Recent 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. Matt Sprague, Associate Director for Climate Strategies (Australia), explains the climate journey for financial institutions to understand and tackle their scope 3 emissions.
As corporates and governments set more ambitious climate goals ahead of COP26, focus is also turning to scope 3 emissions from supply chains and lending/investment portfolios.
For financial institutions such as banks, insurance companies and investment managers, scope 3 emissions are mostly 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 providing a way to measure these emissions.
CDP recently 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 were recently found to be greater than those of Germany, and 1.8 times higher than the UK's own greenhouse gas emissions (excluding aviation and shipping). While financial organisations have a major role to play in the decarbonisation of the global economy, it is estimated that the 60 largest banks have invested $3.8 trillion USD in fossil fuels since the Paris Agreement in 2015. Therefore much more needs to be done to pivot towards more sustainable investment and lending practices.
Change is already underway within the fossil fuel industry with recent developments in the Netherlands, United States and Australia. At the same time, Climate Action 100+, for example, is a group of over 570 investors engaging with large organisations to support decarbonisation, while further influence from investment groups is expected as more focus is placed on their emissions and climate impacts.
For some organisations, scope 3 emissions are simple to calculate, understand and reduce, such as business flights and waste. For other organisations these emissions are complex, highly material to the overall emissions profile and form a major part of their revenue stream. This is the case for financial organisations that may invest/lend to multiple asset classes. The PCAF standard includes six categories: listed equity and corporate bonds, business loans and unlisted equity, project finance, commercial real estate, home mortgages and motor vehicles loans. 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. A financial organisation should consider the footprint (currently only scope 1 and 2, but potentially scope 3 in future) of its financial portfolios to fully understand the impacts for the companies it holds.
Those organisations that have not considered these emissions sources are at risk of misunderstanding the risks to their business.
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. Currently, 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)).
Source: Mining Journal
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:
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 share is then prorated based on their equity or debt investment. 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 SBTi recently published guidelines for setting science-based targets for the financial sector that requires the inclusion of financed emissions. The guidelines show that there is a range of decarbonisation actions depending on the specific lending/investment portfolio. This is a clear statement that financed emissions, and the financial sector, have a major part to play in a decarbonised economy. Financial institutions should calculate their emissions reduction targets in line with the SBTi guidance to ensure they are aligned with the Paris goals. To date, 77 financial companies have committed to setting SBTs. South Pole can help you navigate the process of setting and implementing such a commitment.
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. Using the SBTi guidance for financial institutions, financial institutions will be able to take advantage of the investment opportunities, while reducing their exposure to climate risks.
When developing an investment decarbonisation approach, institutions must consider both a "just transition" where no-one is left behind in the decarbonised economy as well as short term return on investment and reducing warming to below 1.5C.
Change investment mix
A strong decarbonisation strategy may see a blended approach between divesting assets such as thermal coal and then working with other portfolio companies to decarbonise. Thermal coal is widely accepted as an industry with no long-term future and a readily available alternative, namely renewable energy. The other fossil fuels do not have clear alternatives at present, so working with these companies to identify opportunities to invest in new energy sources (e.g. renewable energy or green hydrogen), business models and risk profiles may be a sensible approach.
For each asset class and portfolio, the approach may be different, and it will also depend on the interest of stakeholders and their sustainability objectives.
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 (thermal coal divestment by 2030). 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 typically limit their statements to thermal coal lending. The Powering Past Coal Alliance is a group of 51 organisations and 74 national and sub-national governments looking to accelerate the transition to clean energy away from coal.
A recent report by the Investor Group on Climate Change found that $63b of opportunities would be created if Australia strengthened its climate targets. For investors, financial institutions and asset managers, this presents a significant opportunity through strategic portfolio alignment and investment.
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.
Financing of 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 toward low-carbon or are already meeting these objectives. Supporting “green" and credibly "transitioning" companies to grow 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 in identifying suitable opportunities.
Financial organisations should communicate to the marketplace and stakeholders through established frameworks such as the TCFD. This critical step - disclosing the climate impact of your investments and lending - supports 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 New Zealand by 2023. 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 the measurement and decarbonisation of portfolios.
Contact South Pole's expert consultants to discuss your ambitions.