Did you know that the carbon footprint of your investment portfolio could be hundreds or thousands of times higher than your direct organizational emissions? While many companies implement recycling programs and switch to energy-efficient technologies, they often overlook the significant climate effects of their financial activities.
Financial institutions, through their investment and lending activities, play a significant, yet often obscured, role in climate change. Financial institutions provide capital to various industries, many of which are carbon-intensive. This indirectly contributes to global greenhouse gas (GHG) emissions. This blog post explores what financed emissions are and why they matter for investors, the financial sector, and the planet.
What are Financed Emissions?
Financed emissions are the GHG associated with the loans and investments made by banks, asset managers, and other financial institutions. In simpler terms, financed emissions are the carbon footprint of a financial institution's portfolio of companies. These emissions may come from a variety of sources, such as the burning of fossil fuels for energy production, industrial processes, or deforestation linked to financed projects.
Financed emissions are categorized under Scope 3 emissions within the Greenhouse Gas Protocol. Scope 3 emissions are indirect emissions resulting from activities not owned or directly controlled by the financial institution, but occur within its value chain both upstream and downstream.
A good example to consider is a bank that finances a coal mining company. While the GHG emissions from the mining operations are not directly emitted by the bank itself, the emissions are a direct result of the bank's financial support.
Why do Financed Emissions Matter?
Climate Effect
The climate effect of financed emissions is profound. Financed emissions can be significantly larger than a financial institution's direct operational emissions. A report 1 by the United Nations Environment Programme Finance Initiative (UNEPFI) found that, on average, banks’ financed emissions are 700 times greater than their operational emissions. This obscured level of emissions significantly contributes to GHG concentrations and accelerates climate change.
Financial Risk
Climate change poses significant risks to financial portfolios, including stranded assets, regulatory changes, and physical damages from climate-related events. Stranded assets are investments that have become obsolete or non-performing owing to changes in the market. Understanding and managing financed emissions is crucial for mitigating these risks and protecting the financial stability of institutions. Financial institutions that ignore these risks may face substantial financial losses as the world transitions towards a low-carbon economy.
Investor Demand
As investors and stakeholders become more carbon conscious, there’s a growing demand for transparency regarding the environmental effects of their investments. Investors are increasingly aware of the risks associated with climate change and want to know how their capital contributes to or mitigates these risks. This shift in investor sentiment is driving financial institutions to measure and disclose their financed emissions more rigorously.
How Financed Emissions are Measured
The PCAF Standard
The Partnership for Carbon Accounting Financials (PCAF) provides a standardized framework for measuring and reporting financed emissions. This framework helps financial institutions calculate the carbon footprint of their loans and investments consistently and transparently. By adopting the PCAF standard, institutions can benchmark their performance and track their progress over time.
PCAF has developed methodologies for a range of asset classes to measure financed emissions. Each asset class has unique characteristics and requires specific approaches to accurately measure its associated emissions. Here are a few key examples of the asset classes:
Listed equity and corporate bonds: This covers publicly traded stocks and bonds issued by companies.
Business loans and unlisted equity: This category includes private companies that haven't issued shares on a public stock exchange.
Project finance: This refers to financing specific projects, such as a new power plant or construction development.
Commercial real estate: This category includes financed commercial properties, such as office buildings or shopping malls.
Measuring financed emissions can be complex and requires reliable data. Financial institutions must gather detailed information about the emissions of the companies and projects they finance. Despite these challenges, the push for standardized reporting is leading to improvements in data quality and availability.
What's Being Done?
There are several initiatives driving action within the financial sector. The Net-Zero Asset Owner Alliance and the Glasgow Financial Alliance for Net Zero (GFANZ) are two prominent examples. These initiatives bring together financial institutions committed to aligning their portfolios with net-zero emissions by 2050. They are working to set interim targets, improve transparency, and develop strategies for decarbonizing their investments.
Regulatory bodies are also starting to incorporate climate risk and financed emissions into their frameworks. This will require financial institutions to disclose their financed emissions and integrate climate considerations into their investment processes. For example, the European Union's Sustainable Finance Disclosure Regulation (SFDR) requires financial market participants to disclose how they integrate sustainability risks in their investment decisions.
Investors can play a critical role in pushing for greater transparency and climate action from financial institutions. By engaging with banks and asset managers, investors can advocate for better disclosure practices, encourage the adoption of standardized emissions measurement frameworks, and support the transition to a low-carbon economy.
The Future of Financed Emissions
With a strong global focus on achieving net-zero emissions, the importance of financed emissions will continue to grow. Over the next decade, financial institutions will face increasing pressure to disclose and manage these financed emissions, aligning their portfolios with global climate goals.
As data quality improves, so will the ability to accurately measure and manage financed emissions. Better data and more refined methodologies will help to improve the accuracy and comparability of financed emissions disclosures. Advances in Artificial Intelligence (AI), and data analytics, are making it easier for financial institutions to gather and analyze the necessary data.
As the effects of climate change become increasingly apparent, understanding and managing financed emissions is more important than ever. Understanding financed emissions can unlock opportunities for financial institutions to align their portfolios with climate goals and support the transition to a low-carbon economy. By reducing the carbon intensity of their investments, financial institutions can play an important role in driving the global shift towards sustainability.
In summary
Financed emissions are an important, yet often overlooked, aspect of the environmental effects of financial institutions. By understanding and managing these emissions, investors and financial institutions can make more informed decisions that support the transition to a low-carbon economy.
The financial sector has a unique and powerful role to play in addressing climate change. Through responsible investment and lending practices, financial institutions can significantly reduce their carbon footprint and drive meaningful progress towards a sustainable future
As the importance of financed emissions continues to grow, Zeroe is here to assist in navigating this complex landscape by providing tools and insights to measure and manage financed emissions, helping our clients align their portfolios with climate goals.
References:
1UNEP Finance Initiative | Foundations of Climate Mitigation Target Setting Report
