Financed emissions are emissions generated as a result of financial services, investments, and lending by investors and companies that provide financial services.
Financial institutions have a significant responsibility in funding the transition to a low-carbon economy. They can alleviate the worst effects of climate change by reallocating and decarbonizing their portfolios and investing in climate mitigation and adaptation measures.
In addition to managing greenhouse gas (GHG) emissions created from their day-to-day activities, financial institutions are also accountable for financed emissions. These are the emissions related to loans, underwriting, investments, and other financial services.
According to the Carbon Disclosure Project's (CDP) The Time to Green Finance report, financed emissions account for 700 times more than a financial institution's directly generated emissions. Another recent report also found that the world's 60 largest banks financed up to $4.6 trillion in fossil fuels between 2015 and 2021 — six years after adopting the Paris Climate Agreement. The same report found that $742 billion was financed in 2021 alone.
Financial institutions that commit to going net zero must now act on managing financed emissions. We will cover what financed emissions are, why they're important, and everything financial institutions should know about measuring and managing them.
What Are Financed Emissions?
Financed emissions are emissions generated as a result of financial services, investments, and lending by investors and companies that provide financial services. They fall under scope 3, category 15 from the Greenhouse Gas Protocol (GHGP).
One of the Paris Agreement aims is “making finance flows consistent with low GHG emissions and a climate-resilient pathway." Financial institutions and investors play a major role since they currently provide significant funding for fossil fuels and other high-emissions industries.
Why Are Financed Emissions Important?
Financed emissions are important because they contribute a considerable portion of global GHG emissions.
A recent report from Sierra Club found that the 18 largest U.S. banks and asset managers were responsible for financing the equivalent of 1.97 billion tons of CO₂-eq in 2020. This would make the U.S. financial sector the fifth largest global emitter if it were a country, just behind Russia.
The CDP’s The Time to Green Finance report also found that only 25% of financial organizations measure financed emissions, while 49% don’t analyze their portfolio’s climate impact.
This leaves a sizable blind spot in the global emissions accounting sheet. It also means that the financial institutions responsible for financing emissions aren’t held accountable for their contributions.
Unaccounted financed emissions put the global climate at risk while exposing financiers to reputational and financial risks. Alternatively, when financed emissions are properly accounted for, it gives banks and asset managers an understanding of their products and services’ climate costs.
What Challenges Do Firms Have When Reporting Financed Emissions?
Firms have difficulties collecting and managing data, allocating appropriate resources, and understanding appropriate targets and methodologies due to a lack of standardization.
The World Resources Institute’s (WRI) Banking Beyond Climate Commitments paper highlighted the following challenges:
- Lots of time, money, and resources are needed to assess and develop needed data
- Lack of standardized legislation, policies, methodologies, and tools when measuring impact
- Scrutiny over the additionality and fungibility of green bonds
- Limitations from governments and financial regulators that hinder the progress of Paris-aligned decision-making
- Firms’ participation in greenwashing as a result of difficulty creating standards that apply to all sectors
These difficulties hinder financial institutions from creating comprehensive and accurate reports. Oftentimes, information is incomplete, estimated, or has other issues that don’t capture the full picture.
This can stem from an inability to get complete information from companies in a firm’s portfolio. These companies may not have high-quality data available or may not collect enough usable emissions information for reporting.
Difficulties with data collection, standardized data sources, and policies can also result in missed goals that were overly ambitious or incomparable disclosures between firms.
Who Needs To Disclose Financed Emissions?
Reporting on financed emissions is voluntary in the U.S. and most other parts of the world. However, changing legislation and regulation is likely moving toward more mandatory reporting. For example, New Zealand requires insurers, banks, and other financial institutions to disclose their climate-related impact.
However, several alliances, collectives, and other organizations have agreed to report on their financed emissions.
Race To Zero Campaign
The United Nations Framework Convention on Climate Change (UNFCCC) manages the global Race To Zero campaign. It rallies support from all levels and leads net zero initiatives. The Glasgow Financial Alliance for Net Zero (GFANZ) aligns its goals with the Race To Zero.
Glasgow Financial Alliance for Net Zero (GFANZ)
GFANZ’s goal is to unify net zero worldwide financial industry-specific alliances into one. There are over 450 members representing more than $130 trillion in assets.
The following alliances and initiatives are all part of GFANZ:
- Net-Zero Banking Alliance (NZBA)
- Net Zero Asset Managers Initiative (NZAMI)
- Net-Zero Asset Owner Alliance (NZAOZ)
- Paris Aligned Investment Initiative (PAII)
- Net-Zero Insurance Alliance (NZIA)
- Net Zero Financial Service Providers Alliance (NZFSPA)
- Net Zero Investment Consultants Initiative (NZICI)
GFANZ and the alliances and initiatives under its umbrella align with Race To Zero criteria. The members of these groups commit to transitioning their portfolios to net zero, supporting investing aligned with net zero emissions, and supporting the overall goal of achieving net zero GHG emissions by 2050.
These alliances and initiatives also help in other ways. For example, the PAII published the Net Zero Investment Framework to assist asset owners and managers in setting net zero targets.
What Is PCAF and What Is Its Role in Disclosing Financed Emissions?
The Partnership for Carbon Accounting Financials (PCAF) is a global collaboration of financial institutions that have developed a framework to help firms measure financed emissions.
It was created in 2015 in response to a growing need for fully accountable and comparable financed emissions calculations. Scope 3, category 15 was a precursor to PCAF.
There are nearly 300 PCAF members who've committed to measuring and disclosing their financed emissions. They aim to create and implement a streamlined approach to disclosing GHG emissions resulting from investments and loans.
The PCAF framework achieves this by providing formulas for allocating the carbon impacts for transactions in six major asset classes. This ensures that financed emissions calculations are comparable across the whole finance industry.
PCAF also 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.
How Are Financed Emissions Calculated?
Financed emissions are calculated by looking at an activity's carbon footprint and allocating that footprint to the financial institution. The accounting process for each loan, investment, or debt is conducted in two parts:
- Estimating the total carbon footprint of any activity within a loan, investment, or financial service
- Allocating that carbon footprint to the financial institution through a shared attribution calculation
Estimates and assumptions are sometimes necessary if there aren't clear reporting standards or there’s a lack of available data.
Luckily, many organizations and initiatives are developing tools to expedite this process and fill these gaps. For example, the International Energy Agency (IEA) creates scenarios to help analyze these situations. Over time, institutions will eventually need less proxy data when more organizations start reporting emissions, and we have improved data.
Many organizations and initiatives are also creating helpful guidance for financial institutions. PCAF developed the Global GHG Accounting and Reporting Standard for the Financial Industry to give firms more guidance on reporting on financed emissions. PCAF started with guidance on the following asset classes:
- Listed equity and corporate bonds
- Commercial real estate
- Business loans and unlisted equity
- Motor vehicle loans
- Project finance
PCAF expects to add more asset classes and case studies as the landscape evolves and more data is available. The standard also includes guidance for scoring data quality in cases where data isn’t fully available.
What Resources Do Firms Have To Help Them Measure, Reduce and Disclose Financed Emissions?
Financial institutions can turn to standards, frameworks, and tools developed by various organizations to provide standardized guidance for measuring emissions.
To reduce financed emissions, institutions must first measure and disclose them. Unfortunately, financed emissions are notoriously difficult to measure, leaving much unreported or misreported.
The difficulty lies in the sheer amount of data involved. Large banks or investment groups have millions of customers and many financial products. Data collection and calculations for each product's financed emissions must be performed.
Guidance and Organizations
Many organizations have recognized the need for improved standardization to assist financial institutions with reporting. Below are a few major examples.
As the first standard developed in 1998, the GHGP is the most well-known and widely used. Under the GHGP scope 3, category 15 is the section that pertains to financed emissions. However, from a financed emissions perspective, the level of detail remains slightly underdeveloped.
PCAF is another great resource for firms. In addition to the accounting standard they’ve developed, they also created the Strategic Framework for Paris Alignment to help financial institutions understand how they can better align their portfolios with the Paris Agreement. It accomplishes this by providing three features:
- Explanation and highlights of relevant areas of the Paris Agreement for financial institutions
- Glossary of frequently used terms
- Rundown of current initiatives, tools, projects, and methodologies
This document is a great jumping-off point for financial institutions who want to understand the current landscape and identify which collaborations or resources are most relevant for them and what they can expect in the future. PCAF also provides other resources like workshops and webinars.
The world’s largest financial institutions signed up with GFANZ when it formed in April 2021. The GFANZ Progress Report gives annual updates on the progress of the alliance. They’ve since made strides toward building commitment in the industry to lower emissions and creating actionable guidance for specific sectors.
SBTi has guidance for the financial sector to set science-based targets (SBTs). SBTs are targets in line with what the latest research finds is necessary to meet the Paris Agreement’s goals.
Like financial accounting, getting started with carbon accounting requires the right tools to measure emissions accurately. Typically, carbon accounting has been a lengthy and costly process performed on complicated spreadsheets by consultants. Today, digital tools can help automate calculations and mitigate chances for errors.
Carbon Management and Accounting Platforms (CMAPs)
The recent development of Carbon Management and Accounting Platforms (CMAPs) has enabled businesses to measure their financed emissions at a fraction of the time and cost.
CMAPs have codified the most effective carbon accounting methodologies, including the GHGP and PCAF, to calculate financed emissions. As a result, CMAPs allow banks and asset managers to ensure accountability with transparent emissions data.
Paris Agreement Capital Transition Assessment (PACTA)
Banks can also turn to the Paris Agreement Capital Transition Assessment (PACTA) to see how their portfolios align with different climate scenarios. This can help banks quantify potential risks and their effects.
What Is the Difference Between a Carbon Tax and Emissions Trading?
Carbon taxes charge companies by emissions but don't limit emissions. Under emissions trading, there is a cap on emissions. These programs can ultimately cost financial institutions if they’re slow to decarbonize their portfolio. Governments and jurisdictions typically run these programs.
For example, Canada has a carbon pollution pricing system that charges companies based on fossil fuels (called the “fuel charge”) and on performance (called the “output-based pricing system”).
Emissions Trading Programs
Emissions trading programs provide allowances to specific organizations to produce a set amount of emissions. For example, the EPA’s emissions trading program includes affected sources like power plants.
It’s sometimes called a “cap and trade” program. Penalties for going over the allowance can result in costly fines and forfeiting future allowances.
These programs help limit overall emissions and create predictability for those affected. It also encourages transparency since data collection is necessary to calculate emissions.
A carbon tax is a fee for the number of emissions companies create. In theory, charging companies for emissions helps hold them accountable for the effects of their emissions.
Since these taxes increase the cost of using fossil fuels and other activities that produce emissions, carbon taxes incentivize companies to become more energy efficient.
How Do They Relate To Financed Emissions?
Implementing a carbon tax can take a monetary toll on financial institutions, depending on what types of emissions are considered. Getting ahead of measuring and mitigating financed emissions can prevent costly penalties from future carbon tax or emissions trading programs.
What Should Firms Consider To Create Efficient Targets?
Firms should create targets tested for resiliency, measured against multiple scenarios, and created using science-backed methodologies. Like any goal, firms should be able to measure their progress and achieve the goal under realistic conditions.
However, setting realistic targets is easier said than done for financed emissions. The challenges that commonly hinder financial institutions make it difficult to know what is and isn't overly ambitious.
To get started with creating efficient targets, firms should consider doing the following:
- Use multiple climate scenarios to inform targets in the short and long term.
- Test the climate resiliency of your targets, taking into consideration physical and transition risks, and prepare steps to adjust based on potential predicted outcomes.
- Use science-backed methodologies like PCAF and set SBTs to gather auditable and comparable information.
- Employ PCAF’s guidance for data quality scoring, especially when assumptions are necessary to make up for a lack of data.
- Set ambitious but manageable and realistic targets based on data and current research.
- Set up governance to focus on both physical and transitional risks.
Make Plans for Portfolio Companies That Don't Reduce Emissions
Firms should also consider what steps should be taken if companies in their portfolios fail to decrease emissions.
The ideal next step is to engage with those companies to reduce emissions. Portfolio companies can retain funding by decarbonizing their operations. Both firms and companies benefit since they can collectively reduce their emissions.
Engagement with portfolio companies and customers can look like this:
- Providing services, resources, and guidance to help businesses measure and manage their emissions
- Offering financing that helps companies and customers reduce emissions
- Setting timelines and emissions reduction milestones
- Establishing clear criteria and definitions for reduced emissions
- Transparently sharing data and findings from financed emissions disclosures
- Working with experts to refine the transitions process and adjust to ongoing changes
Firms can also reallocate other investments to carbon-neutral or carbon-negative assets to manage emissions. Investing in these types of assets can help decarbonize their portfolio while financially supporting emissions reductions.
Divesting completely from the company is another option. Although this reduces emissions for the firm, it doesn't encourage portfolio companies to reduce them. Those companies can continue operations as normal if they find funding elsewhere.
Looking ahead, firms can also limit or phase out future financing for fossil fuels and high-emission industries.
How Can Firms Start To Manage Financed Emissions?
Financial institutions should keep key stakeholders informed and educated, create actionable steps to decarbonize their portfolio, and continually improve financed emission plans. This isn't an exhaustive list, but setting down a strong foundation and getting buy-in can give financial institutions a strong start as they begin working toward their targets.
These are some steps firms should take in addition to setting targets:
- Determine key stakeholders needed to reach key targets, their roles, and what actions they need to take.
- Create interim targets and build in checkpoints to keep a pulse on progress.
- Educate key stakeholders, employees, and others on the plans to lower your financed emissions.
- Invest in training for financial advisers, asset managers, and others who will work with customers and portfolio companies.
- Engage with high-emissions portfolio companies and customers to encourage them to begin measuring and/or lowering emissions.
- Prioritize tackling the biggest emissions “hot spots” first to make the biggest impact.
- Research “green” investing opportunities that can help decarbonize your portfolio, like renewable energy and transition bonds.
- Revisit and revise targets as needed when more data becomes available, and more companies begin disclosing.
- Create feedback processes to learn how the implementation is going and how it can be improved.
- Dedicate resources to keep track of changing legislation affecting your portfolio companies and customers.
TD Ameritrade illustrates what this may look like. In 2021, they started measuring financed emissions for businesses in the energy and power sectors. They plan to continue target setting for additional sectors in 2022.
TD Ameritrade has also developed other helpful resources to achieve its goals. For example, they developed a heat mapping framework to help them identify and assess physical and transition risks.
Although fossil fuel investing has become more prevalent for the largest banks, 2021 was the first year banks earned more fees arranging green-related bond sales and loans than they did helping fossil fuel companies. This begs the question: Are financial institutions beginning to realize that the future is green and using their capital accordingly?
Reporting and managing financed emissions is undoubtedly crucial for any financial institution. Powerful carbon accounting solutions are a necessity when taking the steps to tackle this emissions category.