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Decarbonising investment portfolios on the journey to Net Zero
20 September 2023

Decarbonising investment portfolios on the journey to Net Zero

5 minute read
Net zero Corporate climate action Green investments
Matt Sprague Consultant, Climate Strategies
Charlie Brunel-Lister Managing Consultant, Sustainable Finance

Matt Sprague and Charlie Brunel-Lister, climate strategy and sustainable finance experts at South Pole, explain how financial institutions can understand and tackle their scope 3 emissions to accelerate their climate journey.

Our research has highlighted the scale of the financed emissions challenge and the need for financial institutions to use their investment influence to drive decarbonisation efforts.

Climate goals are becoming more ambitious. And this means a tighter focus on companies' scope 3 emissions as this is often where businesses can achieve the biggest decarbonisation impacts.

For financial institutions such as banks, insurance companies and investment managers, scope 3 emissions from supply chains and lending/investment portfolios are often more complex than for other industries. They mostly derive from the investments they hold and the lending/underwriting they provide to other companies, known as 'financed emissions'. Financed emissions are the share of operational emissions from the companies under an institution's investment/lending portfolio, with methodologies such as PCAF or JIM providing a system for measuring these emissions.

While the process is complex, the pay-offs are considerable. CDP found that these financed emissions are on average approximately 700 times higher than the organisation's operational emissions. For example, the indicative financed emissions from the UK financial sector in 2019 were found to be 1.8 times higher than the UK's own greenhouse gas emissions (excluding aviation and shipping). Financial organisations thus have a major role to play in the decarbonisation of the global economy, yet it is estimated that since the Paris Agreement in 2015, the 60 largest banks have instead invested $5.5 trillion USD in fossil fuels. Clearly much more needs to be done to pivot towards more sustainable investment and lending practices.

Change is already underway within the fossil fuel industry, as developments in the Netherlands, United States and Australia indicate. Support for decarbonisation has also been spurred on by Climate Action 100+, a group of over 570 investors engaging with large organisations to take action on climate change and drive emission reductions, with further pressure on investment groups anticipated as more focus is placed on their emissions and climate impacts.

Meanwhile, some financial institutions have already committed to reducing their investment in coal and fossil fuels, such as BNP Paribas (coal divestment in EU and OECD by 2030 and globally by 2040), ING (zero coal by 2025) and Commonwealth Bank (no direct finance for all new and expanded oil and gas extraction projects, as well as some critical enabling infrastructure by 2025). Even JP Morgan Chase, the world's largest investor in fossil fuels, has taken steps to reduce investment in Arctic oil drilling and coal. Other banks and lending institutions have not set clear targets, while those that have done so typically limit their statements to thermal coal lending. The Powering Past Coal Alliance is a group of 167 national and sub-national governments, businesses, and organisations looking to accelerate the transition to clean energy away from coal. Financial institutions looking to get started on their sustainable finance journey should begin with decarbonising their investment portfolio, which starts with five simple steps.

Understanding emission sources in your portfolio

For some organisations, scope 3 emissions may be easy to calculate, understand and reduce, such as those deriving from business flights and waste. For financial institutions, however, these emissions are often more complex and material, and form a major part of the revenue stream. The Partnership for Carbon Accounting Financials (PCAF) standard has developed a methodology to measure these emissions across various asset classes: listed equity and corporate bonds, business loans and unlisted equity, project finance, commercial real estate, home mortgages, motor vehicles loans and sovereign bonds. For all of the companies and projects in your investment or lending portfolio, you are carrying their operational emissions within your overall amount of financed emissions. Currently, a financial organisation should consider the scope 1 , 2, and significant scope 3 emissions from its portfolio; however, this may change to include all scope 3 emissions in the future.

Those organisations that have not considered reducing these emission sources could be misunderstanding the double materiality risks they carry: the risks to their business, like stranded assets or reputational risks, and their contribution to making the Earth uninhabitable.

A simple example is that of a financial investment in a mining company. The operational emissions (scope 1 and scope 2 emissions directly attributed to the mining operations) typically include diesel, electricity and fugitive gases. Traditionally, financed emissions exclude scope 3 emissions from activities such as transportation and use of the coal, either in a power station (known as thermal coal) to generate electricity, or in industrial processes such as steel making (known as coking or metallurgical coal).

In this example, if the financial organisation holds a 10% stake (either debt or equity) in the mining company, their financed emissions would be 1.63 MtCO2e = 10% x (10.5 + 5.8 MtCO2e).

Emissions footprint of a sample mining company. Source: Mining Journal -

Emissions footprint of a sample mining company. Source: Mining Journal -

However, if the financial organisation were to include the significant scope 3 emissions, then the financed emissions would increase to 60.1 MtCO2e = 10% x (10.5 + 5.8 + 584.9 MtCO2e). This is a nearly 37-fold increase!

Steps to tackle financed emissions

Understanding the size of this footprint is the first step, but setting a decarbonisation target is a challenge in itself. Below we outline five steps to start decarbonising your investment portfolio.

1. Calculate your impact

To understand the emissions from investments and lending, organisations need to know their portfolio of investee companies and apply suitable emission factors to each company. Their owned emissions are then prorated based on their equity or debt investment share. This will show the emissions from the investment at a point in time and highlight the high-emitting investments. By following the PCAF methodology, these emissions can be understood with reasonable confidence across multiple asset classes. The portfolio emissions data used (i.e. reported emissions vs. estimated emission factors) will alter the financial institutions' data quality score and its ability to track improvements.

2. Set a target

The Science Based Targets initiative ( SBTi) has developed guidelines on setting science-based targets (SBTs) for the financial sector that require the inclusion of financed emissions. To date, around 70 financial companies have validated near-term SBTs, with a further 160+ having committed to setting near-term targets. South Pole can help you navigate the existing framework as well as the new net zero guidance (FINZ) which will replace it in Q4 2023.

3. Take a strategic approach to decarbonising investments

Financial institutions have options when trying to reduce their financed emissions. For example, they can engage with their portfolio companies to support emission reduction targets in line with climate science. They can also divest from high-emitting industries such as thermal coal production. When developing an investment decarbonisation approach aligned with +1.5°C of warming, financial institutions should also consider both a "just transition" approach, where no-one is left behind in the decarbonised economy, and a short-term return on investment while reducing warming to below 1.5°C.

A strong decarbonisation strategy may see a blended approach between divesting assets and then working with other portfolio companies to decarbonise, depending on the ownership and control of the financial institution on the one hand and the willingness and ability to transition, on the portfolio company side.

Aligning an investment strategy with these new technologies, opportunities and risks can reduce the impacts of climate change, and also reduce a lender's exposure to the increased risks associated with increased fire risk, flooding and drought.

4. Finance climate action

Financing climate action can take many forms, such as green bonds or sustainability-linked loans. Investors and lenders should look to provide finance to the companies and projects which are moving towards low-carbon or are already meeting these objectives. Supporting the growth of “green" companies which are credibly "transitioning" by providing additional finance - including companies that may require flexible finance arrangements to scale their impacts - can increase investor impacts. Leveraging environmental, social, and (corporate) governance (ESG) policies and working with existing fund managers can support portfolio companies with identifying suitable opportunities.

5. Lead and communicate

Financial organisations should communicate their climate action to the marketplace and stakeholders through established frameworks such as the TCFD. This critical step - disclosing the climate impact of your investments and lending - encourages other organisations to take action. It is only with this level of rigour and transparency that organisations can demonstrate authenticity and leadership in their climate strategies.

TCFD is becoming a standardised requirement for many organisations, with several governments looking to make reporting mandatory, such as the case in Switzerland by 2024. Establishing strong reporting principles now will put financial organisations in good stead to meet future reporting obligations.

Financial institutions have a major role to play in decarbonising the economy toward net zero over the coming three decades. However, greater action is required to fully realise this. Understanding your financed emissions and taking strategic investment decisions to decarbonise is key to supporting portfolio companies in their transition.

South Pole provides support to financial institutions of all shapes and sizes on their sustainable finance journey and on measuring and decarbonising their portfolios.

Contact us today
Contact us today

South Pole provides support to financial institutions of all shapes and sizes on their sustainable finance journey and on measuring and decarbonising their portfolios.

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