The messy, high-stakes world of private equity's fossil-fuel dilemma

Efforts are underway at Blackstone, KKR, Carlyle, Apollo, and other private-equity heavyweights. They're moving quickly to profit from decarbonization as an investment theme, pushing into a crowded field of solar-panel suppliers and climate-data providers. The competition for seizing on these opportunities is fierce: annual global clean-energy investments need to triple to $4 trillion in the next few years to reach net-zero emissions by 2050, the International Energy Agency estimated.

This urgent, historic process is shaping up to be a messy undertaking. Private-equity firms, a growing, influential group flush with cash from investors allocating more money to private markets, risk angering a set of their clientele in Republican-led states if they see it as investing public-sector dollars through a lens that seems left-leaning.

Environmental advocates are meanwhile raising concerns that efforts by the industry, where firms sell companies after holding them for several years, may be in vain if they sell their assets to irresponsible buyers.

"The biggest challenges are directly coming from the different states," Josh Lichtenstein, a partner at the law firm Ropes & Gray who advises investors on pension regulation, told Insider.

"If you want to be able to manage money in red states and blue states and across the whole universe of institutional investors, then it can be pretty challenging to figure out how you thread the needle in describing what you are actually doing, what you've undertaken, and what you're willing to do for any particular investor — in a way that avoids any contradictions," he said.

Republicans have seized on anti-ESG rhetoric to rally their bases and frame climate-conscious investing as a boogeyman. Democrats are generally divided on whether to divest from oil and gas — or to focus on working with the oil-and-gas sector to reduce its emissions. Wall Street prefers the latter, prompting criticism from climate advocates pushing for divestment.

"We need to stay invested in conventional energy because that needs to be a part of the transition," Megan Starr, the global head of impact at Carlyle, which manages $373 billion in assets, told Insider. "One of the things we say a lot is that if you want to decarbonize the global economy, you have to go to where the carbon is."

Carlyle is in the process of collecting the first year's worth of data from its portfolio companies after the firm said in February 2022 that it would commit to reaching net-zero emissions across investments by 2050. It's also set targets to get three-quarters of its majority-owned power-and-energy portfolio companies' emissions that they generate directly and indirectly covered by Paris-aligned climate goals by 2025. Starr said that in the past year, about 20 additional portfolio companies, including the oil-and-gas companies Neptune and Varo, have set climate goals.

Last year, Apollo, which manages $548 billion in assets, committed to reducing median carbon intensity by 15% for new investments it controls in its flagship strategy. Meanwhile, KKR is working with some of its majority-owned businesses to implement plans to reach net zero by 2050, and Blackstone won't make new investments in companies involved in oil and gas production in two recently launched funds focused on the energy transition.

Characterizing the overall effectiveness of the private-equity industry's climate-crisis response relative to public-money managers is difficult because some firms have more robust decarbonization plans than others, with commitments all over the map, Andrew Howell, the director of investor influence at the Environmental Defense Fund, said.

"On one hand, private equity is in a very good position to put through action because they do have more influence," Howell said, pointing to advantages including board seats and a bigger say in business operations. "But the reality is that the private-equity industry has been slower to adopt a focus on these issues."

"Is there a strong risk-return case, standalone? Is it purely impact-oriented? Is it purely values-based or are they trying to hit two or three of those at the same time?" Rich Nuzum, the chief investment strategist at investment consultant Mercer, which advises pension plans and other large investors, said. "Because you don't want to get thrown out by a sophisticated investor in due diligence if they think you're one thing and they find out you're another."

As of mid-April, states have introduced 34 total divestment bills and actions overall, with six in effect, including some in New York, Maine, and Connecticut. According to Ropes & Gray, 23 are pending and in committee, and five have failed to pass.

But states have also introduced 85 total actions seeking to restrict ESG considerations from investment decisions. Currently, 24 are in effect in states including Florida, Arizona, and South Carolina; 49 are pending, and 12 failed to pass.

New York City said this month that as part of its plans to reach net-zero emissions by 2040 across two of its public-sector employee-pension plans, it would request that all of their private markets managers exclude upstream fossil-fuel investments, or those involved in the exploration and production of new oil and gas.

The New York City Employees' Retirement System and the New York City Teachers' Retirement System manage some $77 billion and $90 billion, respectively, as of December, each with roughly $8 billion in private-equity allocation. The plans have already divested from some $4 billion of public securities tied to fossil-fuel-reserve owners after announcing plans to do so in 2018.

The New York City Comptroller, Brad Lander, New York City's top finance official who had advocated for a bill that allows for pension plans to increase their private-markets allocations, has championed the net-zero effort that counts divestment as a key step. New York Governor Kathy Hochul signed that bill in December.

Lander's team gathered extensive feedback from asset managers in advance of the net-zero implementation commitment and took into consideration variables including the period of several years that private-equity managers typically hold their investments and what they could feasibly achieve during that time.

"Because we are getting more prescriptive, we really did have a lot of conversations with our managers to say, 'Our goal is to hit this 2040 net-zero goal, and we're externally managed, so that's only going to work if our managers are working with us,'" Lander said in an interview.

Divestment efforts in Maine offer another window into how a big pension plan is seeking to wind down fossil-fuel holdings. The state's $18.2 billion public-employees' retirement system, which had a $10 billion private-markets portfolio as of December, is now working through how it will divest from fossil fuels by 2026 after a law requiring it took effect in 2021.

Firms' plans with their upstream investments tend to draw the most attention because they're involved in drilling for new oil and gas. "If you're a bank, and you continue to lend on expansion projects, if you're a private-equity firm and you continue to make new upstream investments — I don't believe you have a Paris-aligned plan, and the International Energy Agency says you don't have one," Lander said.

The private-equity giant KKR, whose upstream investments are largely within Crescent Energy, is invested in conventional energy through its infrastructure and energy-real assets businesses, Ken Mehlman, the global head of public affairs and the co-head of global impact at KKR, said.

Mehlman told Insider that by responsibly operating traditional energy assets, KKR "can contribute to producing better outcomes than if we exited the space — and therefore transferred emissions — to other operators who may not share our commitment to stewardship." By 2027, Crescent Energy aims to halve emissions its operations have directly caused as of its 2021 figures.

Carlyle's relationship with NGP, a Dallas-based energy-focused private-equity firm that Carlyle invested in with a non-controlling stake a decade ago, has drawn scrutiny from environmental advocates partly because of NGP's upstream investments. After the Private Equity Stakeholder Project published a report that criticized Carlyle and NGP's energy holdings last year, Carlyle told the nonprofit group in a letter, which Insider viewed, that it does not have a say in NGP's portfolio companies or operations. NGP has its own ESG considerations that it factors into the investment processes, with a particular focus on reducing emissions from its upstream and midstream oil-and-gas assets.

At Blackstone, the world's largest private-equity firm with some $991 billion of assets under management, about 1% of the firm's overall portfolio was invested in upstream companies at the end of 2022. The firm controls two oil-and-gas producers and about half of a coal plant, the James M. Gavin Power Plant in Ohio, and it has continued to invest in infrastructure such as natural-gas pipelines. In 2021 Blackstone started working toward a goal of cutting emissions by 15% at new investments where it controls the energy usage within three years.

"As fiduciaries, we believe we can create more resilient, valuable companies through effective energy management and reduced emissions. We also believe global decarbonization goals create compelling investment opportunities for private capital," a Blackstone spokesperson said.

Investors and environmental advocates are scrutinizing not just firms' current oil-and-gas holdings, but where those holdings go once private-equity managers sell them off after their investment periods. What falls into focus is whether the buyer has sufficient decarbonization plans. In January the Environmental Defense Fund, and Ceres, another major climate-focused nonprofit, published climate-related guidance for oil-and-gas dealmaking.

"If you have a management plan or decarbonization plan for an oil-and-gas field which you're selling, it goes without saying that you should be handing those over to the buyer and really encourage them to follow those plans," Howell said.

That additional scrutiny on dealmaking — core to the private-equity model — is one of the myriad challenges firms are grappling with now. Lichtenstein said he is advising clients such as asset managers to watch out for broad statements about how ESG principles are core to everything the firm does. "Those can then have to be walked back, potentially," he said, if a firm is in talks with a pension plan in a Republican-led state.

KKR is a large shareholder in Insider parent company Axel Springer.

This article is part of "The Great Transition," a series covering the big changes across industries that are leading to a more sustainable future. For more climate-action news, visit Insider's One Planet hub.