Banks play a dual role. At one end, they finance decarbonisation; at the other, they finance emissions through loans and investments. Thus, financed emissions are the greenhouse gas (GHG) emissions linked to the investment and lending activities of financial institutions like investment managers, banks and insurers. It’s the carbon footprint of a firm’s investments or loans. There are also facilitated emissions that promote GHG emissions through off-balance-sheet financing activities like underwriting, securitisation and advisory services.
The measurement of financed emissions is a fast-moving area and gets accounted for under Scope 3 category 15 of the Greenhouse Gas Protocol. Only a few of the global banks report financed emissions. Even where they do, measurement methodologies and disclosures vary significantly. 131 banks have committed to reducing their financed emissions and joined the Net Zero Banking Alliance. This is a small fraction of the estimated 25,000 banks worldwide. However, it accounts for 40% of global banking assets.
At heart, the accounting for financed emissions is straightforward. Take the case of a bank with only two bonds of equal amounts in its loan portfolio of power utilities. Bond 1 is from a company that produces 2 kg CO2e per kilowatt hour. Bond 2, on the other hand, produces 1 kg CO2e per kilowatt hour. As a result, the bank has financed 1.5 kg ([2+1]/2) CO2e of emissions. For the bank to meet SBTi targets, the emissions within the loan portfolio should decline to 0.75 kg CO2e.
In practice, assessing and setting targets for financed emissions is not simple. It involves multiple complexities arising from differences between sectors, geographic variation, shifting counterparty plans, changing industry standards, and a nascent and rapidly evolving data environment.
Financed emissions pose a significant risk to financial institutions. They pose a reputational risk from stakeholders who take climate issues seriously. Climate-related regulatory changes may impact the profitability of invested companies and pose a credit risk. Banks that finance carbon-emitting businesses may face financial risk if those businesses are held liable for environmental damage or face penalties for non-compliance with environmental regulations.
Financial institutions need to address and manage the risks posed by financed emissions. Regulatory and governance oversight is critical to ensure banks earn a fair risk-adjusted return while managing climate-related risks.
Utkarsh Majmudar 