Investors are getting transparency with new reporting requirements from the International Sustainability Standards Board.
Financial institutions are continuing to finance climate-damaging activities, yet emissions associated with their lending, investments and underwriting – collectively known as financed emissions – are often missing or underreported in sustainability disclosures.
This lack of transparency hinders the ability of prudential supervisors to evaluate progress towards decarbonization or improved climate risk management, undermining efforts to address systemic climate-related financial risks.
Financed emissions are on average over 700 times higher than financial institutions’ direct emissions. Despite widespread net-zero targets, less than a quarter pledged to reduce these emissions as of 2022, according to an S&P Global survey.
Banks have historically been reluctant to report on financed emissions, often citing issues around data quality and complex methodologies. However, the International Sustainability Standards Board’s (ISSB) latest IFRS S2 climate guidance requires disclosure of financed emissions, so the status quo is rapidly changing.
Financed emissions are on average over 700 times higher than financial institutions’ direct emissions.
Increasing disclosure, reducing reputational risk
Research shows that investors are already taking financed emissions into account, as higher financed emissions result in increased equity costs for banks, though robust disclosures can mitigate this effect. According to a Deutsche Bank research brief, demands from investors will only increase as sustainable investing strategies continue to rise.
Amplifying this pressure, various teams are using publicly available data to carry out investigative research in the absence of comprehensive disclosures, creating substantial reputational risk for individual institutions. For instance, Profundo, a Netherlands-based thinktank, conducted an investigation of large Dutch financial institutions and revealed the ING Group was the number one financer of emissions.
Similar research has been conducted in other jurisdictions, including Hong Kong, UK, US, Canada and elsewhere.
Only 23% of bank executives surveyed by International Banking Federation and Deloitte reported having insight into all their financed emissions, which implies the sector is exposed to near-term reputational and transition risks.
Data challenges and potential solutions
Incomplete or unreliable emissions data is often cited as the main challenge in calculating financed emissions.
A climate risk stress conducted by the European Central Bank (ECB) in 2022 found that, due to lack of quality data, over 80% of banks used proxies to estimate financed emissions, leading to high dispersion in reported data. Such estimation models provide inconsistent granularity and threaten the accuracy of resulting calculations. The ECB has now included financed emissions data for corporate banks in its recently updated climate-related statistical indicators.
Financial institutions also often struggle to obtain granular financed emissions data aggregated by sector or asset class, impeding insight into the role of less transparent asset classes like private equity funds. Another issue is the lack of transparency in reporting the gross exposure, absolute emissions or assets under management included within the financed emissions calculation.
Potential solutions to these challenges include regulatory change, harmonized and mandatory reporting standards, and the development of public databases and platforms for sharing emissions data, such as the Net-Zero Data Public Utility.
Incomplete or unreliable emissions data is often cited as the main challenge in calculating financed emissions.
Other suggestions include leveraging technology – such as artificial intelligence, machine learning and big data analytics – to estimate emissions from public data sources, as well as collaborating along the supply chain to improve data quality and transparency.
Regulatory shifts
The current regulatory approach relies on various voluntary disclosure frameworks, such as the Partnership for Carbon Accounting Financials’ (PCAF) financed emissions standard, resulting in a lack of harmonization and consistency.
The Deutsche Bank sustainability research team have said that “regulation will [be] needed to require companies to evaluate their scope 3 emissions to effect real change and approach carbon neutrality.”
The EU’s corporate sustainability reporting directive will soon require financial companies to report estimated scope 3 financed emissions. Meanwhile, the UK and Japan have announced plans to adopt ISSB standards into national law, likely making financed emissions disclosure mandatory.
Although the US Securities and Exchange Commission decided not to include scope 3 financed emissions in its final disclosure rules, many US firms will be directly affected by global regulatory developments. Others risk lagging behind the growing global consensus if they do not disclose.
Regulators are increasingly incorporating financed emissions into prudential risk management frameworks, such as through stress testing exercises. A report by the City University of Hong Kong recommends further prudential integration via reduced reserve requirements for banks meeting reduced financed emissions targets.
As tighter disclosure standards become the norm, any regulatory regime should account for downstream emissions and the possible use of financial intermediaries to obscure emissions.
Methodological advancements
A lack of consistent methodologies has been mentioned by financial institutions and researchers as another key obstacle to widespread and comparable reporting of financed emissions.
The methodological process involves multiple complexities arising from differences between sectors, market volatility, geographic variation, shifting counterparty plans, changing industry standards, and a nascent and rapidly evolving data environment.
While it has improved methodological clarity, the PCAF standard for calculating financed emissions has limitations such as focusing on direct investments, a lack of dynamic modeling, exclusion of forward-looking pathways, and a lack of explicit guidance regarding certain asset classes such as private equity.
A lack of consistent methodologies has been mentioned by financial institutions and researchers as another key obstacle to widespread and comparable reporting of financed emissions.
It also faces accuracy and comparability concerns, relying heavily on self-reported and proxy data and allowing for significant deviation from its methodology. And while the PCAF standard is clear that reporting bodies should disclose methodologies and calculations, in practice there is “very rarely” a reference to the methodologies used to calculate the emissions, according to the ECB.
Various research teams have responded by developing methodological approaches using publicly available data, such as environmentally extended input-output analysis.
Complex network analysis techniques have also been put forward to capture the interconnectedness of emissions financing across the system and identify central institutions propagating emissions. A study using this approach found that financial institutions “play a central role in how carbon emissions are distributed through investment networks”.
This holistic approach can inform targeted mitigation strategies and guard against the risk of high climate-risk industries seeking more finance from financial intermediaries as a form of “emissions laundering”.
Other suggestions include broadening methodological scope to more asset classes, incorporating dynamic data sources and modeling as well as forward-looking assessments.
This article originally appeared on Green Central Banking, a strategic partner of Climate and Capital Media.
