Financed emissions, part of the family of emissions within scope 3 reporting under the GHG Protocol, refers to the emissions that arise from the projects and activities that banks finance or facilitate. Scope 3 emissions make up the majority of a banks carbon footprint and so ensuring that they are captured and represented correctly is going to be critical to ensuring robust transition plans to net zero.
Accounting for financed emissions presents several challenges that require attention and improvement:
Incomplete Disclosure
The European Central Bank (ECB) has recently published the results of the 2022 supervisory assessment of institutions’ climate-related and environmental risks disclosures. The report analysed a number of systemic banks across Europe and the UK and found most banks did not provide a sufficient explanation of the methods to calculate their emissions. They tended to list in a broad way the methodologies used, without reference to the way in which emissions were calculated or the underlying assumptions and formulae.
The report also highlighted that there is rarely a clear explanation of the age of the underlying data, and where an age was given, it was sometimes old (e.g. 2019 data).
Finally, banks did not sufficiently explain the quality of the data used or the depth of the value chain used in their estimations. For example, where physical goods have been produced, the carbon emissions related to upstream raw materials and component parts manufactured by other businesses.
Complex Attribution
Determining the extent of a financial institution’s responsibility for indirect emissions is not straight forward. The Partnership of Carbon Accounting for Finance (PCAF) is developing standardised methodologies for different types of lending activities , but complexities arise when deciding the level of attribution . This complexity can lead to varying levels of emissions attribution across different lending portfolios.
Put simply there are two main ways to attribute financed emissions:
Asset Approach
Under the asset approach, the attributed emissions are based on the specific asset that is being directly funding. For example, when financing a residential property, the finance provider is solely accountable for emissions generated by the property itself, rather than the borrower’s broader carbon footprint. Moreover, the level of responsibility for emissions is proportional to the extent of financing provided for the property.
Balance Sheet Approach
For more general financing arrangements, such as business loans that support working capital, the balance sheet approach is utilised. Here, the finance provider considers the broader carbon footprint generated by the business and attributes emissions based on the percentage of all business assets financed.
Unintended Consequences
At first glance the delineation in methods has merit. Data constraints, need for consistency and a desire to keep things simple mean that where you have an identifiable asset being financed, you should constrain your attribution to the asset in question. However, an unintended consequence of such an approach is that you may in end up with under or over estimation when comparing different lending arrangements.
Example:
For example, when a bank finances the activities of an oil rig through general working capital, where the financing isn't explicitly earmarked for specific assets and constitutes an insignificant portion of the entity's balance sheet, the resulting financed emissions figure is likely to be considerably lower than if the bank had directly financed the construction of the oil rig .
In the case of Asset-Based Finance, the business receives £50m to support the construction of a £100m oil rig. Upon construction, the rig is responsible for 1,000 tons CO2eq emissions. Applying the Asset approach for financed emissions, the lender will report in their financed emissions 500 tons CO2eq (50% loan to value ratio x 1,000 tons CO2eq carbon emissions of financed asset).
In the case of Working Capital Finance, the business receives £50m for general working capital, and the total assets of the firm are £1bn. The firm undertakes to construct the same oil rig, in part relying on funds released from working capital as a result of the new financing arrangement. Upon the completion of the new oil rig, the overall carbon emissions of the firm are 2,000 tons CO2eq. The new oil rig is responsible for over half of all emissions but because the balance sheet approach has been taken to attribution, this will not be directly reflected in the financed emissions reported. The lender will report in their financed emissions 100 tons CO2eq (£50m loan / total assets of £1bn = 5% x 2,000 tons CO2eq).
These scenarios demonstrate that despite identical amounts of funding, the nuances of the lending arrangement can significantly impact the level of responsibility attributed to the finance provider for emissions. With the lender having to report a figure five times higher under the asset-based approach.
Keep in mind that dependent on the make up of the firms’ balance sheet, assets involved and composition of carbon emissions, either approach could result in a higher reported figure.
This is important. Over the long term the different methods may act as incentives for banks, not only in terms of where they look to decarbonise their lending activities, but also in the ways in which they structure finance. These incentives may not be necessarily helpful to ensuring robust transition plans to net zero and the means by which we track and hold banks to account for those plans. They may also unduly reduce access to finance for certain customer types as banks look to decarbonise lending portfolios and are led to address first those portfolios with higher relative emissions per pound sterling lent.
It is also likely that alongside further refinement of methods for reporting, that we find earlier decisions are subsequently proven wrong as our understanding of how financing activities drive carbon emissions in the wider economy evolves.
To ensure effective accounting and reporting of financed emissions, it’s important that we come back to first principles:
Fair treatment
The chosen method for attributing emissions should be fair and consistent across various finance products, avoiding any biases that may disadvantage certain lending activities . This ensures that transition plans do not unintentionally hinder access to finance for specific customer groups, such as SMEs or consumers. For example, both groups may struggle to quantify an accurate carbon footprint related to their activities, which then becomes an issue for lenders looking to determine impact.
Robust measurement over time
Accurate and consistent measurement of financed emissions is crucial. Financial institutions must establish rigorous data collection processes and maintain up-to-date records to monitor progress in their decarbonisation efforts. Challenges will arise when trying to extract emissions data from customers, particularly the long tail of smaller businesses where data is unlikely to be to hand.
Transparent disclosure
To instil trust and accountability, financial institutions should disclose detailed information about their emission calculation methodologies, the quality of their data and sources and governance arrangements; reasons for chosen metrics etc. Transparent disclosure will enable stakeholders to assess institutions' commitment to climate action.
Conclusion
Accounting for financed emissions is a complex yet essential aspect of addressing climate change. As financial institutions acknowledge their role in contributing to greenhouse gas emissions, they must overcome challenges in data collection, disclosure, and attribution methodologies.
By adhering to the first principles of fair treatment, robust measurement, transparent disclosure, financial institutions can play a significant role in the transition to a low-carbon economy.