Article Summary:

The difficulties in measuring portfolio performance with a dearth of climate data and misaligned methodologies

The direct carbon footprint of financial institution is small, it only covers the energy needed to keep the light and computers on. However, this doesn’t include the GHG emissions being funded by institutions through their lending and investment portfolios. These types of emission can be 1,000 higher that a firm’s operational footprint.

Pressure from clients and campaigners to reduce the impact of funded emissions in increasing, along with reputational and regulatory risks. Specific investments could be invalided by environmental regulations. Some big names in banking and significant asset management player are already taking aim at net-zero targets for funded emissions, either by divesting or through engagement with polluting clients.

But firms have their work cut out: measuring the emissions funded by a portfolio of loans and investments is extremely difficult. Three main methodologies have emerged, each with its own limitations.

Ways of Measuring Funded Emissions

First is to try to measure the carbon footprint of a portfolio, for example through the work of the Partnership for Carbon Accounting Financials (PCAF). But there are notable data gaps: smaller firms do not disclose their footprints, and practitioners must often fall back on sector averages. Double-counting is also an issue, making precise accounting unattainable. Furthermore, allocating emission to investor requires further methodological choices. The PCAF uses enterprise value (equity + debt) as a driver. However, the enterprise value can change according the growth of the company or its debt profile. This affects the lender’s carbon footprint even though emissions remain constant.

Second is to determine how aligned the portfolio is to the Paris agreement (i.e. keeping warning under 2˚C compared to pre-industrial levels). This approach is supported by the 2 Degree Investment Initiative (2DII) think tank who assesses whether a company’s assets and products will meet the Paris objectives. However, the universe of company being considered does not cover all asset classes.

Third is to give the portfolio a temperature rating. This rating aims to capture how much the Earth would heat up if the global economy has the same carbon intensity as a given portfolio. Scientific consensus is that we are on track to experience warming of 3 to 4˚C, which aligns to the portfolio-level estimations that firms have calculated. However, this rating is highly sensitive to the methodology being applied and over a dozen different ones are available. Some consider the emission from the entire supply chain, some do not. Some assumed that company would meet their Paris agreement target, other make no such assumption. Different approaches can produce wide score ranges, from 1.5 to 4˚C.

Pressure from Above

Measurement and methodology disciple may end up being prescribed. Regulators are understandably concerned about the systemic risk faced by the financial sector from climate risk. This can only be measured and mitigated through quantitative disclosure of financed emissions. The impact of GHG emission in a portfolio is the basis of the global warming stress tests being concocted by major national and regional regulators. As climate-risk disclosure become mandatory, so will the publication of finance emissions. Unfortunately, financial firms hitting their financed emission targets may not necessarily be an ends in and of itself. Polluting firm may find other means to fund their emissions. But firms with zero-carbon portfolio may be attractive to clients, but will not by themselves save the planet.

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