Private Equity: Emission impossible

The Government’s efforts to reduce companies’ carbon emissions will have a far-reaching effect on private equity funds. By Sue Woodman

Cremation to be banned? Not quite, but a brave new green world is coming and the Government is legislating to save the planet by introducing a new emissions trading scheme known as the Carbon Reduction Commitment (CRC). This will apply from April 2010 to all ­organisations in the UK having half-hourly electricity meters that consume approximately £1m per annum in electricity.

This broadly means that organisations falling within the CRC remit (both public and private) will need to register and ­forward-purchase allowances for the carbon emissions they expect to make. Evidence packs will later be submitted to prove they bought enough.

The Department for Energy and Climate Change states that the incentive for ­participants is the savings they can make by being made to reduce their energy ­consumption. To make life more exciting, there will be a name-and-shame register in a league of good- and bad-performing ­companies, with a company’s position in that league governing how much of the money spent on allowances is given back. The number of allowances is capped but trading in excess allowances will be allowed for those companies that have acquired but not used allowances, and ‘bonuses’ will be awarded to a company that reduces its ­emissions still further.

This initiative, while undoubtedly being costly and administratively cumbersome to implement, must largely be seen to be a good thing in terms of focusing companies on the carbon emissions they make and encouraging a reduction by financially rewarding those participants that reduce their emissions the most – and penalising those that do not.

Impact on private equity

The downside for private equity is that in trying to ensure that as many emissions as possible are caught, the Government has determined that a private equity fund is a holding company and the legislation ­currently envisages the fund acquiring allowances and co-ordinating the ongoing administration, reporting and compliance. If one or more portfolio companies in the ‘group’ cumulatively passes the usage thresholds for inclusion within the CRC, then all majority-held companies in the ‘group’ would need to report, with ­emissions being aggregated for the purposes of ­acquiring allowances. Many private equity funds would not fall within the CRC remit if it were not for this aggregation.

Whereas this works for a true commercial group – for example, Tesco topco could administer the scheme and buy allowances on behalf of all its stores because there is common beneficial ownership of shares and a common purpose – it will not, of course, work in the private equity model where a manager acts on behalf of different ­beneficial owners and where companies in the ‘group’ have no connection or common ­purpose and, indeed, may not even know of the existence of each other. Furthermore, poor performance by one portfolio ­company could increase costs for the others if league table performance for the whole ‘group’ becomes worse. This situation is ­exacerbated by the baseline against which performance is measured, which cannot be updated if the fund buys a new entity not already in the CRC. Costs will thus increase if the fund buys more non-CRC businesses.

Why should a small majority-held ­portfolio company have to incur the cost and expense of complying with the CRC when it is only brought within its remit because of another company in the group to which it is unrelated? This does not create a level ­playing field for private equity where ­competitors of a similar size and carbon output would not have to incur such costs.
In case one might think that an offshore fund could wriggle out of the legislation, the Government has determined that, in this instance, the largest UK ­organisation in the ‘group’ should take on the responsibility of being the ‘parent’ of all other ­companies in that ‘group’. The ­argument that portfolio companies are independent of each other and have no ­control or sway over the activities of ­another goes by the board and, worse still, there is joint and several liability so that the deemed ‘parent ‘company could find itself ­responsible for the whole ‘group’. Financial and ­reputational penalties for non-­compliance are onerous and directors need to be ­mindful of their own responsibilities and duties under the Companies Act 2006.

Whereas all businesses should be ­encouraged to invest in energy-saving strategies and management should be more aware of the effects of carbon emissions on the ­environment, it is a worrying trend that the Government now seems to be denying the private equity model that has hitherto always treated portfolio companies as ­independent of each other.

Arguments have been put – currently to no avail – that the definition of ‘group’ should be that of a group for tax purposes, ie not only should the topco/subsidiary issue be considered but also the UK GAAP reporting treatment. If the accounts are consolidated then it is evidence that it is part of a group. However, as with private equity, if the accounts are not consolidated, then there can be no group. This seems to be a useful compromise that satisfies the good intentions of the Government but does not prejudice those smaller companies that would, other than for their ownership, not meet the criteria of the CRC.

It is in everyone’s interests to reduce ­emissions and make their businesses more energy efficient and sustainable. The private equity industry endorses and supports this. However, the costs involved for companies that are caught only by reason of their ­ownership is unfairly prejudicial and

A consultation is ongoing and it is ­important that the significance of these issues for private equity is made very clear to the Government. Responses to the ­consultation are due by 4 June 2009 and can be sent to

Sue Woodman is partnership counsel at Alchemy Partners