exhibit 8 | BCG Has Proven Tools for Climate Change and Relevant Technologies

Source: BCG Center for Climate Action; BCG analysis.Note: Others include Global climate scenario model, Bottom-up GHG model, Deep dives on H2-CCU-CCS, Markets insights, Energy Scenario Model, Final energy consumption, Availability of excess electricity, Electricity system costs, Deep dives power-to-x, ESCO benchmark tool, Cost comparison of approx. 200 measures, etc.



About the Authors

Xinyi Wu is a Managing Director and Senior Partner in BCG’s Beijing office, the leader of the PIPE (Principal Investors & Private Equity) practice in Greater China, and the leader for the green energy and sustainability sector in Greater China. He can be reached at [email protected].

Rina Su is a Partner in BCG’s Beijing office, and a core member of the PIPE Greater China leadership team, and a leader for the energy efficiency topic in Greater China. She can be reached at [email protected].

Mengya Lin is a Project Leader in BCG’s Shanghai office, and a core member of the PIPE practice in Greater China. She can be reached at [email protected].

Acknowledgments

The authors thank BCG Center of Climate Action for their great support to this report, and thank BCG colleague Peiqi Sun for her invaluable assistance to this report.

The authors acknowledge global contributors include: Arie-Willem Van Doorne, Peter Czerepak, Veronica Chau, Olof Sundstrom, Ida Zhang, Elena Corrales, Susana Margolin, Tianyan Liu and Zhuo Chai. Sincere thanks are extended to UN PRI and investors who in-terviewed with us (including LPs and GPs). This report would not be possible without other BCG colleagues’ contributions to its editing, design, and production.

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