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Financed Emissions

Responding to growing public expectations for climate action and acknowledging the financial risks that climate change poses, a number of big banks and pension plans have begun the process of aligning their investment portfolios with Canada’s targets for net zero by 2050 or sooner. Being able to accurately track and report financed emissions will be the key to meeting these targets.

What are financed emissions? Put simply, they are emissions funded by lending and investment activity.

More formally, under the GHG Protocol, these emissions “… should be allocated to the reporting financial institutions based on the proportional share of lending or investment in the borrower or investee.” Financed emissions will rise, all else equal, if a financial institution (FI) increases or begins an investment in an asset with emissions greater than zero, or there is emissions growth for an existing investment.

For investors to significantly reduce those emissions, they will eventually have to eliminate high-emitting firms from their portfolios, or ensure that emissions reduction plans are being put in place, and met, by companies they lend to or invest in.

Soon, regulations will mandate financed emissions disclosure. The March 2023 release of a guideline document on Climate Risk Management from the Office of the Superintendent of Financial Institutions (OSFI) of Canada sets clear minimum mandatory climate-related financial disclosure expectations that will help advance financed emissions reporting and give it overall greater (and needed) exposure.

The document specifically states that it expects that by 2025 the major banks and insurers (and other federally regulated financial institutions by 2026) of Canada will disclose “Scope 3 greenhouse gas (GHG) emissions for the period (absolute basis), and the related risks.”

Herein lies the challenge for financial institutions. The category of Scope 3 emissions refers to emissions created in a company’s value chain rather than directly through its own operations. Essentially, financed emissions are made up of other firms’ Scope 1 (direct emissions of firm’s operations) and Scope 2 (indirect emissions from consumed or purchased electricity) emissions. This is an issue because Scope 1 and 2 emissions disclosure rates are less than 100%. This makes it difficult to have complete information to calculate financed emissions.

To back up a bit, the concept of financed emissions first emerged in 2011 when the GHG Protocol released the “Corporate Value Chain (Scope 3) Accounting and Reporting Standard” that contained Category 15, formally known as “Investments.”

Four years later, the Partnership for Carbon Accounting Financials (PCAF) was launched by Dutch financial institutions with the Dutch Carbon Pledge at the now famous 2015 Paris Climate Summit. PCAF holds the official “Built on GHG Protocol” mark and provides more sector specific guidance for this subset of emissions. PCAF expanded beyond the Netherlands to North America in 2018 and globally in 2019.

To fill the gaps that exist in reporting Scope 1 and Scope 2 emissions, PCAF recommends using various estimation techniques to address data quality that range from verified emissions to estimates based on economic activity data.

Recording these data quality values is key, since they give a data consumer some context and an overall indication about its accuracy. The new OSFI guidelines require that “…if the reporting initiative used by the FRFI [Federally Regulated Financial Institutions] is not the PCAF Standard, then disclose how the reporting initiative used by the FRFI is comparable with the PCAF Standard.”

Financed emissions reporting in Canada using PCAF was limited to small FIs in 2020 and followed by a group of large FIs (banks) in 2022. PCAF’s website tracks financial institutions using PCAF and currently reports that nine FIs in Canada have disclosed financed emissions, including all five major banks (RBC, CIBC, BMO, Scotiabank, and TD). However, a lot of this reporting is not complete as it reports emissions from lending and not investments.

There are also nine Canadian banks, including the five major banks, that are members of the United Nations Net Zero Banking Alliance (NZBA), the banking member of the Glasgow Financial Alliance for Net Zero (GFANZ). The Alliance was launched in 2021 by UN Special Envoy on Climate Action and Finance and former Governor of the Banks of Canada and England, Mark Carney.

The alliance follows guidelines from the United Nations Environment Programme Finance Initiative (UNEP FI) which state that targets “shall” (mandatory, on a comply-or-explain basis) cover lending activities and “should” (optional but strongly recommended) cover investment activity. Regarding the level of ambition, targets shall at least align with the temperature goals of the Paris Agreement, which sets out to limit temperature increases to 1.5°C above pre-industrial levels. Members of NZBA “shall” also annually measure and report their current emissions that cover a significant majority of financed emissions, including a set of carbon-intensive sectors. Proper disclosure of financed emissions will be key to these banks meeting their GHG reduction targets and remaining part of the NZBA.

It is worth noting that the NZBA is voluntary so its influence is limited. Glasgow Financial Alliance for Net Zero (GFANZ) also no longer requires its members to be members of the Race to Zero campaign which sets out more explicit and ambitious criteria for participation.

There is no general consensus on how to reduce financed emissions and therefore reach the various reduction targets announced by FIs worldwide. Two central approaches are divestment and engagement. Generally, divestment involves selling assets in high emitting activities whereas engagement involves encouraging and working with firms to reduce their emissions over time.

Strategies employed by FIs usually do not fall wholly into divestment or engagement, rather there is nuance and sometimes a mix of both are used, where the allocation could depend on several factors including the invested firms’ economic sector, general awareness of climate risk, and reaction to demands for climate action.

Large pension plans in Canada highlight these divergent strategies. Caisse de dépôt et placement du Québec (CDPQ) follows more of a divestment approach, stating in their 2021 Climate Strategy report that they “are committing to complete our exit from oil production by the end of 2022” and “Instead, we will focus on projects and investment platforms that are dedicated to the transition to a sustainable economy. This will in turn stimulate innovation in other energy sources and in reducing carbon emissions.” CDPQ is also creating a $10-billion transition envelope for high emitting sectors that are essential for the energy transition such as raw materials production, transportation, and agriculture.

CDPQ’s approach contrasts with the Canada Pension Plan Investment Board which states: “We anticipate oil and gas will continue to play an important supply as the world transitions to net zero. We continue to invest across the entire energy spectrum, from conventional energy such as oil and gas, to renewables like wind and solar power.” Further, “We expect new innovations and technologies will support the decarbonization of the oil and gas sector over a decades-long transition.” And, “We invest and exert our influence in the whole economy transition as active investors, not through blanket divestment.”

There are numerous ways to improve the data quality of financed emissions disclosures. One way is via regulation that encourages or explicitly requires firms to disclose their emissions (which in turn would serve as the input for financial institutions’ financed emissions), as it would lower the number of estimates needed. Financial institutions can also improve their own data quality by encouraging the companies they invest in to disclose their emissions using frameworks such as the GHG Protocol and TCFD. Using standard frameworks and methodologies can help analysts make meaningful comparisons across years and firms. Externally verifying emissions data is another clear way to boost overall data quality.

Completing and submitting CDP’s climate change questionnaire can be helpful as the questionnaire draws attention to the nuance of some data values and asks for other granular and useful pieces of information beyond what is normally found in a traditional corporate sustainability report. CDP, formerly the Carbon Disclosure Project, is a London based not-for-profit charity which holds the most comprehensive collection of self-reported emissions data in the world.

Financial institutions, in the interest of meeting their various financed emissions net-zero targets, should know their invested firms’ GHG emissions reduction plans. This information is usually provided in a sustainability report, or, in a more structured/standardized way, through CDP. Having more information on invested companies can remove guess work and helps to shed light on expected emissions.

Reporting and general awareness of financed emissions is increasing. FIs will continue to build on their reporting capabilities and provide stakeholders with more comprehensive and accurate information in the years to come. The pressure that FIs put on their invested firms should lead to improved economy-wide measurement of GHG emissions.

Setting financed emissions reduction targets, and working towards these targets, will send powerful signals to the market that capital allocators are targeting firms with low emissions or firms that have robust GHG reduction plans.

Capital has influence, and measuring, tracking, and working to reduce financed emissions is a positive addition to the global fight to address climate change.

This series explores the foundations of sustainable finance, one of the most important emerging fields of our time. Sustainable finance aligns financial systems and services to promote long-term environmental sustainability and economic prosperity.