Accounting for the impact of lending and investments: A Briefing Paper on Financed Emissions

Importance of financed emissions

The latest IPCC Assessment Report (IPCC Sixth Assessment Report¹) describes how global temperatures exceeding 2oC of warming above pre-industrial levels would result in catastrophic climate impacts. Decarbonisation efforts are being made across the globe in an endeavour to contain warming to 1.5oC above pre-industrial levels. However, a certain amount of climate change is already locked in due to our historical emissions, leaving the significant challenge of globally becoming net zero by 2050. Organisations around the world must collectively - and rapidly - decarbonise their operations and supply chains, while also increasing resilience to the impacts of climate change. Every organisation relies on capital to finance its operations, with FIs contributing significantly to the pool of global capital. Measuring and reporting on financed emissions, in a comparative and reliable way, will be an early step towards transitioning the financial sector to support sustainable development.

Global efforts are being made to combat rising temperatures and improve adaptation to climate change. The Glasgow Financial Alliance for Net Zero (GFANZ) was launched in 2021 to unite net zero financial sector-specific alliances from around the world into one industry-wide strategic alliance. GFANZ has launched initiatives promoting the movement towards net zero in the financial sector, including the Net Zero Banking Alliance (NZBA), the Net Zero Asset Owner Alliance (NZAOA) and the Net Zero Insurance Alliance (NZIA). These alliances require certain commitments from their signatories. For the NZBA and NZAOA, commitments specifically include annual reporting of GHG emissions, including scope 3 financed emissions. The NZIA takes a broader approach, requiring a commitment to support the implementation of corporate disclosure frameworks (with the example being TCFD's reporting recommendations, which also includes the requirement to report financed emissions).

Increasing disclosure requirements based on financed emissions

Understanding the GHG emissions profile from loans and investments provides significant insights into the portfolio’s exposure to key climate-related risks and opportunities. On the back of the Paris Agreement, international frameworks and commitments aimed at minimising the impacts of climate change have increased at pace. This includes mandatory disclosure requirements related to the financial risks and opportunities arising from climate change.

At a global level, the Taskforce on Climate-Related Financial Disclosures (TCFD) was established in 2015 and tasked with issuing recommendations for climate-related financial disclosures, including GHG emissions reporting. In 2017, TCFD released the first international guidance framework which focused on assessing a company’s exposure to climate risks and opportunities. Following this guidance, disclosure of metrics on financed emissions are considered best practice.

In addition to the TCFD, the International Financial Reporting Standards (IFRS) Foundation created the International Sustainability Standards Board (ISSB) in 2021 to meet the growing demand from investors for more useful reporting on climate and other ESG (Environmental, Social, Governance) issues. When the ISSB standards for ESG reporting (including climate change and GHG emissions) are published, these will build on the TCFD and are expected to become the international standard, in the same way the IFRS standards influence mandatory financial reporting.

Domestically, the New Zealand Government recently passed the Financial Sector (Climate-related Disclosures and Others Matters) Amendment Act 2021. The new law will mean the requirements for large financial institutions covered by the existing Financial Markets Conduct Act 2013 (FMC Act) will be extended to include climate-related disclosures from 2023. In practice, this means approximately 200 large equity issuers, banks, insurers and fund or scheme managers will become Climate Reporting Entities (CREs) and will need to make mandatory climate-related disclosures from FY2023. This will make New Zealand one of the first country to have implemented a mandatory climate-risk reporting regime. The specific disclosure requirements depend on the final Climate-related Disclosures Standard to be released by the External Reporting Board (XRB)², but drafts published for consultation already indicate that reporting entities will need to report on all material Scope 3 emissions. For most FIs this will include financed emissions. This is in line with the recommendations from the TCFD, which provide guidance around methodologies used for the calculation of financed emissions.

Similar mandatory reporting regimes are being introduced in overseas jurisdictions. In 2021, the UK announced its plan to introduce TCFD-aligned requirements for large companies and financial institutions to begin reporting on climate-related risks and opportunities, under the Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2021³. Similarly, in March 2022, the United States’ Securities and Exchange Commission (US SEC) announced a proposed rulemaking package that would implement new reporting requirements for material scope 3 emissions, including financed emissions. Other governments are expected to follow.

Shifts in investor and consumer sentiment

The power of investors in directing the movement of capital to certain industries and companies is undeniable and there has been a significant global shift of capital in sustainable investment funds. Illustrating this, the Global Sustainable Investment Alliance’s (GSIA) 2020 Review⁴ found that global sustainable investments increased by 55% between 2016 and 2020. This is also reflected in the financial sector’s commitments under the Paris agreement; around 40% of the world’s assets are now aligned with the movement to net zero through banks’ commitment to the NZBA. Similarly, more than US$10.4 trillion worth of assets are managed by asset owners committed to the NZAOA. These commitments open FIs up to increased scrutiny from investors and a growing expectation for sophisticated sustainable investment decisions and transparent and accurate reporting on financed emissions.

Knowledge of the GHG emissions from their portfolios enables FIs to manage climate-related risks and opportunities, focus on strategic decarbonisation opportunities and support their customers or investees’ decarbonisation journeys through targeted service offerings. The transparent reporting of financed emissions from FIs will also provide investors and consumers with a clear view of the FI’s exposure to risks and opportunities arising from climate change, and the stage of their decarbonisation journey.

How do we approach financed emissions?

Financed emissions can be calculated at the portfolio level (for the entire portfolio) or the sector level (for sectors where significant emissions from investments arise for the FI). 

The Partnership for Carbon Accounting Financials (PCAF) provides a standardised guidance for calculating financed emissions. The PCAF guidance is aligned with the GHG Protocol’s requirements for Corporate Value Chain (Scope 3) Accounting and Reporting Standard for Category 15: Investments, and is recommended by TCFD. As a contributing body to the International Sustainability Standards Board (ISSB), the PCAF approach is likely to influence the development of international and domestic climate and sustainability accounting standards. 

PCAF’s methodologies for calculating financed emissions are dependent on the asset class of the lending or investment, and the level of client-specific emissions and financial data available to the FI. To date, PCAF’s guidance has been focused on six different asset types: 

1. Listed equity and corporate bonds
2. Business loans and unlisted equity 
3. Project finance
4. Commercial real estate
5. Mortgages 
6. Motor vehicle loans

Broadly, financed emissions are calculated by taking the proportion of an entity’s enterprise, project or asset value that is supported by an FI’s services, and applying this proportion to that entity’s, project’s or asset’s GHG emissions. Where possible, actual data should be used, but where this is not available (see data quality considerations below), activity or sector-level data and emissions proxy factors can be used for estimations. 

In alignment with PCAF, FIs shall report customers’ or investees’ absolute scope 1 and 2 emissions across all sectors. The requirement to account for customers’ and investees’ scope 3 emissions will be phased in by sector, as follows:

• From 2021: Scope 3 emissions from energy (oil and gas) and mining sectors
• From 2024: Scope 3 emissions from transportation, buildings, materials, and industrial activities
• From 2026: Scope 3 emissions of all sectors

FIs that are not able to report the required scope 3 emissions because of data availability or uncertainty are required to explain their rationale for exclusion.

Recognising the limitations in data availability, PCAF has established a “data quality hierarchy” of approaches, and encourages institutions to report a “data quality score”. This score can be used by FIs to assess the overall accuracy of their financed emissions calculation. The data score can also support prioritisation of customer or investee engagement, as focus can be placed on the sectors with potentially high emissions intensity and lowest data scores.

Main considerations for financed emissions accounting:

Data quality and reliance on sector-level emission factors

Data quality is a major limitation for FIs wanting to calculate their financed emissions, as entity- or investment-specific data is often not easily accessible. The key reasons for this difficulty include:

• Many entities do not yet accurately report their GHG emissions.
• Entities’ financial data (which is required to estimate enterprise value) is unlikely to be publicly available, unless it is a public reporting entity.
• FIs are not necessarily able to obtain an entity’s data, even when emissions and financial data is tracked by their investees.
• FIs are not necessarily able to use the entity data they already capture due to inconsistencies in systems and processes.

Because of limitations related to obtaining entity-, asset- or investment-specific data, many FIs currently rely on sector-level data and emissions factors to estimate their portfolio’s emissions in initial reporting years. This limits the ability to make entity specific decisions on financed emissions, although it does allow a FI to understand which sectors or asset classes are more emissions-intensive and might require additional entity specific analysis. 

PCAF recommends sector-level emission factors by dollar of revenue (emissions per sector/$ revenue per sector). PCAF endorses the use of certain sector-level emissions factors and some are provided to companies which choose to join PCAF. However, these emission factors are at a global scale and are not tailored for New Zealand, which impacts their accuracy due to the unique attributes of New Zealand’s emissions profile and our large proportional use of renewable energy. Therefore, the use of global emissions factors may skew the resulting calculated financed emissions. To date, there are no publicly available source of revenue-based, sector-level emission factors for New Zealand.

Governance:

Strong sustainability governance is a key enabler to developing robust financed emissions accounting processes, due to the complexity of the accounting approaches, required data sources and the range of impacted stakeholders. Positive internalities arising from strong sustainability governance include:

• Achieving better buy-in from data owners and teams, meaning access to data is easier and quicker.
• Moving towards an internally driven process, meaning the process runs more smoothly and efficiently.

As financed emissions disclosures become mandatory for some FIs from FY23, scrutiny over the reported metrics will increase significantly. Options such as external assurance may also be sought to improve confidence in reporting methodologies and processes.

Limitations to existing financed emissions accounting approaches:

While financed emissions disclosures are a useful tool increasingly adopted by FIs, due to the reasons outlined above, current limitations arising from the existing methodologies are noted below:

• PCAF currently provides guidance for calculating emissions from investments that fall into one of the 6 asset classes outlined above. PCAF has released consultation drafts for additional asset classes, including green bonds, sovereign bonds and emissions removals, and a discussion paper on capital market instruments. It would be expected that these are included within the PCAF Standard in the near term. As PCAF continues to work on how to account for emissions arising from other additional asset classes and other types of financing, there will be an expectation for FIs to adapt to new guidance as it becomes available. This may result in methodology and boundaries changes and FIs should be prepared for these changes and their impacts on future looking financed emissions targets. 
• PCAF have yet to release guidance on how to account for emissions-negative actions, such as regeneration of forests. Emissions removed (or avoided) are therefore not currently accounted for under this Standard.
• The PCAF Standard does not currently account for benefits arising from transition finance (investments focused on supporting the decarbonisation of entities operating in emissions-intensive sectors) or general decarbonisation solutions.

Further considerations for FIs in their financed emissions journeys

Accounting for financed emissions is very much in its infancy. While FIs may currently only be able to achieve a broad understanding of their financed emissions, there is an expectation that the depth of understanding will continue to improve in the following ways: 

• There is an intent to progressively improve data quality for FIs as the underlying data required becomes more commonly captured by investees across different industries. Movement up the data quality hierarchy will require a more structured way of capturing of information from investees/customers. Information relating to climate risks, including emissions, is currently often documented by FI teams at a high level (e.g., in a credit paper or engagement minutes), but is not captured consistently in a format that can be easily extracted and used. It may be appropriate for FIs to incorporate more systematic information capture, such as through the Know Your Customer (KYC) standards, in order to ultimately integrate data capture, monitoring and reporting into core data systems and processes. 
• Financed emissions, while useful, are just one element of the toolkit needed for FIs to fully assess the extent to which their investments are exposed to climate risks. Other information, including investees’ transition plans, is required to enable good quality dialogue with counterparties/investees. Additional tools may include annual reviews of counterparties’ climate transition plans. 
• Financed emissions is not the only metric by which FIs can track the climate risk of their portfolio. FIs may also use an emissions intensity metric, generally calculated as emissions per activity unit, with the relevant activity unit being determined by the sector of the underlying investment (e.g., emissions per MwH for power generation, per tonne of coal produced for coal mining, per m2 for commercial real estate). Many of the decarbonisation approaches proposed by the various GFANZ initiatives have a sectoral focus, and sectoral decarbonisation targets may be set using intensity metrics as opposed to absolute financed emissions. Organisations that are setting sectoral targets using intensity metrics will need to consider how this can be reconciled with any absolute whole-of-book reporting through financed emissions.