The financial institutions sector has long been regarded as pivotal for addressing the global climate crisis by directing private finance toward decarbonizing high-emitting sectors and advancing low-carbon alternatives. One important way that financial institutions can accelerate climate progress is by measuring and working to address – through decarbonization and divestment – financed emissions.
What are financed emissions?
Financed emissions are the greenhouse gas (GHG) emissions associated with the financial activities of institutions such as banks, asset managers, and insurers. Three main types of financed emissions are equity investments, debt investments, and project finance. This article will focus on equity investments specifically. These emissions occur due to the business activities of companies that receive equity investment and form the Scope 1 and 2 emissions of those investees. In addition, the equity investor accounts for these emissions as part of their Scope 3 financed emissions. For example, when an investor makes an equity investment in a company that operates a coal-fired power plant, the emissions from that plant become part of the investor's financed emissions.
The growing focus on financed emissions reflects the financial sector’s influence in shaping the global economy and its emissions. As a result, regulators and stakeholders increasingly demand transparency and accountability from financial institutions regarding their contributions to climate change.
Growing compliance and stakeholder expectations
As pressure from investors, customers, and stakeholders grows, financial institutions are expected to disclose and reduce their financed emissions. Regulatory frameworks can help financial institutions navigate these expectations to align their portfolios with global climate goals. For instance, The Task Force on Climate-related Financial Disclosures (TCFD) provides reporting guidelines, while the Partnership for Carbon Accounting Financials (PCAF) offers measurement protocols.
The challenges of decarbonizing investment portfolios
Decarbonizing investment portfolios presents a complex challenge that demands a strategic approach. Divestment offers a straightforward solution for reducing financed emissions, but it may not be the most effective path forward. Simply withdrawing financial support from high-emitting companies fails to address the underlying operational issues that generated those emissions in the first place, because other investors may buy those companies and continue to operate them without any change to their total emissions. At the same time, investing in low-carbon technologies does not necessarily lead to lower financed emissions, because manufacturing low-carbon technologies like electric vehicles and solar panels leads to Scope 1 and 2 emissions that are reflected in an investor’s financed emissions totals.
Achieving a low-carbon economy therefore involves cutting emissions within portfolio companies through changes to processes, supply chains and facilities, and rethinking business operations across industries like energy and transportation. Immediate financial returns must be balanced with long-term sustainability goals, especially as climate risk increasingly translates to financial risk. Investors must employ proactive strategies, such as carbon accounting and innovative financing, to guide their portfolios toward a sustainable future.
Developing a decarbonization strategy for financed emissions
Decarbonizing portfolio companies’ operations helps align them with sustainability goals, enhances long-term value creation, and mitigates climate risk. The first and most foundational step in this journey is carbon accounting. PCAF offers a standardized framework that enables financial institutions to assess and disclose the greenhouse gas emissions associated with their investments. PCAF provides different calculation options based on data availability from portfolio companies.
Three general carbon accounting methods are leveraged from PCAF guidance: economic activity-based emissions, physical activity-based emissions, and portfolio-level reported emissions.
Economic and physical activity-based emissions use industry averages to estimate emissions. Using estimations is a great starting point, but it has limited actionability since it reflects industry averages and not the actual operations of the portfolio company.
Portfolio-level reported emissions involve calculating a carbon footprint for each portfolio company. This is the most actionable method for a financial institution to understand the emissions associated with their investments.
By accurately measuring and understanding each portfolio company's carbon footprint, investors can identify and prioritize emission reduction opportunities, set actionable targets, and track performance over time.
Identifying actionable targets to reduce financed emissions
Institutional investors and their portfolios need to set actionable, science-aligned targets to reduce financed emissions effectively. This process involves defining actionable steps, such as transitioning to renewable energy sources and adopting low-carbon technologies within a set timeframe. Financial institutions should monitor portfolio companies and adjust decarbonization strategies over time. By setting science-aligned targets and regularly comparing progress across different decarbonization strategies, financial institutions can make informed investment decisions to decarbonize their portfolio.
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Conclusion
Reducing financed emissions presents an opportunity for financial institutions to combat climate change and lead the transition to a low-carbon economy. Here are four actionable steps for your organization to focus on:
Take inventory of your financed emissions to identify the biggest emissions reductions opportunities in your portfolio.
Encourage companies in your portfolio to measure their carbon emissions for more detailed visibility.
Encourage portfolio companies to set and track science-aligned decarbonization targets.
Report on progress and support portfolio companies with resources and advice to integrate climate considerations into their business strategy.
By helping portfolio companies measure emissions and set science-aligned reduction targets rather than simply divesting, financial institutions companies can direct important capital toward accelerating the shift to a low-carbon economy.
Learn more about Carbon Direct for financial services organizations.
