What are financed emissions and how to effectively measure them?

In this short guide, we consider the new imperatives for accurately measuring and reporting on climate risk across lender portfolios, and how quality data can help lenders get a clear view of their financed emissions. In particular, we look at how these kinds of solutions can help to fill data gaps for SME customers, supporting better lending decisions and initiatives to decarbonise portfolios over time.

What are financed emissions?

Financed emissions are the downstream carbon emissions that commercial lending finances. While lenders have, until recently, focused on scope 1 and 2 emissions, meaning emissions directly related to their operations and processes, and to the purchasing of energy from third parties, this is no longer enough. They also need to accurately report on Greenhouse Gas (GHG) emitted from any organisation that they finance – in whole or in part – either through credit products or investments. This, along with other emissions from their value chain, is known as scope 3 emissions.

Measuring financed emissions is important for financial institutions for three key reasons¹:

1. It’s critical for those businesses that wish to improve their climate reporting and measure their downstream environment impact
2. It provides useful information that can be used to identify and manage climate-related transition risks and opportunities
3. It’s an important part of the process for banks and investors when aligning their portfolios with their Net Zero Ambitions (from measuring emissions, setting science-based targets through to implementing concrete actions)

For those financial institutions who want to improve their climate reporting, the measurement of financial emissions is critical. The measurement and reporting of this information will help the financial institution to understand the climate impact of their investment, underwriting and lending activities. But fully understanding emissions in the supply chain, as well as ‘financed emissions’ from customers is not an easy task. This is especially true where lenders serve a large number of small and medium businesses for whom there is a known data gap on carbon emissions and environmental impact information.

However, there are major benefits for businesses who can calculate and report their financed emissions beyond regulatory compliance. It becomes possible, for example, to implement initiatives to reduce portfolio emissions over time, either by helping SME customers to reduce their own emissions, or by prioritising sustainability linked products and services.

How to calculate financed emissions

In response to industry demand for a global, standardised GHG accounting and reporting approach, The Partnership for Carbon Accounting Financials (PCAF) developed the Global GHG Accounting and Reporting Standard² for the financial industry, with a focus on measuring and reporting financed emissions. As an industry-led partnership, PCAF are widely seen as the standard for the calculation of financed emissions. Due to the global expansion of PCAF over the last few years, financial institutions across the world are able to consistently measure and disclose the greenhouse gas (GHG) emissions of their financial activities.

The measurement of financed emissions will vary dependent on the asset class or in other words, the type of financing provided by the financial services institution. The guidance provided by PCAF³ covers the following asset types:

• Listed equity and corporate bonds – this asset class includes all on-balance sheet listed corporate bonds and all on-balance sheet listed equity that are traded on a market and are for general corporate purposes
• Business loans and unlisted equity – this asset class comprises business loans and equity investments in private companies, also referred to as unlisted equity
• Project finance – this asset class includes all on-balance sheet loans or equities to projects or activities that are designated for specific purposes
• Commercial real estate – this asset class includes on-balance sheet loans for specific corporate purposes, such as the purchase and refinance of commercial real estate (CRE), and on-balance sheet investments in CRE when the financial institution has no operational control over the property
• Mortgages – this asset class includes on-balance sheet loans for specific consumer purposes – namely the purchase and refinance of residential property, including individual homes and multi-family housing with a small number of units
• Motor vehicle loans – this asset class refers to on-balance sheet loans and lines of credit to businesses and consumers for specific (corporate or consumer) purposes – namely the finance one or several motor vehicles
• Sovereign debt – this asset class includes sovereign bonds and sovereign loans of all maturities issued in domestic or foreign currencies

For each of these asset types, the PCAF Financed Emissions Standard provides guidance on how to calculate the financed emissions from activities financed through lending and investment portfolios. The use of this methodology can help financial institutions to measure GHG emissions for each asset class and to disclose information that is clear and consistent.

PCAF acknowledge that the lack of data can be the fundamental challenge when calculating financed emissions. Whilst this is a challenge, this shouldn’t prevent a financial services institution from commencing their GHG accounting journey. It’s important that financial institutions use the highest quality of data available for the specific asset class and they should be continuously improving the quality of their data over time.

Given that two-thirds of corporate emissions come from SMEs, better SME data is key to effective financed emissions reporting. In many cases, lenders may not know which sector a SME customer or prospect operates in or may not even have access to accurate contact details for the customer, making any attempt to understand their ESG status even more difficult.

To accurately measure, report on, and mitigate climate risk, therefore, better and more trusted data is needed on SME customers’ Environmental, Social and Governance (ESG) profiles, including detailed information on their GHG emissions.

The good news for lenders is that we’re able to help by providing readily accessible data delivering an ESG and GHG emissions profile for every SME in their portfolio. This data allows lenders to calculate, manage and report on their downstream customer emissions levels, both accurately and at speed.

This all helps to fill the SME ‘data gap’ and ensures that businesses can begin to not only report effectively on financed emissions, but also take positive actions to reduce overall climate risks. For example, it also becomes possible to adjust policies to reduce financed emissions in the future, and to favour credit products that are sustainable – such as green financing.

What are the challenges with measuring financed emissions?

Understanding that they need to plug the data gap, many lenders have implemented strategies for collecting ESG performance data on their SME customers. Two examples are:

The use of ‘sector proxies’ to calculate financed emissions
One way to calculate emissions and ESG performance for a particular SME customer is by using information about another, similar business with the same core activity and sector of operations – sometimes known as a “sector proxy”. However, our research shows that this approach to assessing ESG performance typically results in an over-estimation of SME emissions of around 200%, introducing correlated inaccuracies into financed emissions calculation.

Manual data collection processes
An alternative approach to understand climate risk across the portfolio is to ask individual SME customers to provide information about their ESG status and carbon emissions. For institutions with large numbers of SME customers, however, this is impractical, or even impossible, from a staffing and cost perspective. Additionally, SMEs typically have little or no experience in terms of providing this kind of information, or they may have a vested interest in playing down or exaggerating certain information, potentially leading to inaccuracies and errors that jeopardise the accuracy of climate-risk assessments.

The better way to optimise climate risk reporting

To ensure that lenders can report accurately and efficiently on climate risk and bring trust to their carbon accounting, comprehensive, high-quality data is needed on individual SMEs’ ESG status and greenhouse gas emissions – rather than simply using sector proxies. Additionally, advanced analytics models are required to make sense of the data, and to assess specific SMEs’ ESG profiles when compared to the underlying UK market.

What are the key benefits of effective ESG data for climate risk reporting?

Effective climate risk reporting of this nature provides a wide range of benefits for organisations.

1. Achieve compliance with climate risk disclosure regulations

   The use of effective ESG data enables lenders to understand SMEs’ activities and likely emissions in an auditable way. Ultimately, enabling them to meet their compliance objectives more easily and efficiently

2. Benchmark portfolio-wide climate risk and chart progress on decarbonisation

   Using rich SME data, climate risk can be benchmarked on a portfolio level. It becomes possible, for example, to understand climate-related risk by product or by product type, as well as to chart how risk increases or decreases over time. Institutions can also assess their credit risk compared with the underlying SME market in the UK, allowing them to assess ESG performance for different products or to understand how newly acquired customers compare to established customers in terms of financed emissions

3. Implement measures to reduce climate risk

   With a trusted view of climate risk, institutions can redefine policy rules to reduce lending to SMEs with unsatisfactory ESG profiles, allowing them to reduce climate risk over time. Additionally, lending can be increased for customers with specific green-finance needs, and sustainability linked loans can also be introduced or increased to reduce overall portfolio climate risk

How can we help?

To help lenders to measure and report on climate risk and financed emissions across their portfolios, we’ve created ESG Insight. This combines rich data on UK SMEs (including 97% of all limited and non-limited companies) with a stable, repeatable, robust methodology for assessing financed emissions by customer, and across the entire portfolio.

ESG Insight provides a number of key benefits for lenders:

1. Major time and cost savings

   Reduced manual data collection effort and costs during the financed emissions reporting process

2. Increased trust in financed emissions assessments and carbon accounting

   This is due to our diverse and trusted data sources, the ability to cross-reference SME data with published UK government emissions data, and the allocation of PCAF data quality scores for each SME ESG profile

3. Actionable insights for decarbonisation

   This is based on the ability to fully understand emissions across the portfolio, including the distribution of emissions across the portfolio and likely per-customer financed emissions, supporting decarbonisation and net zero goals

4. Reduced ‘climate transition risks’

   This is based on the ability to support energy intensive companies and others with large carbon footprints and to help them transition to more sustainable operational practices

5. Prioritisation of sustainability linked products

   This also includes the ability to actively target customers with green financing needs