Challenge: building emission baselines is complex and judgmental
Establishing boundaries for emissions ownership is a particular challenge in assessing the current state of a firm’s emissions footprint. FSOs can struggle to understand where the boundaries for emissions that they “own” are drawn, what should be accounted for within different scopes and which quantification methodologies to use or that may be required.
Unfortunately, companies’ current climate data is often inconsistent and, in most cases, incomplete. Where actual GHG data cannot be collected directly from counterparties, it needs to be estimated based on proxies such as activity data or industry averages.
FSOs also need to review clients’ financed emissions profiles associated with client activities they fund, invest in, insure or facilitate and keep a robust record of the basis of the calculations used. However, calculation methodologies are still relatively nascent. Responding to industry demand for a globally accepted standard for accounting for GHG accounting, the Partnership for Carbon Accounting Financials (PCAF) has recently developed a standard for calculating financed emissions covering six asset classes. In addition, the collective effort of FSOs through respective UN-convened net zero financial services alliances have helped to create joint momentum on framing new methodologies. However, gaps still remain and will need to be addressed in the future.
Challenge: credible decarbonization pathways must be anchored in climate science
A range of climate reference scenarios and transition pathways are available to FSOs. However, their forward-looking nature means that each is based on a set of assumptions about how underlying economic, social and environmental dynamics will play out in coming years. FSOs need to choose between a range of industry and internally driven approaches. Each has its benefits and limitations, and it can be hard to know which methodology has the greatest relevance to each portfolio or loan book, and which will provide the greatest possible comparability between counterparties.
To show leadership, FSOs should consider aligning their targets with the goals of the Paris Agreement, using the latest climate science to ensure sufficient ambition. Best practice is to use methodologies such as the Science Based Targets initiative (SBTi) where possible and to support the decarbonization of emissions-intensive industries, as well as the expansion of climate solutions. However, most methodologies are still evolving and are typically applicable to a limited range of financial institutions, depending on their activities and asset classes. SBTi, for example, is being refined and expanded with a version 2.0 expected to be released later this year.
Challenge: strategy is vital, but represents a difficult balancing act
Selecting decarbonization levers – specific changes to the ways in which FSOs choose the companies, activities and assets they wish to finance, invest in or insure – is the crux of an effective net zero strategy. However, identifying enough of those levers, and implementing them in a sufficiently coordinated way, is highly challenging, even for the most ambitious firms, and involves difficult decisions. There is no shortcut to achieving net zero emissions.
There are several reasons why selecting the right levers is challenging. One is the vital importance of making substantial, tangible reductions in emissions within the current decade. Another is the need to go beyond simple divestment; FSOs will only enable decarbonization in the real economy if they engage with counterparties to support their transition to lower emissions. A third challenge comes from the need to rapidly scale up the flow of capital to clients and activities that provide climate solutions. Finally, FSOs need to balance net zero goals with other sustainable development goals and an appreciation of wider social, economic and political factors. If decarbonization efforts hurt society or prosperity, they will not command public or political support.
The need for support and engagement means that communication is also a crucial element of successful strategies. If FSOs are to build trust and buy-in among stakeholders, they need to find a clear way to communicate decarbonization strategies – and the thinking behind them – to their own investors, clients and key partners.
Challenge: disclosure is evolving fast, but convergence is proving much slower
Public and regulatory bodies around the world are working to develop robust nonfinancial reporting frameworks. That includes a set of emerging requirements around transition plans, which have become a core component of guidance from the Task Force on Climate-related Financial Disclosures (TCFD). Regulators, such as the UK’s Financial Conduct Authority, are now signaling their intention to refer to that guidance when assessing whether firms’ climate-related financial disclosures are consistent with the TCFD’s recommendations. Meanwhile the European Union, seeking to build its green finance credentials, is planning to require transition plans from all large companies, including short-term targets and reports on progress.
Transparency is vital to achieving net zero outcomes, so every initiative is welcome. But while alignment is improving, true harmonization is only beginning. Standards are still multiplying; frameworks are still in development, interpretations vary and inconsistencies are widespread. In some countries, market forces rather than regulation that are driving change. Many emerging frameworks are also unsuited to less mature markets. These limitations pose huge challenges for FSOs, which prize credible data as the basis for decision-making.
Furthermore, the importance of clear disclosure cuts both ways. FSOs themselves need to be able to communicate their decarbonization progress to investors and other stakeholders as transparently as possible. For now, however, we remain a long way from climate-related reporting being anywhere near as reliable or usable as the information in core financial statements.