In the era of increased climate reporting, businesses are increasingly held accountable for their environmental impact. This accountability extends beyond the direct operations of an organisation to include indirect emissions; Scope 3 emissions, a category that encompasses all indirect emissions that occur in a company's value chain. Among these, financed emissions have emerged as a particularly challenging area to accurately, effectively and manageably report.
Financed emissions are one form of indirect, Scope 3 emissions that are linked to the investment and lending activities of banks, insurers, investment managers, and other financial institutions.
In essence, financed emissions represent the carbon footprint of an organisation’s investments or loans, including all the companies in its portfolio/lending book, based on how much of these companies’ activities are financed by the bank, insurer, or financial institution.
For example, were a bank to provide a business loan to a transportation company and the company used the funds to expand its fleet of diesel-powered trucks, the emissions from those trucks would be considered financed emissions for the bank and thus included in its Scope 3 reporting requirements.
As you can imagine, this results in financed emissions being a hefty portion of Scope 3 emissions for many financial companies. For some, financed emissions are many hundreds of times larger than their direct emissions.
Financial institutions, including banks, finance companies, and other lenders, play a pivotal role in the global economy. How they choose to invest, in carbon intensive activities or decarbonisation, will play a significant role in the pace of progress towards a sustainable transition across the globe. As such, these institutions are under increasing pressure from regulators, civil society, and clients to reduce their carbon footprint and provide transparency about their role in climate change.
Measuring financed emissions is not just about accountability; it also offers several benefits:
In some jurisdictions, the disclosure of financed emissions is not just a best practice—it's a legal requirement. New Zealand was a global leader in mandating carbon emissions reporting for 200 of its largest companies and finance businesses, for example. This reporting requirement includes financed emissions, and failure to include this notable category in reports for lenders can result in inaccurate and non-compliant carbon reports.
Accurate measurement ensures compliance with these regulations, helping institutions avoid potential penalties and reputational damage. Moreover, as more countries and regions move towards stricter environmental regulations, it's likely that mandatory disclosure of financed emissions will become more widespread. Early adoption of measurement practices can position institutions as leaders in compliance and corporate responsibility.
Additionally, even non-financial companies have been affected. Legislation has had run-on effects for non-mandated businesses as well that are now required to provide emissions to these large businesses in turn. With large lenders now mandated to report financed emissions, any company seeking capital must expect to provide data on how their capital will be used.
Voluntary disclosure of financed emissions can significantly enhance transparency, providing investors and stakeholders with a clearer picture of an institution's environmental impact. This can be particularly beneficial in today's business environment, where consumers, investors, and the public are increasingly demanding greater transparency from businesses about their environmental practices.
Institutions that measure and disclose their financed emissions can demonstrate their commitment to sustainability, potentially attracting more investors and customers and enhancing their brand reputation.
Quantifying financed emissions can provide an authentic baseline against which institutions can set targets for meaningfully reducing their carbon footprint. It’s now no longer good enough to simply buy some company EV’s and call it job done – ignoring financed emissions in target setting could easily lead to accusations of greenwashing. Without an accurate understanding of their current financed emissions, institutions may struggle to set realistic and achievable targets.
Moreover, regular measurement of financed emissions can help institutions track their progress towards their targets, identify areas where more action is needed, and demonstrate their progress to stakeholders.
Financed emissions can serve as a proxy for transition risk from climate change. Transition risks are business-related risks that follow societal and economic shifts toward a low-carbon and more climate-friendly future. These risks can include policy and regulatory risks, technological risks, market risks, reputational risks, and legal risks. For example, companies that invest heavily on fossil fuels could face significant financial losses as renewable energy becomes more widespread.
By measuring financed emissions, financial institutions can gain a better understanding of their exposure to transition risk, helping them make more informed lending and investment decisions.
Beyond risk management, the measurement of financed emissions can inform strategic decision-making. Institutions can identify high-emission sectors or businesses and decide whether to continue financing these areas or shift towards lower-emission alternatives.
This can be a part of broader environmental, social, and governance (ESG) strategies, which are becoming increasingly important in the financial sector. There may be low hanging fruit in your financed emissions. If an organisation aspires to be climate leading this may be the biggest point of leverage.
In summary, measuring financed emissions is a crucial step for financial institutions committed to reducing their environmental impact. It enables compliance with regulations, enhances transparency, assists in target setting, aids risk management, and informs strategic decision-making. As such, it's an essential practice for any institution aiming to align itself with the global sustainability transition.
Despite the importance of measuring financed emissions, several challenges can make this task daunting:
The application of accounting standards for financed emissions is still evolving, making it difficult for institutions to stay abreast of the latest requirements. The GHG Protocol, the main accounting standard for GHG emissions reporting, considers financed emissions as a specific category of indirect, downstream emissions, for example, but some financial asset types are still developing accepted carbon accounting standards. Others have a limited conceptual relationship to emissions.
Changing guidance and standards that are still in the process of adapting to new reporting expectations can create confusion and inconsistency in how financed emissions are calculated and reported.
Financial institutions are expected to provide more detailed disclosures about their climate risks, which must include an analysis of carbon exposures in their portfolios. This requires a deep understanding of the carbon footprint of each investment, which can be challenging given the complexity and diversity of many investment portfolios.
Furthermore, the need for enhanced disclosures is driving a demand for more granular and reliable emissions data, adding to the data collection and management challenges that institutions face.
The data required to calculate financed emissions is often incomplete or inconsistent across different asset classes. In some cases, it may be entirely missing. Many companies have not yet disclosed the emissions data required to complete this picture. Because of these data challenges, financial industry bodies have begun to develop baseline financed emissions estimates at the sector level using industry/sector-wide emissions factors, but these are still young and may lack enough specificity for some reporting needs. In practice, some data is better than no data, but it can be difficult to know at what point ‘accurate enough’ becomes ‘inaccurate’.
Processing and computing financed emissions data can be complex, especially given the limitations of traditional financial institution reporting software. These systems are designed to record the characteristics of the actual asset, such as the value of a security or loan, but they struggle to incorporate data from the underlying company to which the security or loan relates – such as impact on emissions.
Many firms are exploring how to progress from a largely manual spreadsheet-based exercise to tech-enabled automated financed emissions accounting that is integrated into existing IT infrastructure. This transition can be challenging, requiring significant investment in new technology and changes to existing processes and workflows.
Institutions need to incorporate projections around rates of future global decarbonization into their portfolio selection and management strategies. This requires a deep understanding of the decarbonisation pathways for different sectors and the ability to translate these pathways into investment decisions. It also requires the ability to update these projections as new scientific data becomes available and as policy and market conditions change.
One especially notable practical example is the impact on climate scenario analysis, required as part of mandatory climate reporting in New Zealand. Emission reporting entities must have a short-term, medium-term and long term view of how the changing climate will affect their business and its operations. For finance businesses and insurers, financed emissions (in terms of who they support with finance and security) play a significant role in these evaluations. This can be a complex and resource-intensive task, requiring expertise in both climate science and financial analysis.
Technological advancement has revolutionised many aspects of business, and carbon accounting is no exception. However, traditional financial institution reporting software often falls short when it comes to processing emissions data.
This is where ESP's enterprise carbon accounting program, CSR, comes into play. CSR is designed to overcome the limitations of traditional software, providing a comprehensive solution for managing and reporting financed emissions. It can process emissions data, incorporate data from underlying companies, and generate accurate reports that meet regulatory requirements and provide transparency to stakeholders.
The landscape of financed emissions accounting is likely to evolve in the coming years. Regulatory-mandated financed emission reporting has arrived, and financial institutions will need to be prepared for this change. Moreover, as more portfolio companies report emissions data and industry estimates become more refined, financial institutions will need to update their baseline emissions inventory periodically.
Financial institutions also have a role to play in promoting transparency and lower emissions in the real economy. By working closely with the companies they lend to and invest in, financial institutions can encourage these companies to disclose their greenhouse gas emissions and take steps to reduce their environmental impact.
Accurate financed emissions reporting is crucial for financial institutions seeking to reduce their carbon footprint and contribute to the global sustainability transition. While there are challenges involved in measuring and managing financed emissions, technology like ESP's enterprise carbon accounting solution can provide a comprehensive solution. By implementing such technology, financial institutions can not only comply with regulatory requirements but also enhance their transparency, manage their risks more effectively, and set realistic targets for reducing their carbon emissions.
The time to act is now. To learn more about how CSR can help your institution tackle financed emissions, book a demo today. With the right tools and strategies, we can all play a part in creating a more sustainable future.