Join Sharlene Key, Sphera’s director of ESG product management, and Don Reed, a managing director at PwC, as they discuss financed emissions, the growing pressure to manage and report them and where they fit in the risk landscape.
The following transcript was edited for style, length and clarity.
Sharlene Key:
Welcome to the SpheraNOW ESG Podcast, a program focused on safety, sustainability and productivity topics. I’m Sharlene Key, Sphera’s director of ESG product management. Today we’re joined by Don Reed, a managing director at PwC. Thanks for joining me on the podcast today, Don. Would you like to introduce yourself to our listeners?
Don Reed:
Thank you. Pleasure to be with you and thanks for inviting me. My focus is really on financial services and ESG, and I’m really a lifer in that space. I did that kind of work at the World Resources Institute and at a boutique consultancy called Sustainable Finance Limited, which PwC acquired back in 2009. And today, I work with leading banks, insurers, asset owners and asset managers of all manner, including private equity and alternative assets, across climate change risk, net zero, ESG information and data systems, and how to capitalize on risk reduction and revenue growth through integrating ESG into investment and credit decision-making.
Sharlene Key:
Wonderful. Well, I’m excited to dive into our discussion today. In this episode, Don and I are going to be discussing financed emissions, the growing pressure to manage and report them, where they fit in the risk landscape and more. As the world transitions to a net-zero economy, financial institutions must also transition the way they do business.
Measuring and managing financed emissions is essential to reducing a financial institution’s environmental impact, understanding its climate-related risks and ultimately reaching net zero. Aligning with the Partnership for Carbon Accounting Financials (PCAF)—whether it’s part A for financed emissions, part B for capital markets or part C for insurance—will be key to ensuring that efforts to reach net zero are backed up by data that is standardized and verifiable.
The constantly fluctuating regulatory environment adds a layer of complexity to the uncertainty financial institutions are facing in the current economic climate. Aligning with regulatory frameworks such as the Corporate Sustainability Reporting Directive and Sustainable Finance Disclosure Regulation and ongoing pressure from the U.S. Securities and Exchange Commission and other regulatory bodies are key considerations as financed emissions create regulatory risk for financial institutions. For those that are not familiar, Don, can you explain what financed emissions are and why they should be on financial leaders’ radars?
Don Reed:
Great. Let’s start at the high level and get a little more technical and then go to why it should be on folks’ radar. I think the conversational answer is financed emissions are the emissions associated with investments that the owner reports. And to get a little more technical about that, we’d say in different kinds of financial institutions, investments and loans that the reporter holds. And that is really defined under the Greenhouse Gas Protocol as Scope 3 category 15.
What that really means is that, like other Scope 3 emissions, they are indirect and where the reporter has influence but not direct control. And the Greenhouse Gas Protocol further defines this category 15 as being based on the portion of the capital stack of that emitting obligor or securities issuer that the reporter holds. So, that attribution is really based on that position in the capital stack.
So, they’re generally part of a financial institution’s indirect carbon footprint. And further, this is done annually, like all parts of a greenhouse gas inventory, and expressed in CO2E (carbon dioxide equivalents). Like a balance sheet, it’s based on the assets held at the end of the reporting period. For those assets—what were their emissions on an annual basis, and then what part is attributed to the reporter based on that part of the capital stack?
But we’re really in a moment now where the financed emissions are, as you point out, increasingly reported in regulated reporting. There are several layers to that. So, there’s voluntary reporting, regulated reporting and a couple different variations on that. Then climate change risk, there is a metric for that, and it’s really foundational in any sort of net-zero target-setting commitment. I am happy to drill down on each of those “whys” in more detail.
Sharlene Key:
I’d really like to dig into the risk factor now a little bit more. With the financial industry, risk always seems to be top of mind whether they’re hedging risk or managing risk. Where do financed emissions fit into that current risk landscape?
Don Reed:
The reporting standard for climate change risk—Task Force on Climate-Related Financial Disclosures or TCFD—really specifies financed emissions as a climate change risk metric for financial institutions. And yes, there are other metrics and some of those other metrics include the financed emissions and some do not. But let’s think about the space of climate change risk where we think about transition risk and physical risk, and financed emissions are really a measure of that transition risk.
And as a standalone metric, not all tons emitted give rise to the same financial risk. But in the climate change risk process, which we think of as being risk identification, prioritization, quantification, modeling, and then testing those models against different climate scenarios. So, that’s kind of a standardized view of how to approach climate change risk; in that process financed emissions themselves are helpful in a number of ways.
First, they’re kind of a heat map for where to concentrate, what sectors and security types to prioritize. And then, in that prioritization section, it is an enormous help to be able to look at the financed emissions across a portfolio and decide where to concentrate the effort burst. And then it’s really the data that starts the quantification, which leads to the modeling and the scenario testing. You need lots of other things in order to do good climate change risk analysis, but you can’t really do it without a financed emissions inventory as that starting place and as a means to begin that integration into investment and credit decision-making.
And the other one to add there is in the world of regulated climate change risk analysis. Particularly for banks that have prudential regulation and supervision, in many of the frameworks around the world, including, most notably, the European central banks, it’s a required disclosure as a part of that prudential regulation. So, that doesn’t affect everybody, but for those that are subject to that requirement, it’s an absolute requirement for their overall program and disclosures to those regulators on climate change risk.
Sharlene Key:
That’s really interesting. So just to recap, you’re stating that it’s essential for companies to make sure they first have a materiality assessment, so they can understand where they should dig in deeper before they’re diving into collecting more granular data or taking other aspects into consideration?
Don Reed:
Exactly. And sometimes we think about materiality assessment at the whole company level across all ESG issues, and that’s also true. Here, what the financed emissions inventory can help you understand is where there are material sources of risk in the form of emissions in a portfolio, and sometimes that can be a little bit surprising. Not everybody really understands, without doing the analytical work, where those exist in the portfolio and how they might look and where they might have different dimensions.
No, that’s understandable. I’m sure you’ve seen quite a few surprising hotspots pop up in your day. With those hotspots in mind and the materiality assessment in mind for organizations as well, are there particular parts of their portfolio that they should consider first over others when they’re starting on this journey to net zero?
Don Reed:
Well, everyone’s instinct is very appropriately to think first about what the big emitting sectors are in their portfolio. And that’s absolutely a good starting place. Now most diversified portfolios will have power and oil and gas as the leading sectors there. But it’s important to really be unpackaging that in more detail in the sense that not everything in the oil and gas industry is created equal.
An integrated major may have exposure across the whole life cycle of oil and gas from exploration and production to retailing at gas stations, but many other participants in that industry have different profiles, and midstream financed emissions look very different from exploration production companies. And if you’re going to get at the underlying climate change risk, you really have to understand it at that level of granularity.
Now there are other aspects of that, and oftentimes financial institutions don’t fully appreciate where they may have financed emissions and climate change risk exposure, on that basis, are things in materials production. So steel, aluminum, cement—all of those are high emitting industries that don’t have the same sort of profile as power generation and the oil and gas industry.
And yet they do have high financed emissions. There’s also quite a bit of diversity amongst participants in each of those industries for their actual emissions per unit of production, which is an important metric that having a financed emissions inventory enables you to use at the portfolio level, the sector level and even at the asset level.
Sharlene Key:
Wonderful. So, it sounds like certain industries are definitely going to struggle more with this and there may be some movement of cash from the financial industry, either into certain projects or out of certain industries, based on what they’re wanting to do and strategize for their portfolios themselves. What are the current strategies that financial institutions should be adopting to tackle their financed emissions within their portfolios?
Don Reed:
I think there’s a couple of things there, and we take a first aid principles-based approach with the knowledge that there are specifics that are going to vary significantly by investment type and lots of other characteristics, but the key principles are real basic stuff. First, be very clear about why you’re doing this because there will be differences in “We’re doing this for voluntary reporting purposes” or “We’re also doing this for some regulatory reporting purposes.”
And what’s the nature of those regulated reporting? Is this a standalone ESG regulation? This information will increasingly be reported in financial reporting under the ISSB (International Sustainability Standards Board) or the integration of ESG data into regulated financial reporting under IFRS (International Financial Reporting Standards). It’s also, as we mentioned, that prudential regulation that some banks have.
So, that clarity about “why” will determine a lot about what standards and what degree of specificity you need to have on that. Then a plan for building a program that has the destination in mind—that you’re clear about what is our future state of the data and our ability to do this. What’s our current state? What does that future state need to look like? And therefore, what kind of capabilities do we need to have?
And we always think about that like any transformation across people, process and technology. And here, we really mean people—that you need, a multi-stakeholder group inside when you’re looking to implement a financed emissions inventory.
You need to have people involved in the investment and credit decisions, the sustainability function, communications and reporting, some people around risk and regulatory… And again, it will vary a bit with the type of company and institution, but there would be that multi-stakeholder group. And we focus a lot today on the process, because the process is fundamentally new, and you are in the world of the technology to do this kind of work. And in some ways, that’s just in the process of becoming; people are only beginning to use the technology to be able to do this.
So, today we focus a lot on the process and that the principles that are in play there are really: “How do we maximize actual reported and verified data? How are we clear about the place where we have complete gaps in the data and where we have estimation and which estimation techniques are we using? How do we have sufficient data to use the best available estimation techniques?” Then, how do you have a single source of truth across the enterprise on these, and then that enterprise sort of system that you would expect to be tech-enabled and controlled or auditable.
But then also that contemplates multiple use cases because yes, there’s a use case around the disclosure in reporting and use cases around the climate change risk. We’ve already talked about those, but we’re finding that some clients also have use cases that are around engaging the security issuers or engaging their clients in banking with rich data and more information than they had before they had a financed emissions inventory.
So, those are some of the key principles and strategies for doing the financed emissions inventory itself. There is also an additional set of strategies that are quite related, which are around maybe setting a net-zero target and how to choose which method to use for setting those targets. Financed emissions play a key role in that process because you really want to be able to test different methodologies with actual data about your actual investments.
And then on the fulfillment of those decarbonization commitments, the inventory is critical in being able to track that progress, particularly if absolute financed emissions are one of the metrics in your decarbonization commitment. But it’s also an ingredient in almost all of the major metrics for a net-zero commitment.
Sharlene Key:
That’s really interesting. Just going back to the data aspect, you did say there’s a lot of companies just struggling to get access to data and/or taking on projects to engage their suppliers and their investors to gather more data. With everything that the financial institution is currently facing with the data challenge itself, are there certain strategies to handle the data perspective of this, especially as they’re wanting to mature through the data maturity scale and move up in data quality so they can have a clearer, more transparent picture of that inventory?
Don Reed:
Oh yeah. It is a huge problem. And our first plank of advice is don’t panic because many, when they look at this for the first time, they see third-party vendor data and they think, “Oh my goodness, a lot of this doesn’t match my needs, the places where I’m investing.” Or there are other attributes of it where they’re missing key pieces or maybe the data’s a little confusing—it doesn’t seem like it’s right. And so, we’re all kind of in the same boat on this.
This is very early days. And so, there’s both that maturity progression at the individual company and financial institution, and the maturity of the whole field. We’re in this kind of awkward adolescence in terms of maturity, where there’s data available, so you think you ought to be able to have a quality inventory of reported data, but in fact there are lots of gaps there.
This is going to get better and better over the next few years, where there’s more mandatory greenhouse gas reporting globally, and more that is subject to assurance. But today, there are still lots of gaps. So, I think the first things to keep in mind here are that you want to understand what you actually have, what is reported, what is reported and assured, what is in the emissions data and what is estimated and how it is estimated.
And PCAF has a very useful framework for scoring that data quality more broadly. You always want to be applying that to the data you have to understand that the portfolio sector and other sorts of levels—what is the data quality you have? Where you have totally missing emissions data, how are you estimating that? How do you understand what your vendor may be estimating? And then, where they have gaps, how you might estimate that, and what are the better estimation techniques and the least favored estimation techniques? And try to be always moving up to having enough data to improve your estimation.
The big picture there is you want to have the best sources available, the best estimation techniques possible for the data you have using that data quality store, and understanding what the implications are where you don’t have the highest quality data yet. And then, as you mentioned, I think many are going to that direct acquisition where it’s feasible. So, you see that in supply chain, top suppliers getting direct data from them using some of the services that exist around that. CDP supply chain has been around for a long time, but there are others, and there are other approaches to direct acquisition that we are beginning to see.
Most obviously in the financial services world, in private equity for example, direct acquisition is already well underway, at least for some portfolio companies. So, that really puts everybody in a situation where it’s like, “Okay, my plan and strategy around improving the quality of data in my financed emissions inventory is going to remain a pretty big task, but a relatively clear one, at least in terms of how to approach it.” And we expect that that’s probably going to be the case for the next couple of years.
Sharlene Key:
That makes sense. Going back to your steps of making sure you have what you need to manage and then double clicking on everything that does actually make sense for you to dive into that deeper data quality itself.
Many financial institutions are stepping into the emissions space for the very first time, and you did touch on this recently where this is a very nascent industry for them to approach so far. There’s a huge knowledge gap that many are desperately trying to fill and wanting to do so without having to take resources away from other areas.
Fully understanding what it takes to reach net zero—the educational gap between that and how this will benefit them in the long run—and a realistic, executable plan that will be required for the market so that they are able to move forward with that net-zero plan. How can financial institutions implement PCAF methodologies within their existing processes?
Don Reed:
So, let’s make sure that we’re clear about the calculation for a financed emissions inventory includes both the emissions data and then PCAF is the attribution portion of that calculation, like how do you attribute the emissions associated with the issuer to your portfolio? And you don’t want to conflate the two, and you take different actions, the ones we’ve already discussed, to solve the emissions data gaps.
But there are also gaps to doing that attribution portion for which PCAF is the accounting standard. It’s really most typical to develop an enterprise approach to greenhouse gas data and being able to think about that really from end to end, like, “How do we acquire the data? How do we manage it, aggregate it, process it, transform it, perform the calculation and then apply that in different use cases?” That can be particularly tricky for many because they’re using multiple data sources for each piece of this.
So, they will have sources of data for the emissions and then usually more internal but can also include some external sources for that PCAF attribution portion. And so, the need to have the ability to bring together multiple data sources, have them match, so really at the entity level, we’re really talking about the same entity where you have the securities and the emissions data.
And then there are other capabilities that go beyond that, such as in a decarbonization or net-zero setting. You really want to be able to say, “Do we have the data we need to be able to do the attribution? Do we have the fair market value, the book value, the financial measures that will enable you to do the attribution?” And then, if you’re looking forward in time, most of our clients are thinking about not just what targets to set, but how to achieve those targets.
You want to be able to have that rejection capability. Like what will my portfolio look like in a year, a couple of years, maybe even all the way to where I have an interim target. What’s my “what if” capability, like if I were to make these changes in my portfolio, when these bonds run off, I will reinvest them in a lower-carbon set of entities, for example, that sort of “what if” capability that enables the managers of the assets to understand what their plan is and how they can work that plan to decarbonize the portfolio.
And then, being able to track the performance of multiple metrics, including financed emissions and financed emissions-based metrics and project them into the future. All those are things that we think are critical to the long-term success of implementing the PCAF methodologies and working with your financed emissions inventory. That all needs to happen within the existing investment management process, as you point out.
And the net of that is that the team and the solutions need to have a life that’s within that controlled environment for data and analytics and for that investment decision-making. And there are lots of different ways of doing that, but there’s really no substitute for having the same data and analytics people that are getting all the data to the decision-makers to have this part of their world—that this is delivered side by side with other analytics and maybe adapted for different use cases to be able to meet the user’s actual need for this data and how it integrates into the existing risk management process or all the way down to customer reporting.
That sounds really interesting. I’m assuming with the level of effort that it will take to actually integrate into all of these existing operational processes that it is going to be quite a long transition for many industries to incrementally get to their net zero in the long run.
Don Reed:
Exactly.
Sharlene Key:
Are there certain portions that companies are starting with first, that they found are easier to actually dig into? Or is that really case by case?
Don Reed:
Yeah, so there are some things we can say at the overall level, where you’re really saying “The challenges we’ve been talking about, what’s our plan for dealing with them? How do we get all the data in the right place to the right people, in the right form, at the highest quality?” And so, a huge portion of effort today is really focused on those sets of tasks.
And those that are already beginning around the decarbonization process are really focused on a couple of areas. First, they’re really focused on “How do we engage those that have the most influence on our financed emissions inventory or our other climate risk metrics? How do we engage them?” And that is ordinary in equity investing amongst publicly traded companies, but not really ordinary in any other category, for example, lenders and bond holders.
And so, there is a lot of capability-building around how to actually engage the obligors or security issuers about their emissions, their transition plans, how they see it as a competitive dynamic in the industry and what’s the governance of that at the board level?
All of that is really enabled by having quality financed emissions data. That’s the foundation for that engagement. So, you can say, “You are a top emitter in our portfolio, and here’s how we analyze your emissions.” And that’s really the starting place to having that kind of engagement. So, engagement is one. A second is really a bit by sector. That is to say that in the power generation sector, market decarbonization is already well underway, some driven by regulation, but much of it driven by improvements in technology, such as replacing aging power plants and the like.
Many of our clients are happiest with what’s going on in power gen because there is already decarbonization happening at the market level and they can capitalize on that. And in fact, there are some market plays they can make around that. I think it’s much harder in most other high-emitting industries because the market decarbonization is either less advanced, it’s happening at a slower speed, or it is not clear what the pathway to decarbonization fully is.
So, we think about decarbonization in automotive as being relatively clear in the sense that it’s the adoption of electric vehicles and the decarbonization of the grid charging those vehicles. But that’s less true in other categories, including some of the building materials that we mentioned earlier.
Sharlene Key:
That’s fascinating. So, we’ve already gone over materiality, different regulatory compliance, as well as the data quality and the need to engage suppliers and where certain industries are standing within here as well as having their source of truth. With that integrated source of truth, working with a solution that can offer flexibility I feel is going to be a main key to managing long-term compliance as these regulations shift with the environment and economic uncertainty, along with the pandemic and other things that often fluctuate within the financial industry. What other aspects do you feel will give leaders an advantage in the market?
Don Reed:
Well, I think the idea that we’re going from data, and data and analytics systems from non-existent to fully auditable and reported in regulated financial filings in a very short period of time—that sort of sends your mind spinning, especially if you’re coming from the world of regulated financial reporting, controllers, et cetera. And so that’s a very big deal.
There are already a wealth of solutions out there, but they are still advancing themselves in their own right. But the usual answers of how you slowly mature a process like that over long periods of time, as we have with financial reporting, really aren’t on the table.
It’s more like these immature data and accounting standards are getting dropped into those financial reporting environments, and there are going to be lots of challenges around doing that, some of which will raise their heads in internal audit processes and regulatory reviews with the SEC and other regulators. But we really think about it as being the rapid maturation of that process where we think about audit readiness.
At the same time, we’re thinking about building the system. And so, that really puts the pressure on doing it quickly, efficiently, with good documentation and clarity and knowing that that’s probably going to go through a couple of different iterations to get to the place we need to be to put this kind of data into financial filings and other regulated reporting.
Sharlene Key:
And you bring up a really, really good point about the auditability and the assurance and what that is going to mean to organizations, as well as data quality, in the future. Can you talk more about the importance of having audit-proof financed emissions?
Don Reed:
Yeah so, I think that the actual full audit and comfort with that you would say, use a term like “audit-proof,” is going to take some time, but that cycle is going to have to be really compressed. And so, it’s already clear from the regulations that are announced and enforced in many parts of the world, and pending in other parts of the world, that there really isn’t going to be an alternative to that.
And so, there’s a lot of attention to and scramble for that. And then also readying the audit machinery that’s internal audit inside companies for these challenges. This is a different challenge than internal auditors have typically been faced with before, and the whole audit readiness portion of the company that’s getting the audit, as well as folks like us at PwC who provide those audit services.
And so all that is an essential part of the landing place we need to achieve within a couple of years, if not sooner, but it’s on this sort of scary compressed timeframe. But again, if you’re including the data in financial reporting, there really isn’t an alternative to have it not only audited but audited to the standards that are associated with financial reporting. And that really depends very critically on having it come from a system that provides that sort of audit trail transparency and in which the controller and others have complete confidence and know that the system is ready, even if the data is still maturing and the accounting standards are still maturing.
Sharlene Key:
That completely makes sense. Just to go back to regulatory compliance with the ever-changing regulatory environment currently, I’m assuming that everything is going to compile into a few different standards. So, we’ll have some clarity across the board, but I know it will take some time. From your opinion, how long will it take for these standards to really stabilize? I know it’s a loaded question.
Don Reed:
Yeah, but it is on everybody’s mind. We think that it really has to be in an almost completely transformed state on a sort of 24-month time horizon. And that may be stating it with too much precision. It almost certainly is. But particularly the European regulatory environment and much of Asia-Pacific following that European model really requires it. And so we expect all that to happen. It’s already in process. And some of it, you could say, is somewhat accomplished.
There’s a hundred financial institutions that have reported financed emissions according to PCAF standards already. But that’s going to grow logarithmically. And we’ll see that in this current year reporting cycle. So, 2022 reporting already started, but really in April, May, June of 2023, we’ll see way more of that.
We are seeing controllers really taking the helm on this and saying to finance departments and particularly the controllership, accounting standards and accounting policies all have to build this stuff in. And so much of what has to happen is already in motion. It just hasn’t fully landed or doesn’t have a full public manifestation yet.
Sharlene Key:
Understandable. How do you think the SEC’s climate-related disclosure rule will impact everything that’s already been happening within the regulatory environment?
Don Reed:
I think the answer is that it will very much depend on the specifics, and to kind of enumerate them. What will the final rules say about Scope 3 reporting for all issuers, and then the level of detail that would be required, the disclosures required and where companies have set targets? Both of those are really instrumental in the decision-making about what issuers will need to do on the data and analytics to have the reporting meet the new rules. But those are both pretty much up for grabs. The SEC got a lot of comments back on both those topics in their review, and it will depend very heavily on those specifics.
Sharlene Key:
It’ll be exciting to see what they finally decide on with the SEC ruling. Well, that’s all the time that we have for today. Do you have any final thoughts you want to share before we wrap up?
Don Reed:
We are cursed with interesting years. This is all a big challenge at the societal level, at the standard-setting level and at the individual business level, both financial institutions and others. And that’s both exciting and a bit daunting. But there we are.
Sharlene Key:
Yep. There we are on the daunting, exciting journey towards net zero together. Thank you again, Don, for joining me on this SpheraNOW podcast.
Don Reed:
Thank you, Sharlene. I appreciate it.
