Financial institutions are pledging to lower carbon footprints. Here’s what you need to know about financed emissions.

In current carbon accounting models, ownership of GHGs associated with investments and lending activities is considered part of a financial institution’s carbon footprint. Specifically, GHG protocol accounting standards define these GHGs as Scope 3 Category 15 emissions, or financed emissions. Lending and investment are not the only sources of carbon in financing. Insurance underwriting, for example, is another source that some regulators and industry groups recommend considering when assessing and mitigating climate risks. There’s no established emissions quantification methodology for these activities at this time, but that could change as several potential methodologies are currently under development.

These are early days. Thus far in 2021, seven US banks have committed to climate action with the Net-Zero Banking Alliance, including some of the largest in the US. The work to calculate financed emissions is taking place now. At least one of the alliance members  released sources of its financed emissions in four categories as well as plans to baseline and mitigate emissions in late October 2021. At the COP26 climate conference in November 2021, the Glasgow Financial Alliance for Net Zero (GFANZ) announced a global group of firms with $70 trillion in assets committed to Paris Agreement goals.

Disclosure of financed emissions is currently primarily voluntary in the US. At the same time, regulators are signaling expectations for enhanced climate risk disclosures, which for some financial institutions will likely include an analysis of carbon exposures in their portfolios. The European Banking Authority, for instance, has already proposed requiring that all banks under its jurisdiction measure and disclose financed emissions by June 2024 at the latest.

Leading firms are considering financed emissions in the context of the overall level of climate change risk to the business. Climate change risk can manifest itself not only in the increasing frequency and severity of extreme weather events but through increasing transition risks as we move to a low-carbon economy. The potential imposition of a carbon tax is an example of a transition risk that could have a direct financial impact due to the emissions in a company’s portfolio. Another example would be the impact on a firm’s sustainability rating from external rating agencies that consider emissions levels as one of their rating factors.

Firms are digging into their entire portfolios, asset by asset, to build a full picture of their emissions intensity, a measure of emissions relative to the intensity of a specific activity or asset class that they support. Some portfolio companies may have already disclosed the emissions data required to complete the picture, but it’s likely that many have not.

To fill in the gaps, firms can engage a third-party data provider to acquire Scope 1 and Scope 2 emissions by sector and asset class as well as production-related data (emissions per kilowatt) of corporate securities and loans companies. Companies may also need to supplement this external data with estimates using industry emissions factors provided by sources such as the International Energy Agency (IEA). In practice, such industry estimates may diverge materially from emissions actually calculated by a company.

There are guidelines and industry alliances to help. The GHG protocol sets the foundation for measuring Scope 1 and 2 emissions and in some instances Scope 3, while the Partnership for Carbon Accounting Financials (PCAF) offers a methodology to assess and allocate GHG emissions associated with investments and loans, such as mortgages or car loans. In general, emissions allocated to financial institutions under PCAF methodology are based on the ratio of the investment in a company made by the financial institution divided by the enterprise value, including debt, equity, and cash, of the company.  This generally straightforward allocation principle can be difficult to implement in practice; company ownership structure, market price fluctuations, and  limited data are examples of challenges financial institutions may face when calculating their financed emissions.   In late 2021, the PCAF released new draft guidance covering additional asset classes (sovereign debt and green bonds), highlighting how quickly the financed emissions landscape can change.

Recognizing that there can be incomplete data available on emissions at a company or issuer level, it’s critical to first form a broad view of the firm’s financed emissions by calculating its share of emissions from lending or investing activities at the sector level. These are generally based on industry/sector-wide emissions factors. 

Expect to encounter gaps in emissions data and consider how to handle concerns that may arise on the quality of the data. The PCAF has developed a data hierarchy and scorecard that firms can use to understand the overall quality of their emissions data and to develop strategies for improvement. Financial institutions should continually strive to improve the quality of their financed emissions data. Engaging with portfolio companies to disclose emissions can support this goal.