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Financed Emissions Explained: A Comprehensive Guide for Financial Institutions



Financed Emissions Explained: A comprehensive guide for financial institutions by StepChange

Climate change demands collective action, and the financial sector plays a crucial role. While direct emissions from banks and investors themselves matter, they often pale in comparison to the financed emissions associated with their investments and lending activities. In simpler terms, these are the greenhouse gas (GHG) emissions generated by the companies and projects they support. Understanding and addressing financed emissions is essential for a truly sustainable future, prompting growing scrutiny and action from investors, regulators, and the public alike.


What Are Financed Emissions?

Think of financed emissions as the indirect carbon footprint of a financial institution. Every loan, investment, or underwriting decision contributes to the activities of the recipient company, and with those activities come emissions. These emissions, though not directly generated by the financial institution, are nonetheless linked to its financial choices.


For example, a bank that finances a coal-fired power plant indirectly contributes to the greenhouse gases released by that plant's operations. Similarly, an investment fund holding shares in an airline is indirectly responsible for the emissions from its flights.


Financed emissions fall under Scope 3 of the Greenhouse Gas Protocol, a standardized framework for measuring and reporting GHG emissions. Specifically, they're classified as Scope 3, Category 15: Investments.


Why Are Financed Emissions Important?

Financial institutions' impact on climate change goes far beyond their own operations. While their direct emissions are relatively small, a new report shows they're indirectly responsible for 700 times more greenhouse gases through the investments they make. 


Another report states that despite the Paris Agreement aiming to curb climate change, the world's 60 biggest banks haven't stopped backing fossil fuels. Since 2016, they've collectively channeled a whopping $5.5 trillion into these companies, and just in 2022, they provided another staggering $669 billion in financing. This raises concerns about the banks' commitment to climate action and the ongoing support for fossil fuels.



CDP's The Time to Green Finance report reveals two critical gaps:


  • Measurement Gap: 49% of financial organizations fail to analyze their portfolio's climate impact, hindering progress towards transparency and accountability.

  • Accountability Gap: Unaccounted financed emissions pose a double threat:

  • Climate Risk: Unmitigated emissions accelerate climate change, jeopardizing our planet's future.

  • Financial Risk: Ignoring financed emissions exposes financial institutions to reputational damage and potential financial losses from climate-related regulations and market shifts.


Why Do Financed Emissions Matter?


  • Climate Risk: High levels of financed emissions expose financial institutions to transition risks as regulations and consumer preferences shift towards a low-carbon economy.

  • Transparency and Accountability: Disclosure of financed emissions enhances transparency and accountability, allowing stakeholders to assess the climate impact of different financial institutions.

  • Sustainable Investment: Understanding financed emissions informs investment decisions, enabling institutions to support companies actively transitioning towards a low-carbon future.

  • Regulatory Scrutiny: Regulatory pressure for mandatory disclosure of financed emissions is growing, making proactive management essential.


What Challenges Do Firms Face When Reporting Financed Emissions?


Data Collection:


  • Incompleteness and inconsistency: Data on emissions from investee companies, especially those in complex or opaque industries or lacking strong disclosure requirements, can be incomplete, inconsistent, or unavailable. This makes it difficult to get a comprehensive picture of a firm's financed emissions.

  • Complex ownership structures: Untangling the emissions associated with investments in funds, syndicated loans, and other complex financial products can be challenging, requiring significant effort and expertise.

  • Lack of internal resources: Firms may lack the dedicated personnel, expertise, and technology needed to effectively collect, process, and analyze emissions data from their portfolios.


Standardization and Methodology:


  • Evolving standards: The methodologies and standards for calculating financed emissions are still evolving, leading to inconsistencies in reporting across firms and industries. This makes comparisons and benchmarking difficult.

  • Allocation challenges: Deciding how to attribute emissions to specific investments, especially in situations with multiple investors or indirect financing, can be complex and subjective.


Regulation and Reporting:


  • Voluntary nature: Currently, reporting financed emissions is largely voluntary, leading to uneven adoption and limited comparability across firms.

  • Regulatory uncertainty: The regulatory landscape around financed emissions disclosure is still developing, creating uncertainty for firms and hindering investment in data collection and reporting infrastructure.


Who Needs To Disclose Financed Emissions?


The landscape of mandatory financed emissions disclosure in India is currently in flux, but multiple players are pushing for progress:


Investors:


  • Domestic institutions: Growing awareness among Indian investors like insurance companies and pension funds is leading to demands for transparency on financed emissions from fund managers. This pressure is expected to rise as ESG considerations gain traction.

  • International investors: Global investors with exposure to Indian assets are increasingly pushing for consistent disclosure of financed emissions, aligning with international trends.


Regulators:


  • Securities and Exchange Board of India (SEBI): While not directly mandating financed emissions disclosure yet, SEBI's Business Responsibility and Sustainability Reporting (BRSR) framework for top 1000 listed companies indirectly incentivizes it. BRSR encourages reporting on climate-related risks and opportunities, which may include financed emissions in the future.

  • Reserve Bank of India (RBI): Recognizing the risks posed by climate change, RBI is encouraging banks to assess and disclose their financed emissions. This could pave the way for future regulations.


Industry Initiatives:


  • PCAF India: The Partnership for Carbon Accounting Financials (PCAF) is working with Indian financial institutions to develop standardized methodologies and encourage voluntary disclosure of financed emissions.

  • GFLI India: The Global Financial Literacy Initiative (GFLI) India is raising awareness about climate finance and responsible investment, including the importance of financed emissions disclosure.


How Are Financed Emissions Calculated?


Calculating financed emissions involves several steps:


  1. Identify relevant investments and loans: Determine a list of companies and projects financed.

  2. Gather emissions data: Collect data on the Greenhouse Gas Emissions generated by these companies/projects/investments

  3. Apply calculation methodologies: Use accepted methodologies like PCAF's Global GHG Accounting and Reporting Standard for the Financial Industry.

  4. Allocate emissions: Proportionally attribute the emissions to the financier based on their ownership or investment stake.


What Is PCAF and What Is Its Role in Disclosing Financed Emissions?

The Partnership for Carbon Accounting Financials (PCAF) is a global industry-led initiative focused on developing standardized methodologies for measuring and reporting financed emissions. Created in 2015 in response to a growing need for accountability and comparable emission calculations, PCAF has nearly 300 members who have committed to measuring and disclosing their financed emissions. 


The PCAF framework provides formulas for allocating the carbon impacts for transactions across six major asset classes to ensures that financed emissions calculations are comparable across the whole finance industry:

  1. Listed Equity and Corporate bonds

  2. Business Loans and Unlisted Equity

  3. Project Finance

  4. Commercial Real Estate

  5. Mortagages

  6. Motor Vehicle Loans

  7. Sovereign Debt 


PCAF is build on the GHG Protocol and aligns with the CDP, Science Based Targets initiative (SBTi), and the Task Force on Climate-Related Financial Disclosures (TCFD) to streamline reporting and complement guidelines from those respective initiatives. Eventually, the goal is for financial institutions to also make changes in their portfolio to reduce emissions and align with the Paris Agreement.


What Should Firms Consider To Create Efficient Targets? 


While these firms should set targets that are tested for resiliency, measured and tested for multiple scenarios, and base them on science-based and backed methodologies, it’s not straightforward for financial institutions to know whether a goal is realistic or overly ambitious 


  • Alignment with Science-Based Targets: Align the targets with the Paris Agreement's goal of limiting global warming to 1.5°C.using methodologies like pCAF and set SBTs to gather information 

  • Ambitious but Achievable: Set ambitious goals and test targets for long and short term against multiple climate scenarios and test the climate resiliency of the targets, considering physical and transition risks

  • Phased Approach: Break down your targets into smaller, phased milestones for easier tracking and accountability.

  • Engagement with Stakeholders: Involve stakeholders like investors and investees in setting and achieving targets.

  • Regular Review and Adjustment: Set up a governance process to focus on physical and transitional risks.

  • Game Plan: Prepare steps to adjust targets and activities based on potential predicted outcomes 


By understanding and addressing financed emissions, financial institutions can play a pivotal role in accelerating the transition to a low-carbon economy. Taking action not only demonstrates climate leadership but also mitigates future risk and unlocks new investment opportunities. 


While the resources mentioned above provide a valuable foundation, navigating the complexities of financed emissions management can be daunting. That's where StepChange comes in. StepChange is a climate-tech firm dedicated to empowering companies and brands to accelerate their sustainability journey and transition to net-zero. We offer a comprehensive suite of solutions specifically designed to tackle financed emissions head-on:


  • Measurement: Leverage StepChange’s proprietary science-based methodologies and partnerships with leading data providers to gain a clear and accurate picture of your financed emissions across asset classes, sectors, and regions at a loan and sub-loan levels 

  • Analysis: Go beyond numbers with insightful breakdowns and visualizations on powerful, customizable dashboards that reveal key emission hotspots within your portfolio, enabling targeted action.

  • Reporting: Generate high-quality, credible reports aligned with international frameworks like PCAF and GRI, ensuring transparency and meeting stakeholder expectations.

  • Target Setting: Develop science-based and achievable reduction targets aligned with your unique circumstances and industry best practices, setting a clear path towards net-zero.

  • Actionable Strategies: Collaborate with StepChange’s climate scientists to craft practical plans that address specific emission sources within your portfolio and support investee companies in their transition.

  • Engagement & Communication: Effectively communicate your financed emissions efforts and progress to internal and external stakeholders, fostering trust and building a positive reputation.


At StepChange, we don’t just provide tools; we become your trusted sustainability partner, guiding you through each stage of the financed emissions management journey. With our expertise and cutting-edge, science-based solutions, you can gain control of your carbon footprint, mitigate risk, and contribute to a more sustainable future, all while demonstrating true climate leadership.


Remember, tackling financed emissions is a collaborative effort. By taking action with the support of dedicated partners, we can collectively build a financial system that works for both people and the planet.



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