Financed Emissions

Introduction to Financed Emissions

Financed emissions refer to indirect greenhouse gas (GHG) emissions arising from financial services, investments, and lending activities conducted by investors and financial service providers. As a practical example, banks often indirectly contribute to financed emissions by financing fossil fuel companies. Financed emissions are categorized as scope 3, category 15 under the Greenhouse Gas Protocol (GHGP).

The landscape in this space is evolving, especially with the introduction of the International Sustainability Standards Board’s (ISSB’s) IFRS S2 climate guidance and the European Union's European Sustainability Reporting Standard (ESRS). The European Financial Reporting Advisory Group’s (EFRAG) Sustainability Reporting Board (SRB) observed a misalignment between these two new standards concerning financed emissions, as the ISSB explicitly mandates reporting of financed emissions, unlike the ESRS. However, the SRB noted that financed emissions are clearly material for credit institutions, and therefore credit institutions should report on them. It's important to note that many countries and jurisdictions are actively moving towards more comprehensive regulations in this area, so we should expect to see more requirements regarding the disclosure of financed emissions in the near future.

The IFRS S2 climate standard states that “an entity that participates in one or more financial activities associated with: asset management, commercial banking, or insurance shall disclose additional information about the financed emissions associated with those activities as part of the entity’s disclosure of its Scope 3 greenhouse gas emissions” (paragraph B37). Since direct measurements for financed emissions are often unavailable, companies must rely on indirect estimations that are challenging to measure. This article will dive into the different ways these financed emissions can be measured.

Measurement of Financed Emissions

While many banks have publicly committed to achieving net-zero portfolios by 2050, the practical implementation of measuring financed emissions has been undertaken by only a select few. KPMG underscores this by stating that most banks currently do not incorporate financed emissions due to challenges with data collection and the time-intensive process required for effective reporting. Thus, it is crucial for financial institutions to initiate their efforts in this space.

To ensure that the financed emission measurement requirements did not stifle the evolution of industry practices, the ISSB created high level requirements across all financial activities. The financed emissions disclosure requirements include the following for asset management, commercial banking, and insurance activities:^[1]

Asset Management - the disclosure should include the following:

Commercial Banking & Insurance - the disclosure should include the following:

As mentioned before, these measurement requirements are high level, and IFRS S2 does not lay out a step-by-step process for calculating financed emissions. Instead, it only requires that companies disclose “the method of allocation the entity used to attribute its share of emissions in relation to the size of investments.” These high-level measurement requirements offer flexibility and supports industry development. However, the lack of measurement methodology creates complexity and confusion as there is not a universally accepted measuring standard. Thus, different companies use different data sources which makes consistent and transparent measurement challenging.

Partnership for Carbon Accounting Financials (PCAF)

A significant resource for measuring financed emissions that has gained widespread attention is the Partnership for Carbon Accounting Financials (PCAF). PCAF represents an industry-driven initiative with a focused mission to promote consistent measurement and disclosure of financed emissions within the financial sector. As of November 2023, more than 440 financial institutions holding over $94.7 trillion in total assets were subscribed to the PCAF initiative. Prominent institutions such as BlackRock, Morgan Stanley, Deutsch Bank, Barclays, and Bank of America are among the prominent subscribers to the PCAF initiative, underscoring its influence and industry-wide significance.

In response to the industry's demand for a standardized approach to measure and report financed emissions, PCAF has developed The Global GHG Accounting and Reporting Standard for the Financial Industry. This Standard marries deep industry expertise with the rigorous standards of the GHG Protocol.^[2] PCAF aligns with the Carbon Disclosure Project (CDP), the Science Based Targets initiative (SBTi), and the Task Force on Climate-Related Financial Disclosures (TCFD) to enhance reporting efficiency and complement the guidelines of these respective initiatives. The GHG Protocol has assessed the Standard and has confirmed its compliance with the Corporate Value Chain (Scope 3) Accounting and Reporting Standard, for Category 15 investment activities.^[3]

PCAF: Finance Activities (Asset Management and Commercial Banking Activities)

Financed emissions are assigned to financial institutions using consistent accounting principles that are tailored to different asset classes. It should be noted that the PCAF Standard was developed primarily for use by banks and, therefore, has not yet fully addressed the asset management and portfolio context. Guidance is continually being proposed and reevaluated for various asset classes. However, within the Asset Management and Commercial Banking sectors, PCAF currently provides methodological guidance to measure and disclose GHG emissions associated with the following six asset classes:*

Although each of these asset classes are measured differently, PCAF consistently uses an attribution methodology to assign financed emissions for all asset classes. In general, the PCAF emissions attribution methodology is based on a straightforward concept: it calculates emissions by comparing the financial institution's investment in a company to the enterprise value of that company, which includes its debt, equity, and cash. This attribution factor is then applied to that entity’s GHG emissions. The specific calculations for each of these asset classes are depicted below^[4]:

This generally straightforward allocation principle can be difficult to implement in practice. Factors like a company's ownership structure, market price fluctuations, and limited data availability can make it hard for financial institutions to calculate financed emissions. To the extent possible, companies should prioritize the use of precise and direct data. Nevertheless, in cases where direct data is unavailable, estimations may be calculated with activity and sector-level data, along with emissions proxy factors.

Although the scarcity of data presents challenges in calculating financed emissions, the PCAF Standard mitigates this issue by offering guidance on data quality scoring for each segment. The PCAF Standard highlights the quality of the data used so investors are more informed. Emissions reported directly by companies often receive favorable data quality scores because of their specificity and the potential for third-party verification. Conversely, emissions factors based on economic activity are typically considered to have lower data quality, resulting in less favorable scores. These scoring metrics are reported alongside financed emissions and allow reviewers to understand the accuracy of the related financed emission measurements.

Examples

The following examples of disclosures by BlackRock and Morgan Stanley can be found on PCAF's website. PCAF provides these disclosures from its signatories on their website to enhance stakeholder transparency. It is important to note that the incorporation of these disclosures on the website does not imply certification or endorsement by PCAF regarding the alignment level of a disclosure with the PCAF Standard. Nevertheless, considering the novelty of these standards and disclosures, they serve as valuable examples for gaining insight into how companies approach the disclosure of financed emissions in practice.

Asset Management: BlackRock Example

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Measurement Overview

BlackRock acknowledges that the PCAF Standard has been primarily developed for use by banks and, therefore, has not yet fully addressed the asset management and portfolio context. BlackRock referenced PCAF Standard as a starting point for estimating absolute emissions associated with BlackRock’s Assets Under Management (AUM). However, the PCAF Standard does not address all asset classes and BlackRock has made several methodological decisions that are not included in the PCAF Standard.

The GHGP makes a distinction between asset owners and asset managers. It requires asset owners to report emissions linked to their investments, while asset managers are not mandated to report emissions related to their AUM for external clients. However, the GHGP lacks clear guidance on financed emissions reporting for asset managers. This gap in guidance could potentially result in underreporting of emissions, particularly in cases where financial institutions manage investments for themselves and other asset owners.

BlackRock contends that disclosed financed emissions should specifically relate to investments made with assets owned by the company, excluding those managed by an asset manager for external asset owners. Consequently, the disclosed financed emissions pertain to BlackRock's seed and co-investment portfolios, reflecting investments made using BlackRock's own capital.

BlackRock discloses that its reported financed emissions are not comprehensive. The company’s disclosed financed emissions are limited to corporate securities (listed equities, corporate bonds, and associated derivatives) within BlackRock's seed portfolios and co-investments. The data coverage includes approximately 61% of BlackRock's seed and co-investment portfolios and excludes strategic investments, hedge investments, carried interest, as well as seed and co-investment portfolio investments in non-corporate fixed income, commodities, derivatives not linked to corporate issuers, and alternative assets. BlackRock intends to incorporate additional asset classes as data and methodologies become available.

Corporate Securities

BlackRock currently allocates emissions for corporate securities (listed equity, corporate bonds, and associated derivatives) based on the proportion of a company's enterprise value including cash (EVIC) represented by BlackRock's investments on behalf of its clients. This methodology includes considerations for derivatives, short positions, and green bonds. Related to derivatives and short positions, BlackRock chose to report metrics that best approximate economic exposure as this method aligns more closely to how financial metrics are reported. This method includes reporting net exposure to each corporate issuer, incorporating exposure obtained through derivatives. BlackRock also invests in green bonds, which are debt securities designated to finance environmentally friendly projects. BlackRock believes that emissions from qualifying green bonds should not be attributed to the issuer when calculating portfolio emissions. In this regard, only the most environmentally friendly “medium” or “dark” green bonds are considered for exclusion from emissions calculations.

The PCAF Standard, while useful, has limitations, particularly regarding the sensitivity of these metrics to fluctuations in asset values, driven in part by changes in EVIC. Recognizing this, BlackRock collaborated with the PCAF industry working group to develop a methodology addressing the impact of market volatility. BlackRock’s 2021 report presents both unadjusted and adjusted carbon footprint metrics for AUM in corporate securities, illustrating the influence of market value fluctuations on these metrics. It emphasizes the need to consider factors beyond EVIC in understanding changes in absolute emissions and carbon footprint.

Soverigns

BlackRock also uses the metric of Sovereign Emissions Intensity to assess a nation's carbon efficiency and measure emissions related to sovereign bonds. Sovereign emission levels cover all emissions produced within a sovereign territory. The primary challenge tracking sovereign emissions is when companies inadvertently count the pollution from private entities twice, as these emissions are already included when calculating the environmental impact of business investments. To address this issue, the recommendation is to measure and report the pollution from government investments separately. This approach helps prevent the double-counting of the same pollution for specific assets.

While corporate emissions exposure is calculated based on percentage ownership, no analogous ownership concept exists for sovereign nations resulting from investments in sovereign bonds. Consequently, the extent of a sovereign portfolio's exposure to emissions is determined based on average emissions intensity, in contrast to the percentage ownership used for corporate emissions.

In reporting, BlackRock specifically uses GHG intensity per GDP PPP (Purchasing Power Parity), leveraging MSCI data. This metric is aggregated as a weighted average, with weights corresponding to the investment into each sovereign represented by BlackRock's client assets.⁵

Commercial Bank: Morgan Stanley Example

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Measurement

Morgan Stanley's method for measuring financed emissions closely aligns with PCAF's methodology, differing only in minor details. Following PCAF guidelines, Morgan Stanley calculates financed emissions by multiplying an attribution factor with the emissions generated by borrowers. This factor depends on the ratio of the financing amount provided and retained in relation to the enterprise value, including cash. Subsequently, Morgan Stanley normalizes its financed emissions by sector based on the level of financing commitment made to that specific sector. This approach allows Morgan Stanley to manage its financed emissions independently of portfolio size.

This intensity-based approach encourages Morgan Stanley to actively engage with clients on climate transition opportunities rather than solely reducing emissions by withdrawing capital from carbon-intensive sectors. Referred to as the financed emissions lending intensity metric (FELI), this standardized metric is applicable across sectors. The calculation methodology for FELI is as follows:⁶

A notable distinction from the PCAF standard is Morgan Stanley's focus on total lending commitment, representing the maximum amount it is willing to lend to a company across all facilities. In contrast, PCAF utilizes drawn amounts for loans, representing the actual disbursed funds. This distinction arises from the nature of Morgan Stanley's lending, which involves products like revolving loans and line of credit facilities.

Morgan Stanley's leadership contends that effective long-term target management necessitates examining committed amounts, as they mirror the firm's actual decisions to extend credit to a client. In the short term, drawn amounts may fluctuate due to external factors. While drawn amounts are suitable for accounting and reporting financed emissions, they may not align well with business or strategic management objectives. In alignment with its commitment to PCAF, Morgan Stanley has affirmed its intention to report progress on financed emissions using both committed and drawn amounts in its annual climate report. While Morgan Stanley’s approach differs slightly from the PCAF standard, it is still accepted as appropriate by the GHG protocol standard.

Data Quality Scoring

Regarding data quality scoring, Morgan Stanley sources GHG emissions and financial data from various channels, primarily relying on publicly reported client data. In cases requiring market value data, Morgan Stanley turns to exchanges and data aggregation services like Bloomberg or Refinitiv. In instances where public GHG emissions data is not accessible, Morgan Stanley resorts to estimates from S&P Global's GHG emissions model. For companies beyond the model's coverage, additional calculations are conducted. This involves multiplying a company's revenue by the pertinent Global Industry Classification Standard (GICS) subindustry-level GHG emissions per dollar revenue coefficient, provided by S&P Global. Coefficients from PCAF also serve as a reference in this process. This comprehensive methodology underscores Morgan Stanley's dedication to transparent and accurate reporting of its financed emissions.⁷

PCAF: Insurance Activities

PCAF has also developed a methodology for insurance companies to report financed emissions. The guidance provides insured-emissions calculation methods for commercial lines and personal motor insurance. Much like PCAF's guidance on financial financed emissions, its insurance methodology also relies on attribution factors to calculate the insurer's total financed emissions. Emissions linked to insurance will be computed by multiplying a specific attribution factor by the emissions generated by an insured company.

PCAF’s guidance outlines distinct attribution factors for commercial lines and personal motor portfolios. In the case of commercial lines, the attribution factor is derived from the insurance premium in relation to the customer's revenue. For personal motor portfolios, the attribution factor is based on the insurer's revenue from the insured (insurance premium) in relation to the annual expenses associated with vehicle ownership. Please see the toggles below to view the specific formulas for these calculations.^[8]

Formula to Calculate Insurance Commercial Lines Emissions

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Formula to Calculate Insurance Motor Portfolio Emissions

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Data quality is also assessed, scored, and reported for insurance-associated emissions just as it is for financed emissions. These scoring metrics are reported alongside financed emissions and allow reviewers to understand the accuracy of the related financed emission measurements.

Conclusion

Financed emissions reporting is experiencing a transformative shift, marked by evolving standards and regulatory frameworks. The introduction of IFRS S2 and ESRS evidences the importance of measuring and disclosing financed emissions. As these standards gain prominence, a comprehensive regulatory framework becomes imminent. Measuring financed emissions presents challenges, including data complexities and a lack of universal standards, necessitating a more concerted effort from financial institutions. The Partnership for Carbon Accounting Financials (PCAF) has emerged as a key resource, guiding financial institutions toward consistent measurement practices. Its Global GHG Accounting and Reporting Standard reflects a collaborative, credible approach. The journey toward a sustainable financial future hinges on a collective dedication to innovative standardized approaches. As methodologies mature and industry practices evolve, accurate and meaningful reporting remains central to addressing climate-related risks and fostering a low-carbon economy.