What are Financed Emissions and how can we reduce them?
When it comes to climate change, we often think about the emissions that come from our own daily activities. But a large portion of emissions come from something called financed emissions.
Financed emissions are the emissions generated when a bank lends or invests in another company. But why are they important? Well, according to a report from the CDP, financed emissions are 700x larger than a bank's direct emissions.
In this blog post, we'll explore what financed emissions are, why they're important, and what we can do to reduce them. We'll also take a look at how the banking industry is responding to the challenge of climate change. Finally, we'll share some lessons learned about what it takes to reduce financed emissions on a global scale.
The importance of financed emissions
So why are financed emissions so important? Well, there are a few reasons.
Financed emissions tend to be much higher than a bank's direct emissions, which would cover the emissions from fuel, electricity and supply chain. However, only half of the financial institutions reporting on their emissions include the CO2 of the companies they lend to and invest in. This means that financed emissions are actually much higher than what is being reported.
Financed emissions are often "locked in" for long periods of time. This is because they're often financed through long-term loans or investments. Even if a company decides to reduce their emissions, it may still be responsible for the financed emissions associated with its past activities, so there's often a lag on Net Zero goals.
How are financed emissions measured?
There are a number of challenges associated with measuring financed emissions, including data availability and complexity. Financed emissions cover two main areas: lending and investments. It's slightly confusing but, within these two categories, there are also two methods for calculating emissions: the average data method, and the investment/lending specific method.
There are advantages and disadvantages to both approaches. The advantage of using the investment/lending specific method is that it's more comprehensive. However, the disadvantage is that it can be more difficult to obtain this data at scale. The advantage of using the average data method is that it's more accessible. However, the disadvantage is that it doesn't always give a complete picture as it's an estimate. Let's look at each method below.
The average data method uses an average emissions intensity factor based on a company's industry and revenue. It's a simple and quick way to measure financed emissions but isn't as accurate as company specific methods. In a simplified form, this calculation would be:
Total company revenue x Industry emissions factor (kgCO2e/£ revenue) x % of total debt/equity
The lending-specific method relies on actual project or company emissions data. For example, if you were lending to a company that was using the capital to build a specific project, you would need a figure for the total emissions of the project along with the total costs. Then you would work out your share of the emissions based on this:
Scope 1 and scope 2 emissions of the project x your share of total project costs (%)
The calculation for investments is similar to lending but slightly easier. When you invest in a company for an equity stake you are essentially 'owning' a percentage of that company. Therefore, you would own a percentage of their emissions:
Total company revenue x Industry emissions factor (kgCO2e/£ revenue) x % of total equity
For the investment-specific method, you are relying on the actual emissions data for the entire company:
Scope 1 and scope 2 emissions of the company x your share of equity (%)
No matter which approach you use, measuring financed emissions can be complex. However, it's important to remember that financed emissions are a significant source of greenhouse gas emissions. Whichever approach allows you to get started on measuring and reducing financed emissions is the best one for you.
What regulation is focused on financed emissions?
There are a number of regulations focused on financed emissions, including the Task Force on Climate-related Financial Disclosures (TCFD), the Sustainable Finance Disclosure Regulation (SFDR), and the Climate Risk Financial Disclosure Regulation (CRFD).
The TCFD was set up by the G20 in 2015 in order to improve climate-related financial disclosures. It's focused on four main areas: governance, risk management, metrics and targets, and disclosure. The TCFD recommendations are voluntary, but many banks and investors are starting to disclose climate-related risks in line with them.
The SFDR is a European Union regulation that requires companies to disclose how they integrate sustainability risks into their investment decision-making processes. It also introduces a new classification system for sustainable investments, which will help investors to understand the different types of products available.
The European Union's Corporate Sustainability Reporting Directive (CSRD) will define the minimum standards by which almost 50,000 EU firms will report their climate and environmental impact. The CSRD, proposed by the European Commission in April 2021, would replace and build on the Non-Financial Reporting Directive (NFRD), adding more detailed reporting requirements and widening the scope of companies that must comply.
All of these regulations are focused on improving disclosure around financed emissions, in order to help investors to make more informed decisions.
What are the benefits of reducing financed emissions?
There are a few key benefits of reducing financed emissions. First, it can help companies avoid stranded assets. This is when an asset becomes worthless because of changes in technology, regulation, or market conditions. For example, if a company has financed a coal mine that can no longer operate because of new environmental regulations, then that loan could become a stranded asset.
Second, reducing financed emissions can help companies manage their climate risks. This is because financed emissions are often hidden or unaccounted for. By disclosing and managing financed emissions, companies can get ahead of any potential risks.
Finally, reducing financed emissions can help companies build trust with their stakeholders. This is because it shows that companies are taking climate risks seriously and are committed to managing them in a responsible way.
How can banks reduce their financed emissions?
There are four strategies that banks can incorporate into their business in order to measure, track and reduce their financed emissions.
- Set a target for emissions reduction
- Increase transparency around financed emissions
- Financing renewable energy projects
- Working with clients to reduce their emissions
Set a target for emissions reduction
Carbon reduction targets are goals that banks can set to reduce the emissions associated with their loans and investments. For example, a bank might set a target to reduce the emissions associated with its loans and investments by 50% by 2030. There are a few different types of carbon reduction targets:
- Absolute targets: These are targets that set a specific emissions reduction goal.
- Relative targets: These are targets that set a goal to reduce emissions relative to a baseline.
- Intensity targets: These are targets that set a goal to reduce emissions per unit of output.
Increase transparency around financed emissions
To increase the transparency of a bank's financed emissions you need to first measure the emissions of your portfolio. Carbon accounting tools help banks to understand the emissions associated with their loans and investments (what we help with at Dodo - book a demo to hear more!) These tools can be used to assess the emissions of a company's activities, set targets for emissions reductions, and track a company's progress in reducing its emissions.
Financing renewable energy projects
To reduce financed emissions, banks will need to reduce the financing they advance to emission-intensive sectors. Instead, banks can finance companies that are focusing on renewable energy, energy efficiency, and electric vehicles.
For example, Goldman Sachs pledged $750 billion for environmental causes, JPMorgan Chase has set a 10-year target of over $1 trillion in green investments, and Virgin Money have set a £200m green loan to help farmers decarbonise their farms.
Working with clients to reduce their emissions
Banks can also help their clients to develop strategies that will help them reach Net Zero. This might involve working with a company to set targets for emissions reductions or helping a company to disclose its emissions. One example of this is with Sustainability Linked Loans. A sustainability-linked loan is a loan where the interest rate is linked to the borrower's progress in reducing their emissions.
For example, let's say that Company XYZ takes out a $1 million loan from Bank ABC. The terms of the loan might state that the interest rate will be 1% lower for every 1% reduction in emissions that Company XYZ achieves. This gives Company XYZ an incentive to reduce its emissions because it will save money on interest payments.
Sustainability-linked loans are a way for banks to finance emissions reductions. By linking the interest rate to the borrower's progress in reducing their emissions, banks can incentivise borrowers to take action on climate change. (See our guide on finding green funding for your business here)
When it comes to climate change, we need to take action on all fronts. That includes reducing the emissions generated when banks lend or invest money to other companies.
While this may seem like a small part of the problem, it actually accounts for a significant portion of greenhouse gases. And unless we take action to reduce financed emissions, we're unlikely to meet our goals for combatting climate change.
In addition, we need to create incentives for banks to finance low-carbon projects. This can be done through government policies and regulations, as well as through private initiatives such as sustainability-linked loans.
The banking industry is starting to take action on climate change. A number of banks have committed to reducing their financed emissions, and some are even divesting from fossil fuel companies.
But there's still a long way to go. If we're going to meet our climate goals, we need to do more to reduce financed emissions.