Globally, businesses of all sizes are working to reduce their carbon footprint by developing sustainability strategies with net zero as the ultimate goal. One of the more complicated aspects of this effort is the calculation and reduction of Scope 3 greenhouse gas (GHG) emissions—a task that presents different challenges in different industries.
In the financial sector, the reduction of Scope 3 emissions has implications for capital markets. In order to build a carbon-neutral economy, investors and lenders need to direct the flow of capital away from carbon-intensive activity, toward more sustainable businesses. To support this process, they must determine the GHG emissions tied to their portfolios—what we refer to as “financed emissions.”
The topic of financed emissions is gaining traction as companies explore all available avenues for decarbonization. Recently, it was the subject of a Sphera podcast that featured Sharlene Key, Sphera’s director of ESG product management, and Don Reed, a managing director at PwC.
Financed Emissions Are a Measure of Risk
Motivated by a variety of factors, financial institutions (FIs) have been taking steps to address their portfolio emissions. In some cases, reporting frameworks and regulations are driving, or at least encouraging, action.
Reed pointed to the Task Force on Climate-Related Financial Disclosures (TCFD) as the reporting standard for climate change risk, noting that it “specifies financed emissions as a climate change risk metric for financial institutions.” He identified financed emissions as a measure of transition risk—the risks associated with the transition to a green economy.
And while financed emissions represent transition risks for FIs, they are not the only risks. Like other businesses, FIs are also exposed to physical risks—the risks linked to natural disasters and events such as heat waves and rising sea levels. The Basel Committee on Banking Supervision discusses these two types of risks in its report – Climate-related risk drivers and their transmission channels. “Banks and the banking system are exposed to climate change through macro- and microeconomic transmission channels that arise from two distinct types of climate risk drivers”—physical risks and transition risks. Because these risks are characterized by “unprecedented frequencies, speeds and intensities and the non-linear form that the risks are expected to take” they create “a material level of uncertainty as to how climate risk drivers and their impacts will evolve.”
To an extent, scientific modeling can help FIs and large companies prepare for the physical risks they may face, but there are still unknowns. On the other hand, transition risks may be easier for banks and investors to prepare for because the warning signs can be detected further in advance than the warning signs linked to heat waves and hurricanes. The transparency required from companies under new regulatory frameworks will give investors more visibility into potential risk factors, allowing them to make better decisions and mitigate these risks.
Measuring the emissions tied to their portfolios enables these institutions to determine how to address them, which also helps them mitigate transition risks. Reed explained that financed emissions offer “a heat map for where to concentrate, what sectors and security types to prioritize.” So, once FIs have determined their priorities—through what is essentially a materiality assessment—they can decide which segments of their portfolio will be the focus of their reduction effort.
In summary, climate change risk analysis requires data and quantification, modeling and scenario testing—among other things—but it can’t be carried out without a financed emissions inventory. From there, the risk analysis can be integrated into investment and credit decision-making, according to Reed.
Where to Begin: Finding the Hotspots
As a starting point for the exercise, Reed noted that many tend to begin with the bigger emitting sectors within their portfolios. While the impulse is to look first at oil and gas as well as power, he advised listeners to be mindful of the variations within oil and gas, as different industry members will have different profiles. It’s important to appreciate these differences because a certain level of granularity is needed to truly understand the underlying climate change risk.
Reed also pointed out that risk exposure is often found in the production of materials, citing steel, aluminum and cement as examples. But, as with oil and gas, there is variance in each of these industries when it comes to actual emissions per unit of production. A financed emissions inventory enables FIs to use this metric at the portfolio, sector and even asset levels.
Understand What Is Driving Your Effort
Calculating a portfolio’s financed emissions is just the beginning of the effort for large banks and investors; it’s a means to an end. And according to Reed, the measurement and reporting of emissions requires the right people, processes and technology. But before they build their teams and processes and acquire the technology, financial institutions need to be clear about why they are embarking on the effort. Are they measuring emissions for voluntary or mandatory reporting? If it’s for required or regulatory reporting, what does that requirement look like?
In terms of people, Reed explained that a multi-stakeholder group is needed within the organization. It should include people involved in investment and credit decisions, as well as those focused on sustainability, communications and reporting, and risk and regulations. While these roles are not new, the processes used for measuring and reporting financed emissions are evolving. And the people on the teams are just beginning to use technology to calculate and disclose these emissions.
Build Capacity and Act Quickly
So, it may be early days as far as capacity-building is concerned, yet there’s no time to lose. The CDP reported that the “finance sector’s funded emissions (are) over 700 times greater than its own.” But it also pointed out that less than half of the reporting financial institutions actually disclosed steps to align their portfolios with a “well below 2-degree Celsius world.”
It’s clear that everyone—consumers, government bodies, policymakers and businesses—must act to reduce the GHG emissions that are causing global warming. For financial institutions, this means they must begin by measuring and addressing the emissions in their portfolios.
